GPSOLO October - November 2008
Remedies for Resolving Your Retirement
It is time to treat yourself like your most important client and begin to construct a framework for turning your retirement dreams into a realistic retirement lifestyle. As a lawyer, you spend your days advocating for your clients’ needs, yet you may lack the tools or knowledge to begin addressing your own retirement planning goals. In particular, solo or small practice lawyers enjoy many benefits and freedoms, yet when thoughts of retiring from that practice arise, planning can seem burdensome. If this sounds familiar, you have not been representing yourself very well financially—whether from a lack of time or knowledge. For too long you have put off addressing your inevitable need for retirement income planning. This article will give you a general blueprint to get your financial house in order and help you focus on the most important remedies to maximize your retirement wealth.
Measuring Your Net Worth
Building retirement financial security starts with making an honest assessment of where you are today. You have to collect and assess the materials you have to work with before building your retirement plan. The first tool to help build your retirement financial security is a net worth statement, which is just a snapshot of what assets you have accumulated to date. Simply list your assets less liabilities to show what you would be worth if you sold everything you owned today and turned it into cash after paying off all your debts. The goal of your planning is to grow your net worth—your “financial house”—so that your assets are far greater than your debts. Your net worth is an important way to keep score, and it is a key measurement of your financial progress. Your net worth represents your financial security and, ultimately, your financial independence because it has to be enough to cover the 100 percent drop in income you will face when you fully retire. So, of course, the closer you are to retirement, the higher your net worth should be. You should measure your progress by annually recalculating your net worth to see if it has grown or not. That way you can make adjustments to ensure that you stay on track toward growing your assets.
One question I often hear is, “Do I include my personal residence as a retirement asset?” Unless it is going to be used to provide retirement income, I suggest not counting your home as a retirement asset. I do not see too many lawyers selling the home they love when they retire, buying a much cheaper double-wide trailer to live in, and investing the difference for retirement income. Even if you do sell your home, you will end up spending more than what you sold it for to purchase that new “retirement condo.” Renting out your home to make it produce income, reverse mortgages, or tearing off a wall and selling it to pay bills are also not preferred options. Yes, you can borrow against your home to access the equity, but that produces debt at a cost that erodes, not builds, retirement wealth. Take the same approach with your practice value. It is prudent to be conservative here and not delude yourself into thinking that you will be able to sell your practice for a large sum at retirement. The types of assets you need to accumulate are those that can be easily converted to a retirement income stream.
Maximizing Your Savings
The second financial tool you must develop is your monthly budget (income less expenses) to help avoid spending more than you earn. Whatever system you use, its main purpose is to produce a monthly surplus for you to add to your assets. This is a critical strategy because the vast majority of lawyers develop retirement assets by earning an income from their practice, spending a portion of that income to live on today, and saving and investing the rest each month toward future goals. From running numerous retirement projections over the years, I have found that you generally need to be saving between 15 percent and 20 percent of your gross (before tax) income to potentially avoid running out of money during retirement. The more serious you are about being able to retire, the more focused you will be on saving the most you can from your income.
If you find that you cannot save very much at the moment, start somewhere, at any amount, and set it aside each month. A critical strategy is to then find ways to gradually increase the amount you save and invest over time. Every year a major goal for you should be to increase what you save. You have the potential to accumulate substantial retirement assets as long as you stay committed to increasing your investment contributions each and every year. Below are some key budgeting habits that you can implement to help save more each month:
- Escrow in a separate “savings-to-spend” bank account to pay larger irregular bills that occur during the year, such as vacations and Christmas expenses.
- Reset your income tax withholding or estimated tax payments to avoid receiving large tax refunds—you need to have those dollars invested sooner, not loaned to the government at 0 percent interest.
- Develop an emergency/opportunity cash fund to help you avoid having to sell retirement assets.
- Automate your monthly savings with automatic withdrawals from your checkbook so saving becomes a habit.
- Be careful not to adjust your lifestyle spending to your higher income when you get raises, bonuses, or large case payouts—try to save the excess income.
- Try to earn more money so you can increase the amount you save.
- Reduce debts and invest at the same time to give retirement assets the longest time to grow.
Accumulating Retirement Assets
The most common vehicles in which to accumulate retirement assets are tax qualified retirement type accounts. One main advantage they offer is an income tax deduction now on annual contributions so it will cost you less to contribute to them. Another advantage they provide is tax deferral of earnings so you do not have to pay income taxes on the money in these accounts until the funds are withdrawn. The most popular plans include traditional individual retirement accounts (IRAs), savings incentive match plan for employees IRAs (SIMPLE IRAs), simplified employee pension IRAs (SEPs), pension and profit-sharing plans, and 401(k) plans.
Traditional or deductible IRAs allow you to invest up to $5,000 (for the year 2008) as long as you do not have another qualified plan or make a Roth IRA contribution (see below). If you are over age 50, you can add an additional $1,000 “catch-up” amount (2008), and you may be able to make a contribution for your spouse as well. Be aware there are income limits and other caveats that may limit or prevent you from making deductible IRA contributions, so it is best to check with your tax advisor regarding your eligibility.
If you can afford to save more than the traditional IRA limits, you may want to consider setting up a SIMPLE IRA plan for yourself or your firm. A SIMPLE IRA allows for any owner or employee to contribute up to $10,500 (2008). If you are over age 50, you can add an additional $2,500 catch-up amount (2008) as well. The employer also must choose a matching contribution between 1 percent and 3 percent per year or a flat 2 percent contribution for any eligible employees. The match is immediately vested.
If you can save still more and want to control contributions somewhat, you may want to set up a profit-sharing plan. These are qualified plans where employers can make discretionary contributions that may vary from year to year. Each employee usually receives the same contribution percentage unless the plan is designed to take advantage of permitted disparity rules. These permitted disparity rules allow you to allocate a higher percentage of the dollars to older or more highly compensated people (partners and associates) in a firm. The maximum deductible employer contribution that can be made to a profit-sharing plan is 25 percent of “eligible” compensation, up to a maximum of $46,000 (2008).
You also can add a 401(k) component to your profit-sharing plan, which allows employees and owners to make tax deductible contributions from their own paychecks. The maximum annual deferral is $15,500 (2008). If you are over age 50, you can add an additional $5,000 catch-up amount (2008) as well. Employers then often add matching contributions to encourage employees to help fund their own retirement and may impose a vesting schedule with respect to the employers’ matching funds. Still, the limit together of employer and employee contributions each year is $46,000 (2008).
Many smaller practices choose to do a SEP IRA instead. SEPs are very similar to a basic profit-sharing plan, and the employer-only contribution limits are essentially the same. However, you are not allowed to put a vesting schedule on a SEP IRA. You also must contribute for all employees that have worked for you during three of the last five years.
You may consider investing in a Roth IRA if your income is below $116,000 (single tax filer) or $169,000 (married). You do not get a tax deduction today, but under current law, all the growth is tax deferred. The big advantage to Roth IRAs is that you receive all withdrawals tax-free when you take the money out at retirement. Their contribution limits are the same as deductible IRAs. Be aware 401(k) plans now allow the addition of “Roth 401(k)” (after-tax) deposits, which may make Roth IRAs accessible for more lawyers.
Just because you have made the maximum contribution to the above plans in some fashion does not mean you are necessarily saving enough for retirement. You also may have to make additional contributions to other investment areas such as non-qualified annuities, life insurance cash value, real estate, and individually owned stocks, bonds, and mutual funds.
Protecting What You Saved
Once you have begun building up assets, you still need to protect these assets from some common risks that could significantly deplete them.
Losing your income owing to disability. The greatest asset you have for most of your law career is your ability to earn an income. You cannot build retirement wealth without it. You should maintain sufficient personal disability income insurance to mitigate this potential loss throughout your career.
Losing your investment growth to large losses. Because the assets in which you invest force you to take various risks, you must have an overall investment plan to earn sufficient returns for the risk taken. Investments will fluctuate, and when redeemed they may be worth more or less than when originally invested. The first step, then, is to set an investment objective or model allocation that fits your risk profile and time frame. Then mix your assets across the asset classes of stocks, fixed income, and cash, including the sub-styles within each class. For example, if you invest $1,000 per month, of which $600 goes to stock mutual funds and $400 to fixed-income funds, you create an asset allocation strategy of 60 percent stocks and 40 percent fixed income. By properly diversifying, some assets will go up to offset others that might go down, smoothing out the volatility. Then, at least annually, you should rebalance your mix back to your model to make sure that it stays on track with your risk profile. Keep in mind, diversification does not guarantee against loss but is a method used to manage risk.
Losing your investment principal to taxes and penalties. Contributions and earnings to traditional IRAs will be taxed at ordinary income rates when withdrawn. Distributions must begin after age 70 1/2 or a penalty (50 percent of the amount that should have been distributed) will be assessed. There also is a 10 percent penalty for early withdrawals before age 59 1/2. Roth accounts do not have required minimum taxable distributions, however Roths must be held for at least five years or until age 59 1/2 to avoid a 10 percent early withdrawal penalty. Roth IRA withdrawals prior to age 59 1/2 are income taxed as well (on earnings only). Allow these accounts to grow untouched for the longest period of time you can. Always roll over these accounts and prior pension plan balances to avoid paying these taxes and penalties.
Depleting your assets owing to long-term care expenses. The most incalculable concern today is how to pay for the cost of potential medical and long-term care expenses in retirement. These costs can force very large withdrawals that can significantly deplete retirement capital very quickly. Besides having proper powers of attorney for medical and financial needs and establishing a revocable living trust, you should consider securing long-term care insurance to protect your assets. If designed right, these policies can cover almost any type of care you need at home or in a facility. One affordable policy design used today is to secure a larger monthly benefit for a shorter period of years on you and your spouse. That benefit can be inflated at compound interest each year (while the premium stays the same), and each spouse can access the other’s policy benefits if left unused. For example, a $5,000-per-month, five-year-duration plan yields about $300,000 of coverage, $600,000 accessible to both spouses. The amount of coverage also will grow over time with the inflated benefits feature to protect even more of your assets over time.
Drawing out too much retirement income. As a general rule, try not to withdraw more than what your investments earn each year. If you do, you will deplete the principal. Too many years of withdrawing more than you earn just hastens the time when you will run out of money.
Rather than focus only on “the number” you need to have at retirement, I have outlined some key remedies (habits and strategies) you need to be implementing to make your money last as long as you do. An easy way to remember them is to look at the four overall choices you have:
- Save and invest enough money from your current income as soon as possible.
- Increase potential rates of return by reallocating investment assets.
- Delay retirement—work longer.
- Live on less during retirement.
Focus now on the first two options to avoid being forced to implement the less desirable third and fourth choices. If you have not been able to implement these strategies effectively, maybe it is time to hire a trusted financial advisor who understands the challenges you face as a lawyer and can help you to plan and implement successful retirement savings strategies. Ultimately, you will get what you plan for.
The information in this article is a general discussion of the relevant federal tax laws. It is not intended for, nor can it be used by any taxpayer for, the purpose of avoiding federal tax penalties. This information is provided to support the promotion or marketing of ideas that may benefit a taxpayer. Taxpayers should seek the advice of their own tax and legal advisors regarding any tax and legal issues applicable to their specific circumstances. The American Bar Endowment (ABE), a not-for-profit affiliate of the American Bar Association, sponsors Thomas A. Haunty for participation at various ABA Section meetings and to write articles for ABA Section publications. (The ABE provides insurance plans to ABA members. Each plan contains a unique charitable giving component.) North Star Resource Group, in which Thomas A. Haunty is a senior partner, offers securities and investment advisory services through CRI Securities, LLC, and Securian Financial Services, Inc., Members FINRA and SIPC. CRI Securities, LLC, is affiliated with Securian Financial Services, Inc., Tracking #18866 DOFU 5-7-08.
Thomas A. Haunty, CFP, RHU, REBC, ChFC, is a senior partner with North Star Resource Group in Madison, Wisconsin, and an investment advisor representative with Securian Financial Services, Inc., and CRI Securities, LLC, registered investment advisors, members FINRA/SIPC. He has provided financial assistance to lawyers and their clients since 1982 and also serves as a volunteer financial advisor, supporting Young Lawyers Division members, for the American Bar Endowment. He is the author of Real Life Financial Planning for Young Lawyers and may be reached at firstname.lastname@example.org or 608/271-9100.