You might think that retirement planning is what you do while you are working, and it stops once you retire. Nothing could be further from the truth. Managing your investments is even more important once you are no longer actively contributing, as you can’t simply keep working to overcome any issues. The investment process not only includes what to invest in, but also what to sell when you need to access the funds. There are many considerations for this next phase that require a different approach.
Maintaining a consistent and comfortable lifestyle in retirement does not necessarily depend on having a certain amount of money set aside, but instead relies on the ability to generate a particular income. That income can come from many sources, including withdrawals from retirement accounts. In order to begin planning for what type of investments you should consider, you first need to put together a plan for when those investments will be needed. You can see my article on constructing an income plan, and that plan is the first step in the investment process.
Income planning will help reinforce the idea that a federal annuity is one of the most significant assets most federal employees will have, and contributes greatly to ongoing income. Social Security is also a significant income source for FERS employees, and figuring out the best strategy for maximizing this benefit is also important (see Maximizing Social Security for Retirement). There are also many other potential income sources to factor in, such as rental income, part time work, inheritances, etc. These will all affect the timing for when your retirement funds are needed.
Once an income plan is put together, you can use the resulting timeframe for utilizing the funds as the basis for investment decisions. The money that will be needed in the next few years should be much more conservative than the money that won’t be needed for a decade or longer. A more detailed look into this process can be found in my article, The Tiered Approach to Retirement Income For The Federal Employee. Once you have used an income plan to develop a general idea of the appropriate allocations, you can then look more closely at specific strategies to make the most of the investments themselves.
Once you have determined an appropriate risk level for a portion of your overall investment allocation, you will want to make sure that those investments stay consistent with the initial goals. Over time, it is possible for higher returns by some investments and lower returns by others to shift the allocation significantly away from the intended target. Imagine an account with 50% in stocks (C fund in TSP) and 50% in bonds (F fund in TSP), where the stock portion goes up 20% and the bond portion stays flat. Your net allocation at the end would be 55% stocks and 45% bonds. This is called “drift”, and can be minimized by regularly rebalancing back to the original allocation.
Rebalancing regularly can also raise your overall returns, in addition to keeping the risk level consistent. As one portion outperforms (stocks in the prior example), they would be sold and the underperforming investments bought to even out the allocation. This has the effect of selling one investment while it is up, and buying another at what should be a relative discount.
A trip to the financial section of any bookstore will give you access to more investment strategies than you could ever put into action. Some of these have stood the test of time (buy and hold a diversified portfolio), and others are newer but show promise in some market conditions. Unfortunately, there is no strategy that always outperforms all others.
Much like a good mutual fund attempts to diversify its holdings into different stocks, it is also possible to diversify your overall portfolio with different strategies. One core portion of your allocation can stay fixed in a buy and hold model, while other portions can be managed in more active styles. Each strategy may perform better in different market conditions, but the overall portfolio returns may be smoothed out when all strategies are combined. Taking the concept a step further, you can even utilize the rebalancing concept between strategies themselves, not just individual funds.
A typical investment portfolio, whether in the TSP or in other investment accounts, will consist of various stock and bond funds and sometimes individual stocks or bonds. As an account grows, however, a higher degree of diversification and sophistication becomes possible. Some alternative types of investments are only truly appropriate to those with larger accounts who also don’t need access to a portion of their funds for some time. In those cases, other investment options can help provide both increased stability and potential returns. Some of those options include:
- Commodities – Commodities can include many things, including oil and energy products, gold and precious metals, agricultural products, etc. Investments in these areas can be very volatile, but also have the potential for additional diversification and returns. Depending on your risk tolerance, it may make sense to allocate a small portion of your portfolio to commodities investments.
- Real Estate – Real estate investments are often income producing, and are subject to valuations that don’t necessarily correlate to the market as a whole. They can also provide good diversification for a small portion of a portfolio.
- Illiquid Investments – There is a wide variety of investment options that are illiquid, meaning the funds are tied up for a length of time and not accessible. Those could include real estate investments, energy investments, corporate financing, and others. There is often a premium paid in exchange for the lack of liquidity, and they can provide a stabilizing influence along with potentially good returns. These can be more complicated, however, and should only be considered for those with significant assets and under the advice of someone familiar with the programs.
Many retirement accounts, including TSP, 401k’s, and IRA’s are tax-deferred accounts. Taxes were not paid on the contributions, but will be paid at the time of withdrawal. There are also Roth versions of these same account types, which were taxed on the contributions and all eligible retirement withdrawals are tax-free. The taxes on the investment earnings are then determined by the type of account rather than the investment itself.
For investments in taxable accounts (not a designated retirement account), taxation is determined by the type of investment itself. The interest income paid by a bond or bond fund, for example, is taxed at ordinary income tax rates. Capital gains, however, can either be short term (taxed at income tax rates) or long term (taxed at lower long term capital gains tax rates). There are also other categories, such as municipal bonds, where the interest income is typically tax-free.
It is very important in taxable accounts to pay attention to what type of investments are being held, and what the tax implications would be if they were sold to generate income. In an optimized portfolio, the actual allocation can vary significantly between different account types to manage the tax burden.
In addition to managing the taxation within a taxable account, it is also important to consider the effects of multiple account types. Here are a few simple strategies that might make sense, depending on the situation:
- Keep investments that pay out interest income in a tax-deferred account, such as an IRA or TSP. Any withdrawal from those accounts will be taxed at income tax rates anyway, so there is no opportunity for lowering the rate.
- Municipal bonds or other potentially tax-free investments should be in taxable accounts. In tax-deferred or Roth accounts, the tax benefit is not realized.
- The most aggressive investments are often advantageous to hold in Roth accounts, since any higher return that may be earned will typically end up not being taxed at all.
- Strive for paying long-term capital gains rates on taxable accounts whenever possible. This may include selecting fund types that do not usually incur significant short term gains.
- When planning withdrawals, utilize tax deferred accounts while in a lower tax bracket. As you move up to a higher bracket, consider other sources to avoid the higher rate.
- If needed withdrawals do not fully utilize all of a lower tax bracket, consider doing Roth conversions, moving money from a tax-deferred account to a Roth account and paying the associated taxes. You then “lock in” that lower tax rate, and future earnings are tax free. This strategy can be utilized in any year with a lower than normal income.
The final piece of the puzzle, once you know how much money you need to withdraw, is figuring out what investments you should sell to generate the funds. You can use the tiered concept to select which portion of the overall portfolio makes sense. From there, liquidation can serve to rebalance that portion each time it is done. In a taxable account, extra attention should be paid to the unrealized gain or loss and how long the fund has been held. By putting together a cohesive strategy, you can shift more earnings to the long-term capital gains rate and even offset some by selectively realizing losses.
It is important to remember that tax rules are complex and change frequently. You should consult a financial expert and tax advisor about your own unique situation in order to avoid potentially costly mistakes.