05 Feb Self-employed with unreliable income – and nearing retirement

Elsa lives on unpredictable self-employed income.

She doesn’t market herself, she said, and business comes to her. For years she’s been saying she will cut back, but she hasn’t yet.

At age 62, she’s divorced, and she’s been sharing a home with her partner — who is still married — for more than 25 years.

They share living expenses, but it’s not always 50-50.

“We have both put various documents in place so we will inherit some money from each other, but I don’t want to count on this as a retirement plan,” Elsa said.

Instead, she has lots of savings in retirement plans and taxable accounts, but she regularly supplements her income by drawing on her savings.

“I am not sure whether to draw only from regular investments or whether I should start drawing from tax-deferred accounts,” Elsa said. “I’ve been told that my tax bracket might go up when I reach age 70 and have to take mandatory distributions, so one advisor has said I should convert some of those accounts to annuities and starting taking the funds.”

She also wants to wait until the last possible moment to draw her Social Security benefits, which she knows will grow every year.

Alison Williams, a certified financial planner with Stonegate Wealth Management in Oakland, reviewed Elsa’s financial plan for NJMoneyHelp.com.

THE OUTLOOK

Williams looked at Elsa’s financial analysis by using actual cash flow figures, real assets and liabilities. Part of this analysis involved running Monte Carlo simulations. Monte Carlo analyzes your plan by randomizing the return rates within the normal assumed distribution range each year, she said. Monte Carlo performs this analysis hundreds times to simulate a number of possible financial outcomes. Those outcomes able to satisfy all financial objectives are considered successes, Williams said.

“Elsa’s result was a 91.6, which says to us that there’s 91 percent chance she will not outlive her money if she fully retires at age 65, and lives to age 100,” Williams said.

Not bad, but there are risk factors that could impact this outcome, including: Poor returns or unexpected events and expenses are an area of risk that can threaten your situation; sequence risk e.g. poor returns in the first few years of retirement could significantly impact your score, and; rising costs of health care expenses as well as increasing life expectancy due to medical advances. It is very difficult to project what future health care costs will be for retirees.

“The state of the Social Security system could also pose a threat,” Williams said. “We believe that those who are presently younger than 55 are most at risk to changes in the program.”

Elsa wanted to hold off on taking Social Security, and Williams agrees that it’s smartest to wait.

“Social Security benefits increase approximately 8 percent each year you delay payment,” she said. “Since you do not currently need the additional income, we recommend waiting until age 70 to begin collecting.”

To supplement her income, Williams recommends Elsa draw from her regular investment account. In addition to her retirement accounts growing tax-deferred, the move would mitigate her tax liability.

INVESTMENT CHANGES

Elsa claims to be risk-averse, and her investments are allocated with 60 percent in stocks and 40 percent in bonds.

Williams said the portfolio is not well diversified, and some of the investments have higher-than-average fees.

“Some of the holdings are high-cost funds and are not necessarily the best in their asset classes,” Williams said. “By choosing lower cost funds — index funds, and ETFs — portfolio-related expenses can be reduced significantly.”

Plus, Elsa has retirement assets scattered across many accounts.

Consolidating accounts of the same type will facilitate investment allocation and potentially reduce fees even further, Williams said.

Her employer-sponsored retirement accounts are not active, so Williams said it makes sense to combine them into one IRA.

“This will facilitate investment allocation and potentially reduce fees even further,” Williams said

Then, there are the investments themselves.

“By properly allocating holdings in accordance with her risk tolerance, a similar return can be achieved while taking on much less risk,” Williams said.

If Elsa doesn’t feel comfortable making investment choices for her portfolio, she should consider hiring a pro. If she does, there’s plenty that professional needs to understand before making recommendations on Elsa’s behalf.

“It should be taken into account that she will be retiring in the near future and plans to draw down cash for existing expenses, as well as what is currently being earned in salary,” Williams said.

Given that Elsa’s tax bracket will likely be higher when she begins collecting Social Security benefits and withdrawing Required Minimum Distributions (RMDs) from her traditional IRAs, Williams recommends Elsa contribute the maximum amount to her Roth IRA as long as she is working and has earned income.

“By contributing to the Roth, you will pay tax at your current, lower rate, shielding those funds from the higher tax bracket in the future,” Williams said. “Since you’re over age 50, the contribution limit is $6,500 or 100% of income, whichever is lower.”

Someone had recommended Elsa put some of her retirement savings in annuities to help with taxes down the road, but Williams isn’t so sure that’s a solid recommendation.

“The commission for an annuity salesperson is quite high, so there may have been ulterior motives for the initial recommendation,” she said. “Generally speaking, annuities have high fees and expenses. They are also illiquid and wrought with surrender penalties. Given your situation, we do not believe an annuity is warranted.”

This story was first posted in February 2015.

Net Worth:

Assets:

• Checking: $1,000
• Savings: $19,000
• CDs: $11,000
• Inherited IRAs: $316,700
• 401(k): $1,587,200
• Mutual Funds: $468,000
• Primary Home: $450,000
• Personal Property: $20,000
• Autos: $23,000

Total Assets: $2,895,900

Liabilities:

Total Liabilities: $20,000
Total Net Worth: $2,875,900

Budget:

Annual Income:

• Self-employment income: $40,000
• SRent: $10,000
• IRA RMDs: $10,700
• Investments: $15,000

Monthly Expenses:

• Income Taxes: $226
• Housing: $1,767
• Utilities: $809
• Food: $1,014
• Personal Care: $425
• Transportation: $859
• Medical: $700
• Insurance: $166
• Entertainment: $20
• Vacations: $396
• Charity: $46
• Gifts: $20
• Misc.: $292