Life does happen. For many, the passage of time seems to accelerate as the years go by. In retrospect, the interval between the first day on the job and retirement may seem to have occurred at light speed.
Although retirement may appear distant to the young person entering the world of work, it is never too early to begin planning for the event. The reality for many is that they arrive at the end of their careers ill prepared financially. Taking stock in one’s situation and consulting an investment professional pays dividends, literally and figuratively. Since 1991, Mike Brown, a senior vice president with Morgan Keegan & Company, Inc., in Chattanooga, has seen the best of times and what could be described as some very challenging times. While the market may fluctuate, the long-term benefits of investing wisely become readily apparent.
“I have seen those super fantastic times from 1995 to 2000, and then the longest downturn and most severe period from March of 2000 to October of 2002,” remembered Brown. “That was the deepest and most painful period. Then, with the exception of a few blips, things have been truly euphoric during the last four years. Back in 1994, we had a flat market which people had not seen for a while, and although I wasn’t in the middle of it, I remember 1987 when Black Friday hit. Really, that was nothing but a blip. It was brief and short lived compared to the 2000-2002 downturn.”
Brown says that daily swings in the market may not necessarily be as significant today, with the Dow Jones Industrial Average above the 12,000 mark. In the current environment, a decline of 120 points equates to one percent or so. However, in the early 1990s when the Dow hovered at 3100, an increase or decrease of the same number of points was nearly four percent of the index value.
Through it all, preparing for the day of retirement is a necessary step in life’s planning which just about everyone must undertake. Brown is very frank when it comes to discussing common mistakes and lost opportunities in investing.
“The biggest mistake I see people making in their retirement planning is that they don’t prepare sufficiently,” he related. “They just don’t give it enough time. It is a sad commentary that the time I talk to most people about their retirement is when it is time to fill out a rollover packet -- and that is a crying shame. We are living in a different society today, and young people do have a multitude of financial obligations, whether they are buying a house, an automobile, or paying for college or children. For me, a guy at 53 years old, my first Social Security check is nine years away. I graduated from high school in 1972, and I remember it like it was yesterday.
Sometimes it isn’t palatable to get a handle on family expenditures and cut back,” he continued. “People don’t want to hear it, but it is a fact. They can get very comfortable driving fine cars and living in big houses. They do need to maximize contributions to their retirement plan from their employer and pay attention to how the money is invested. If they qualify to invest in a Roth IRA, they should do that. Then, they should make contributions to variable annuity contracts shielding growth from current taxation.”
A simple exercise underscores the stark reality of just what an individual can expect at the conclusion of his or her working life. A sum of $1 million should produce a five percent retirement distribution for an individual upon retirement. Therefore, the annual income from that million would be $50,000. Thus, the question arises as to whether the individual can live on $50,000 per year, and perhaps more pressing, whether that person has the million. Factoring in historical rates of inflation, which have hovered between 2.75 percent and 4.50 percent during the last decade, clouds the issue to an extent.
Twin strategies, maximizing return and minimizing the tax bite, serve as guiding principles when considering investment options. To potentially reduce current tax liability, an individual may wish to consider maximizing contributions and catch-up contributions to employer sponsored retirement plans or replacing taxable earned interest and dividends with tax-free interest and dividends. If borrowing is necessary, consider a home equity line of credit so that interest payments may be deductible on the federal income tax return.
Investing for retirement and minimizing tax liability at the same time is a definite challenge. In reality, it is virtually impossible to save oneself into financial prosperity due to the impact of inflation and taxes which continually erode the value of the dollar. However, some investment opportunities may allow the individual to maximize growth and reduce personal tax liability. Consider the establishment of an emergency cash reserve equal to three to 12 months of the funds required to sustain all financial obligations. Again, contribute the maximum allowable to employer sponsored retirement programs. If eligible, consider an annual contribution to a Roth IRA, consider lump sum payments or systematic contributions to variable annuity contracts, and take a look at variable universal life insurance policies.
Investments in equity/stock mutual funds are taxable if owned outside an IRA. In fact, such equities are taxed in two ways. Annually, a fund will generate capital gain and dividend distributions, which both create taxable events. If sold, the owner is responsible for taxes on the short-term or long-term capital gain if the value has increased. Mutual funds do have a special place in an investment portfolio. Some are more tax efficient than others, but if owned outside a tax sheltered account, they do create tax liability.
Municipal bonds may be an investment option to reduce tax liability, but these are best suited for individuals in higher marginal tax brackets. Interest earned from municipal bonds is usually paid every six months and free from both state and federal taxation if the owner resides in the state of the issuer. When making a decision on the purchase of municipal bonds, the credit rating of the issuer and the marginal tax bracket of the purchaser are key elements in the process.
Variable and fixed annuities may reduce tax obligations; however, it is important to note that these are distinctly different types of investments. They are also complex and misunderstood. While the purchase of an annuity may be an excellent decision, this does not provide tax relief. After all, annuities are purchased with after-tax money. Growth in either a fixed or variable annuity accumulates tax-deferred rather than a tax-free basis. A frank, detailed discussion should take place between the seller and purchaser of any annuity. These may be excellent investments, but it is critical to understand the suitability, credit quality, and fee structure of the annuity.
Contributions to employer sponsored retirement plans may be affected in the event of a job change. While the individual’s contributions always belong to them, contributions made by employers are generally subject to a vesting schedule. Once an individual is 100 percent vested, the contributions made by the employer belong to the individual as well. Rollovers and lump sum distributions must be handled with care to avoid unnecessary taxes or penalties.
“The thing I am interested in at retirement is creating realistic monthly income stream vs. monthly expenses.” Brown commented. “The process of evaluating a person’s financial position is simple. Unfortunately, sometimes people leave disappointed because they are behind the yield curve. If they don’t find out about their situation now, they could be in a difficult position in their late 50s. Usually, I am seeing that once someone retires from their primary vocation they are going to take a respite for a while and then come back into the workforce in an area they love and enjoy. However, many people may be forced into employment as an income supplement, ending up with a minimum wage job because they remove themselves from the job market to long and minimum wage positions are the only things available to them.”
One word of advice Brown offers is to seek the input of individuals in specific areas of expertise. Acknowledging that his forte is in investing money for people based upon specific financial goals and objectives, he reasons that some professionals overlap into numerous areas, including banking or accounting. For advice in areas which are complementary to investing, he refers clients to contacts in those fields. In the best interest of the client, he asserts, he does not intend to be all things to all people.
“I encourage people to plan well ahead for retirement and to be as tax efficient with their investing as they possibly can,” he related. “Don’t put it off until it is too late. I would also encourage people to ask for references in my industry and among CPAs, estate planning attorneys, and bankers. Quality individuals are happy to provide references because we simply cannot go around patting ourselves on the back all the time. If you have done a good job, others will pat you on the back.”
Planning for retirement efficiently and effectively helps to ensure that the standard of living to which an individual is accustomed may be maintained. Perhaps of greater importance is the fact that it also provides peace of mind.
Mike Brown is a Financial Advisor with Morgan Keegan & Company, Inc. Securities and insurance products offered through Morgan Keegan are not FDIC insured, may lose value and are not bank guaranteed.