Several less-than-obvious strategies and tactics can help you get your finances in better shape for retirement.
Some, like converting a traditional Individual Retirement Account into a Roth IRA, could be highly beneficial in the right situation, though there's a cost to bear in the meantime.
Others, like trying to invest Social Security benefits, are tempting but probably more difficult to implement successfully than you might think.
And a few, like using Health Savings Accounts, weren't even designed as retirement tactics but can be highly effective in that regard.
Here's a look at these three possibilities:
Converting IRAs, at a cost
Many investors can't get enough of Roth Individual Retirement Accounts. These vehicles are quite attractive, offering the potential for tax-free withdrawals with no required minimum distributions as with regular IRAs.
One way to build up your Roth holdings is by converting some of your regular IRA money into one. But there is a cost involved, as you would face income taxes on the amount you switch over, and that bill could easily run thousands of dollars.
If you converted a traditional IRA into a Roth, it's best to pay the resulting tax using outside money so that you wouldn't need to tap into your retirement account. But coming up with the cash could pose a challenge for some people, and nobody likes to write a check to the Internal Revenue Service earlier than necessary. Those are two drawbacks of converting.
Nevertheless, this might be a decent time to consider the move, argues Sheryl Rowling, a certified public accountant at Rowling & Associates in San Diego. The reason? Income tax rates dropped two years ago with tax reform, thereby lowering any Roth-conversion bill, and they might be heading higher sometime in the not-distant future.
We now have "some of the lowest tax rates in recent history, and they are unlikely to stick," Rowling wrote in the winter edition of Morningstar magazine, citing federal budget pressures as a potential catalyst. (Another possible catalyst she didn't mention would be a change in tax policy resulting from the presidential election this fall.)
Justin Smith, a financial adviser at Savant Capital Management in Phoenix, also considers generally low tax rates to be a strong rational for converting into a Roth. "It's like filling up when gas is cheap," he said.
The decision also depends on your personal tax situation and where it might be headed. If you expect to be in a higher bracket later — owing to a more lucrative job, for example — converting now might make sense.
But converting and recognizing more income could cause other problems, such as possibly making some of your Social Security income taxable, undermining the strategy.
"You have to be really sure," Smith said. "You can't just do a back-of-the-envelope calculation."
Making sure is especially important now since conversions no longer can be canceled or "recharacterized," as was possible in prior years.
The converting decision often is more timely late in the year, when the pieces of your tax and investment puzzle come more clearly into focus. In fact, a late-year stock market slump, if one materializes, could make converting more attractive, as you would be paying less tax on a lower account balance.
Claiming early and investing
One of the toughest Social Security questions for many people is deciding when to start claiming retirement benefits. You can start as early as age 62, when you would lock in minimal monthly benefits, or wait as late as 70, when benefits are maximized. Or you can start somewhere in between.
Taking the money early can make sense if you really need the cash to pay bills, if you are in poor health and don't expect to live long, or if you truly don't think the Social Security system will be able to make promised payments. Otherwise, many financial advisers suggest delaying if you can.
But what if you claim benefits early and invest all that money? Veteran financial commentator Jane Bryant Quinn weighs in on that question in her new book, "How to Make Your Money Last: The Indispensable Retirement Guide." Her conclusion: It's not a good idea.
Between the ages of 62 and 70, a single person would need to earn more than 7% a year on his or her investments, after expenses, assuming an average lifespan and inflation at 3% (which implies a 3% cost-of-living hike in benefits), she wrote. "A married couple would have to earn 9% or more to beat what Social Security offers for delaying their combined retirement and spousal benefits."
Claiming at 62 could make sense if you invested all benefits and knew for certain that you'd never need the money. That way, she said, you would build up an account that your beneficiaries could inherit.
"But if you're expecting the market to pay you more than Social Security over a long lifetime, forget it," she concludes.
It's worth noting that long-term returns in the stock market have averaged better than 10% annually, which makes a strategy of claiming early and investing plausible. But after 11 years of a bull market, returns going forward could be much lower, while bonds, now paying low single-digit rates, won't help much.
Preparing for retirement health costs
Health Savings Accounts can be nice to have before or during retirement, yet they are largely underutilized. HSAs have been around for around a decade and a half, commonly available as a workplace benefit. Yet only about one-quarter of employers offer them, and eligible workers often fail to take advantage of them.
“Workers with access to an HSA option often misunderstand the opportunity, confusing it with the ‘use it or lose it’ requirements” of another type of vehicle, Flexible Spending Accounts, said a new study by the Plan Sponsor Council of America.
The report cited a Bank of America survey last year that indicated only 11% of employees and 7% of employers could correctly identify the key advantages of HSAs.
Those benefits include: triple tax shelter (contributions, account earnings and withdrawals all are untaxed), funds in an account can be invested, funds don’t expire, and funds can be passed to a beneficiary at death. Withdrawals avoid taxes if used for qualifying medical expenses, which include many types of costs.
Still, at a time when most workers don’t maximize their contributions to 401(k)-style retirement accounts, the report questioned why employers should encourage savings in HSAs? The answer was focused around the triple tax advantages.
“Unlike 401(k) assets, HSA assets can be distributed tax-free to cover qualifying medical expenses — today and in the future,” the Plan Council report said. That includes tax-free reimbursement of deductibles, copays, coinsurance and premiums for Medicare, as well as doctor visits, prescriptions, dental care and more.
“This triple tax advantage means that HSA savers can get all the tax benefits of both a 401(k) and a Roth 401(k) — and apply savings to an element of retirement expenses (health care) that looms ever larger for pre-retirees and retirees alike,” the report said.