Retirement can seem like a distant goal until suddenly it isn’t. When you’re only a few years away from retirement, the financial decisions you make take on new importance. Once you’re inside the five-year window, it’s a good time to review your plan to make sure you’re on the right track. It is useful to understand why the last five years before your retirement are crucial. Talking to a financial advisor can shed some light on what is and isn’t working in your plan.
Timing is important for retirement planning
When you’re younger, time plays in your favor when it comes to investing for retirement. The more time you have to save and invest, the more your money is likely to grow. Waiting to start saving for retirement can mean having to catch up later. If you are approaching the last five years before your retirement, a late departure can put you at a serious disadvantage. There are two reasons for this.
First, you have less time to take advantage of compound interest. Even if you maximize annual contributions to a 401(k) or IRA, including catch-up contributions because you’re 50 or older, that may not be enough to make up for lost time in the market.
The second reason is related to the first. It’s natural that as you get older you may begin to transfer more of your assets to safer investments. Switching to more conservative investments, such as bonds, can reduce the risk of losing money just before you retire. But you can also trade higher returns by doing this, which is something your portfolio might need if you started saving late.
Why the last five years before your retirement are crucial
The last five years before your retirement are essentially a test of your preparation and planning up to this point. When there are five years to go until you retire, there’s a big question you need to answer: can I afford it?
Whether the answer is yes or no largely depends on how much you’ve done to plan ahead. Some of the most important factors that can influence retirement readiness include:
What you’ve saved in workplace retirement plans or IRAs
The amount of debt you have, apart from your mortgage
Your expected retirement expenses, based on your preferred lifestyle
How long your savings should last, based on your retirement age
If you’ve planned well and stayed consistent with your plan, you may not need to make many changes in the last five years before you retire. On the other hand, if your plan has gaps or you haven’t started planning at all yet, you may have more work to do to prepare for retirement.
5 Years to Retirement Checklist
If you have five years left until you retire, it’s helpful to know what you should be doing to assess your readiness. Here are some of the most important things to address to ensure you can retire comfortably and on time.
Review your savings: To be where you want to be in retirement, you need to know where you are now. Specifically, it means understanding how much you’ve saved for retirement and how much more you need to save over the next five years to reach your goal.
Running the numbers in a retirement savings calculator can help you see how close or far you are to your goal. You can use the resulting number to shape the next steps in your financial plan.
If you fall behind, for example, you may need to significantly increase 401(k) or IRA contributions. Or you may need to adjust your investment strategy to generate higher returns in the years you have left until you retire.
Know your sources of income: It’s a good idea to know what sources of income you can count on when you retire. Depending on your situation, this may include:
Withdrawals from a 401(k) plan or similar work plan
Traditional or Roth IRAs
Pension income if your employer offers a pension plan
Social security benefits
Benefits of the Federal Employees Retirement System (FERS)
Rental income if you own real estate
You may also have income from other sources, such as retirement accounts you inherit or a health savings account (HSA). An HSA is not a retirement account on its own, as it is intended to be used for eligible medical expenses. However, after age 65, you can withdraw money from an HSA for any reason, without penalty. You will only pay ordinary income tax on the distributions.
Taking inventory of your potential sources of income can give you a better idea of how much you may need to spend. It can also help you determine things like when to start withdrawing from tax-advantaged plans, how much to withdraw, and the best age to apply for Social Security benefits.
Estimate retirement expenses: Income is one side of your retirement budget and expenses are the other. If you have five years left until retirement, now is a good time to start thinking about the lifestyle you want versus what you can afford based on what you have saved.
Typical retirement expenses include housing, utilities, food, and health care. But your budget may also extend to travel, hobbies, or new hobbies you’ve wanted to try. Creating a fictional budget and then comparing the numbers to your expected monthly income can help you see how far off the numbers are.
You can also take it a step further and try to live within your retirement budget for the last five years before you retire. This can help you gauge how realistic it is. If you plan to spend less in retirement than you do now, testing your budget could leave you with extra money to save each month.
Consider long-term care needs: Long-term care costs can easily wipe out your retirement savings. If you are in the five-year period before retirement, now is a good time to assess your personal risk.
Medicare does not pay for long-term nursing care, but Medicaid can. There is a catch, however, because qualifying for Medicaid usually means spending assets. If you don’t want to do that, you might consider buying a long-term care insurance policy in the five years before you retire.
Long-term care policies may pay benefits to cover necessary nursing care. If you’re unsure whether you’ll need long-term care, you might consider a hybrid policy that also includes life insurance. If you don’t use the long-term care benefit, the policy can still pay a death benefit to your beneficiaries.
Take stock of your tax situation: Managing taxes in retirement can allow you to retain more of your savings. You can consider making tax changes in the last five years before retirement that may allow you to pay less to the IRS later.
For example, you can convert your traditional IRA to a Roth IRA to benefit from tax-free retirement withdrawals. Converting from a traditional IRA to a Roth doesn’t completely evade taxes; conversions are subject to the same tax rules as withdrawals.
However, once you convert to a Roth account, you will not pay any tax on distributions in the future. This could generate significant tax savings if you expect to be in a higher tax bracket when you retire.
The last five years before your retirement can pass in the blink of an eye and there is no time to waste finalizing your plans. Taking the time to review where you are and where you hope to be can help ensure that you won’t be short once it’s time to leave the workplace for good.
Retirement Planning Tips
Creating a five-year plan for retirement can also include planning for any contingencies that may arise. Talking to a financial advisor can help you find a plan B if you’re worried that something might derail your retirement schedule. Finding a financial advisor doesn’t have to be difficult. SmartAsset’s free tool connects you with up to three approved financial advisors who serve your area, and you can have a free introductory call with your advisor to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, start now.
Investing in tax-efficient accounts, like a 401(k) or an IRA, is a smart move for retirement planning. If you want to add another savings option to the mix, you might consider opening a taxable brokerage account. Taxable accounts are subject to capital gains tax when you sell investments for a profit. However, they don’t have the same annual contribution limits as tax-advantaged accounts and there are no early withdrawal penalties either.
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