Under present law, only taxpayers with a modified adjusted gross income less than $100,000 may convert from a traditional IRA to a Roth IRA.  Under the new law,  regardless of income, contributions can be made to a traditional IRA in 2009 (and prior years) and then rolled over into a Roth IRA in 2010.

The remaining question is whether executing a Roth IRA conversion is the right move for you. That’s where a conversion calculator can help. Here are some online Roth conversion calculators that I have learned about:

RothRetirement.com was one of the first to publish a complete website about Roth conversions, including a conversion analysis calculator. The output from the calculator can be confusing, which may be intentional.

Fidelity Investments has introduced its version of a conversion evaluator but you will have to sign up to use it.

Dinkytown is well-known for offering a multitude of different financial calculators, including a very simple Roth conversion calculator with an easy to understand graphical output.

SmartMoney Magazine has an online site including an electronic worksheet for Roth IRA conversions. I like that the output includes a definite “yes” or “no” recommendation.

Vanguard Investments also has a conversion calculator but it seems not to know about the rule change for 2010.

The TIAA-CREF Roth IRA conversion calculator is unremarkable and does not appear as comprehensive as some of the others.

The Bank of America conversion calculator is the most interactive because it uses sliders for input with the results instantly displayed on the same page.

Overall, of the online Roth IRA conversion calculators that I have tried, I like the RothRetirement.com and SmartMoney versions the best.

What are your plans for a IRA conversion in 2010?

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1. The new tax credit is available to existing homeowners. The original credit, which was to expire on November 30, provides $8,000 to first-time homeowners. The new credit is slightly smaller at $6500 but it applies to anyone who is a “long time resident” of an existing home. To meet this test, you (and your spouse if married) must have been occupants of your current home for 5 of the 8 most recent years before your new home purchase.

2. You do not have to sell your existing home to qualify for the home buyer credit. Although you have to be a “long time resident” of your existing home, claiming a credit under the new law does not obligate you to sell your present home. You can rent it or keep it as a second home. If you choose not sell your present home, don’t overlook the tax consequences of losing the capital gains tax exemption for a home that you no longer occupy principal residence. Right now, to qualify for that exemption, you must have lived in the home for 2 of the past 5 years.

3. You do not have to “upsize” to qualify for the credit. The new home buyer credit for existing homeowners does not mandate that you “move up” in size or price. A pure downsize move to a less expensive home still qualifies. The credit is based on 10% of the new home price, capped at $6500. There is an upper limit, in that your new home purchase cannot exceed $800,000. That shouldn’t be an issue for a typical downsizer!

4. The income limitations have been increased. The original first-time homebuyer credit was available only if your modified adjusted gross income (MAGI) was less than $75,000 or $150,000 for a married couple. The new law raises those limits to $125,00o for singles and $225,000 for couples, at which point the credit begins to phase out. The credit is completely lost at incomes of $145,000 (singles) and $245,000 (couples). MAGI is generally calculated by using your total income and subtracting “above the line” deductions and adjustments.

5. The credit has been extended into 2010. Under the new law, you must close on a new home, or be locked into a purchase contract, before May 1, 2010. The actual closing must take place before July 1, 2010. Note that as with the original home buyer credit, you may have a choice as to when you claim the credit. For example, if you purchase a new home in March 2010, you can claim the credit on your 2009 tax return. Alternatively, if your income is a factor, you can wait until you file your 2010 tax return the following year. The credit remains “refundable” meaning that even if you owe no tax, the IRS will send you a check in the amount of the credit.

For additional information on how the credit works, here is the current IRS Form 5405. I assume that this will be updated soon.

So start strategizing baby boomers. The new homebuyer tax credit may be just want you need to make downsizing a reality.

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Unfortunately, most of these tools have fundamental flaws in them and/or mistakes are made when they are used.

The Pension Research Council has studied some of the better know retirement planning tools and summarized some of the major problems.

The free planning tools tested were:

• AARP retirement planning calculator
• Fidelity Retirement Income Planner
• MetLife calculator
• T. Rowe Price Retirement Income Calculator
• U.S. Department of Labor

These are the major problems found with one or more of the tools:

1. Predicting Plan Longevity. Baby boomers often underestimate how long they will live. The consequence is that they don’t realize long their retirements will be and how long they will need their plan to provide income. (See Life Expectancy and Retirement Planning)

2. Preparing for the Effects of Inflation. While inflation is low now, that won’t be the case in the future. Most retirement planning tools make unrealistic assumptions about a constant future retirement rate or worse, they expect you to predict it. That’s why I think that at least part of your retirement portfolio needs to be protected against inflation. If you use one of the online tools, experiment with different inflation rates to understand the effect on the tool outputs.  (See Inflation and Retirement Investing)

3. Planning for Payment of Medical Expenses. I agree with the Pension Research Council on this: Many retirement planning tools do not properly estimate what our expenses will be for retirement health care. There are tools for that as well and you should probably look at those first, before running a comprehensive planning tool. (See Healthcare Costs in Retirement)

4. Social Security Benefits. A big weakness in some retirement planning software is is either ignoring Social Security entirely or not allowing the user to input a personalized benefit level. This can create plan flaws because Social Security income may be a significant component of your retirement income plan. An estimate of your Social Security retirement benefit is easy to obtain. (See Social Security Retirement Benefit Estimator)

5. Defining Retirement Success. Many online retirement planning tools use their own definition of what a successful plan outcome should look like. Your definition of retirement success may be different. As just one example, you may have a specific desire to leave an inheritance for your children. (I don’t necessarily agree with that but I can understand how others might feel differently. It is important for the user of the planning tool to understand what differences may exist between their ideas for a good plan outcome and what the planning tool assumes.

For more resources on retirement planning tools that I’ve tried or developed, see “Create a Free Financial Plan” (and links therein) and “Creating a Plan for Guaranteed Retirement Income.”

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Stop cashing out those 401(k) accounts!

According to a recent survey by Hewitt Associates, 46% of those persons who changed jobs or lost their jobs in 2008 took the cash out of their 401(k) accounts. Even for those in the age groups 40-49 and 50-59, the cash-out rates were 43% and 34% respectively. That is a terrible statistic. Yes I know that they think they need the money then, but not as much as they will need the money when they retire. This sad trend by the way did not begin with the current economic crisis. The cash-out data has remained stable since 2005.

Baby boomers (ages 55-64) have been doing an awful job of exploiting tax-advantaged retirement plans. In fact, a study done by the Boston College Center for Retirement Research showed that 401(k) and IRA accounts represent just 7%  of their retirement wealth. This compares to 20% represented by the value of their primary residence. Of course, that data is from 2007 and we know what has happened to real estate values since then.

The knee-jerk reaction to this information is to blame the 401(k) plan for the early withdrawals. I disagree. The real problem is lack of financial discipline. Too many folks treat their retirement accounts as a “rainy day” fund. They use their departure from one employer – even just to take another job – as an excuse to raid their 401(k) account. Unless they have reached the magic age of 59 1/2, the 10% early withdrawal penalty and taxes will take a huge bite out of that money.

Baby boomers who withdrew 401(k) cash (or stopped contributing) also suffered by losing out on the stock market rebound since March 2009. This data from the Employee Benefit Research Institute show declining average 401(k) balances for many folks in the 45-54 and 55-64 age groups since January 2008 whereas the accounts of younger employees did much better.

What are folks doing with this 401(k) cash out money?  An earlier study by the Employee Benefit Research Institute found that while many just “spent it” , even more used it to pay down debt, buy a house, or start a business. These don’t sound like hardship withdrawals to me.

I suppose from these numbers you could conclude that there is at least one thing wrong with 401(k) plans. They make it too easy for employees to get at their accounts before they retire.

Think about this before cashing out that 401(k) account fellow baby boomers: The pain of financial discipline is much less than the pain of retirement (or unretirement) regret.

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There are many “rules of thumb” in personal finance. Lots of them are actually rules of “dumb.” The retirement income replacement rate or ratio is one of them.

In this article from CNN/Money, a reader asks what percentage of his income he should be saving for retirement. The writer – a well known personal finance pundit – refers the reader to this “What You Need to Save” calculator. This simple retirement planning tool contains only three inputs: your age, current income, and existing retirement savings. How can this tool accurately tell you how much you need to save, you ask? It can’t.

If you look in the calculator footnotes when the result is displayed, you read that the calculation assumes that Social Security and income from your savings will replace 80% of your pre-retirement salary. This 80% number is seen often in discussions of retirement income replacement ratios. Another “rule of thumb” that is frequently cited is that to maintain your current lifestyle in retirement, your income replacement rate should be 70%. Other writers go higher, even to 100%.

In my view, the concept of using an income replacement ratio for retirement planning  is flawed. Other experts (not that I’m claiming to be an expert) agree with me.

In a recent paper published by the University of Michigan Retirement Research Center, the authors addressed the question of “What Replacement Rates Should Households Use?”  According to their research:

The rule of thumb that replacement rates should be above 70% to maintain living standards in retirement is conceptually flawed.  In fact, no more than 15% of the population needed to replace 65% to 90% of their pre-retirement income. And almost 50% of the population needed to replace less than 65% of their pre-retirement income.

Replacement rates of low-income individuals and families would need to be higher than replacement rates for high-income individuals and families.

That data is quite a departure from a fixed percentage replacement ratio “rule of thumb.”

In this MarketWatch article on retirement plan building, Robert Powell discusses the study and quotes another well-known finance professor:

“The use of replacement rates to form financial plans does not meet a reasonable fiduciary standard,” said Larry Kotlikoff, a Boston University professor.

“Rules of thumb are, quite simply, rules of dumb,” he said. “Their use violates the financial planner’s Hippocratic oath: First do no harm.”

Kotlikoff is well-known for economics-based financial planning based on consumption smoothing.

So what should we do to determine how much of our pre-retirement income we will need in retirement? My recommendation is to prepare a real world retirement spending plan. Base it on what you spend now and on what you anticipate your expenditures will be when you retire. That number is what your estimated income needs will be. A little time on a spreadsheet goes a long way and gives you much more accurate data than using an income replacement rate.

That’s exactly what I did to generate my retirement income plan using the Failsafe Retirement System.

So skip the rules of thumb. Go right to the data, your data. Otherwise, you could end up over-saving or under-saving for your retirement.

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Retirement Health Care Cost Categories

So what health care expenses can we expect when we retire? Let’s first list them by category.

1. Medicare premiums. Yes, Medicare is a benefit provided to retirees at age 65 but it’s not free. There are Part A (hospital coverage) premiums (if you do not have enough work credits) and Part B (other medical expense) premiums for everyone. For 2009, the Part B premium is $96.40 per month, if your income is less than $85,000 per year.

2. Medicare supplement insurance. As with most health insurance policies, Medicare doesn’t cover everything. Traditional Medicare coverage is estimated to cover only 60% of the average retiree’s health care costs.  Some of the coverage gaps are significant and justify purchasing a “Medigap” (Medicare Supplement) insurance policy. This is the explanation from the official Medicare site.

A Medigap policy is health insurance sold by private insurance companies to fill the “gaps” in Original Medicare Plan coverage. Medigap policies help pay some of the health care costs that the Original Medicare Plan doesn’t cover. If you are in the Original Medicare Plan and have a Medigap policy, then Medicare and your Medigap policy will pay both their shares of covered health care costs.

Insurance companies can only sell you a “standardized” Medigap policy. These Medigap policies must all have specific benefits so you can compare them easily.

You may be able to choose up to 12 different standardized Medigap policies (Medigap Plans A through L). Medigap policies must follow Federal and State laws. These laws protect you. A Medigap policy must be clearly identified on the cover as “Medicare Supplement Insurance.” Each plan, A through L, has a different set of basic and extra benefits.

It’s important to compare Medigap policies because costs can vary. The benefits in any Medigap Plan A through L are the same for any insurance company. Each insurance company decides which Medigap policies it wants to sell.

Generally, when you buy a Medigap policy you must have Medicare Part A and Part B. You will have to pay the monthly Medicare Part B premium. In addition, you will have to pay a premium to the Medigap insurance company.

You and your spouse must each buy separate Medigap policies. Your Medigap policy won’t cover any health care costs for your spouse.

The cost of Medigap coverage can vary depending on what level coverage (A through L) you purchase. Yearly premiums range from a few hundred dollars to $5000 or more.

Some Medigap policies are “attained age” policies in which the premiums increase as you age. Others are “issue age” policies in which the premiums are not increased as you get older.

3. Medicare deductibles and co-pays. These are not insignificant. For 2009, these costs look like this:

For Part A: (inpatient hospital, skilled nursing facility, and home health care), Medicare pays all covered costs except the Medicare Part A deductible (2009 = $1,068) during the first 60 days and coinsurance amounts for hospital stays that last beyond 60 days and no more than 150 days. For each benefit period you will pay $1,068 for a hospital stay of 1-60 days, $267 per day for days 61-90 of a hospital stay, and $534 per day for days 91-150 of a hospital stay (Lifetime Reserve Days), and all costs for each day beyond 150 days.

For Skilled Nursing Facility Coinsurance: You pay 133.50 per day for days 21 through 100 each benefit period.

For Part B: (physician services, outpatient hospital services, certain home health services, and durable medical equipment): You pay $135.00 per year deductible and 20% of the Medicare-approved amount for services after you meet the $135.00 deductible.

4. Dental, vision, and hearing care. These categories are generally not even covered by Medicare and may be 100% out of your pocket.

Estimates of Lifetime Costs for Retirement Health Care

The Employee Benefit Research Institute in June 2009 projected that a male retiree will need $68,000-$173,000 in savings to have a 50% probability of being able to cover retirement health care premiums and out-of-pocket expenses. For women, the projected need is for $98,000-$242,000 in dedicated savings. For a 90% probability, those projections increase to $134,000-$378,000 for men and $164,000-$450,000 for women. That’s no chump change.

Fidelity has estimated retirement healthcare costs by category for the typical retiree. At age 65, these estimated costs are $6,631 annually or $551 per month. These costs do not include long term care.

For estimates of health care costs if you retire before age 65 (and therefore are not eligible for Medicare), Bankrate.com has an interesting summary of healthcare cost data and estimates for retirement.  This article projects that in 2018, a relatively healthy 65 year old couple will need to have saved $518,000 to cover healthcare expenses through retirement!

Final Thoughts on Healthcare Costs in Retirement

Although changes are in the works for healthcare in the U.S., it is unlikely that these “reforms” will lessen the cost burdens for retirees. Therefore, your retirement income planning needs to factor these costs in to the budget. Allocating a significant portion of your retirement nest egg to healthcare is a must.

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A required minimum distribution is the smallest annual amount that must be withdrawn from an IRA or 401(k) beginning in the year that the account owner reaches age 70½. The 2008 law waives required minimum distributions (RMD) for 2009 for IRAs and 401(k)s). It also allows certain amounts distributed as 2009 required minimum distributions to be rolled over into an IRA or another retirement plan.

When the law was first passed, an account owner who had already received an RMD was allowed 60 days after receiving the money to put it back into the retirement account. The IRA has now extended that deadline until the later of November 30, 2009 or 60 days from the time you withdraw the money. This is good news for retirees to be sure.

1. You are allowed to return only one IRA withdrawal back into the account within a 365 day period. This means that if you received regular distributions every month, you can return only one of those withdrawals. However, if you received the RMD in a lump sum, you can put it all back into the account.

2. If any taxes were withheld from your RMD, that money needs to be returned also. If it is not, the amount withheld for taxes will be considered a distribution and will be taxed as ordinary income.

3. Since you didn’t have to take an RMD in 2009, that leaves more IRA money available for possible conversion to a Roth IRA.  Although you will pay taxes when you make the switch, you can take tax-free withdrawals after five years. The Roth conversion also means no more required minimum distributions and a potential a tax-free inheritance for your heirs. If you want to make the conversion in 2009, your adjusted gross income just needs to be below $100,000. That income limit is removed in 2010.

4. If you notified your IRA or 401(k) account service to stop RMD withdrawals in 2009, be sure to restart them in 2010 to avoid being penalized.

For more information on the RMD payback extension, you can read IRS Notice 2009-82.

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There was also a warning about being overly cautious with your investments after you retire or even as you approach retirement. Even though you may begin drawing income from your investments in a few years, that need may last for an additional 20-30 years or more. That’s why I like having two distinct retirement nest egg components: One for our basic retirement income needs that is secure and inflation protected and a second component for long term growth.

I also like the advice not to forgo “living the good life in order” just so you will have something for an inheritance to your children. I occasionally joke that I want my the last check I write to bounce!

Finally, the speaker was an advocate of downsizing. As for the concern about having extra room so that your kids and the grandkids can visit, he suggests saving the money from downsizing the house so that you can put your visitors up at a hotel. I think that may be extreme but that there is better balance than simply hanging on to the family home.

For some other readings on baby boomer and retirement issues, consider these:

The Best Life reminds us that it’s never too late to find your next career. Actually, it can be too late for some folks but it’s a lot later than you might think.

Flexo at Consumerism Commentary summarizes some of the psychological reasons why we make bad money decisions.

Forbes compiled its own list of the top ten countries for Americans retiring abroad. In the process, the author takes some shots at other countries that have been promoted as retirement havens for Americans. Interesting stuff.

Enjoy the rest of your weekend.

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I don’t have any statistics to cite but my belief is that more baby boomers are thinking about a phased retirement. There seem to be fewer folks who can financially or emotionally adjust to going from full-time employment to no employment in a single leap. I am in that category. Deciding when to retire is an important first step. Planning how that will happen is equally critical.

Apart from the income, there are aspects of work life that many of us enjoy. I am in no particular hurry to abandon those psychological and emotional benefits. I also do not want to cause disruption at work. On the other hand, there is a desire to make time and energy to pursue other interests. So count me as someone who has been contemplating how to implement a phased retirement in a way that is fair and reasonable for everyone who would be affected. There needs to be a plan for this. That’s what this post is about.

What is a Phased Retirement?

Let’s start with a definition of “phased retirement” or at least the definition that I like to use. In a phased retirement, the transition from full-time employment to not working at all is gradual and not made in a single leap from one stage to the other. There can be multiple phases or transitions as part of a planned decrease in paid work activity and corresponding increase in non-paid activity.

In some cases, the phased wind-down occurs in your present job, with the cooperation and understanding of your employer. In other cases, a phased retirement plan may require leaving your full-time job entirely and moving to a part-time job with a different employer, perhaps in an entirely different field altogether.

In either case, one of the goals of a phased retirement (at least in my mind) is to eliminate that “I’m working for the weekend” feeling which all of us occasionally experience in a full-time job.

What are the Advantages of a Phased Retirement?

I can think of several good reasons to leave full-time working life in phases rather than abruptly:

1. Emotional Preparation. Many new retirees report difficulty in losing their connections with work and with fellow workers. This can effect your feeling of self-worth as you search for other interests, activities, and people to interact with. A phased retirement allows you more time to adjust and to explore your proper place in a retired world.

2. Financial Benefits. A phased retirement means a continuation of income and, hopefully, a continuation of benefits.  This can allow you to begin the retirement process earlier. Even if you have a pension and/or plan to take Social Security at age 62, there is still that issue of healthcare, since Medicare eligibility doesn’t begin until age 65. This may change somewhat under proposed healthcare reform but any such changes are unknown and won’t be immediately effective anyway. If the continued part-time income allows you to delay claiming Social Security retirement benefits, that can improve long-term finances for you and for a surviving spouse.

3. Mental Health Benefits. First, recent studies tell us that skewed work-life balance is a major source of stress in our lives. Phasing into retired life can immediately relieve some of that stress. Second, another study tells us that retirees who work part-time are healthier than those who move abruptly into complete retirement. An interesting result from that same study is that phased retirement was also beneficial to mental health, but only if the part-time work was related to the retiree’s previous career.

4. Keeping Your Options Open. Another advantage of a phased retirement is that you can enter your phase-out period but keep your exit options open. For example, while you are working part-time you can assess the overall economic environment and its impact on your investments before deciding when to stop working entirely. That can be less stressful than retiring completely and then being forced to “unretire” when things don’t go well financially.

Making a Phased Retirement Plan

So how does one plan for a phased retirement? There probably is no one-size-fits-all planning process. Differences in ages, health, availability of pension income, etc. can significantly impact the plan. But I think there are some common elements.

1. Be Prepared for a Shortened Plan. It’s unwise to start a phased retirement unless you are prepared for a worst case scenario, that being the complete loss of any employment income. No job is a sure thing and for baby boomers working part-time, the risks of unemployment are increased. Make sure that you can financially handle the downside.

2. Have Health Care Covered. A phased retirement cannot mean phased healthcare coverage. That needs to be rock-solid and affordable. Keep in mind that many part time jobs do not include benefits. Even when health coverage is theoretically available, some group health plans require a minimum number of hours worked for eligibility. You don’t want to phase yourself right out of coverage.

3. Try to Stay in Your Field. Ideally, your phased retirement would start by staying in your present job while reducing your work hours. Moving to a different employer can add stress because of having to adjust to a new environment. That stress can really ramp up if you change careers and thereby add a steep learning curve in the process. Retirement is intended to decrease stress!

4. Know the Impact on Other Income. Working part-time after you are technically retired (e.g., collecting Social Security) can have a significant negative impact on those other benefits. Working after receiving Social Security will cause a loss of benefits prior to full retirement age. You also need to understand how your employment income and benefits will be taxed.

Final Thoughts on Phased Retirement Planning

If there is anyway possible that a baby boomer can plan for a phased retirement, I recommend it. It’s a time to test the waters and ease into a new life. If you leave your options open, you may decide to extend your working life. Or you may do just the opposite. Either way, it will be your decision, based on your own experiences.

Does anyone have a phase-out plan in place?

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Let’s take a quick look at the official National Save for Retirement Week website. Right from the front page there is a link to a “Five-Minute Check-up” tool. It’s more like a five-second check-up tool. The first problem I observed was that the tool automatically assumes that your income needed in retirement will be the same as your current income. There are so many reasons why that assumption is flawed. It makes a lot more sense to create a theoretical spending plan and budget for your retirement years. At that stage of your life, it’s all about what you spend, not what you used to earn.

Here are all of the assumptions incorporated into the retirement check-up tool:

1. You will need 100% of your current income in retirement. Not true for most retirees. See above and my post on creating a plan for guaranteed retirement income.

2. You will live in retirement for 30 years. This assumption is OK. If you want to play with the longevity number, check my post on life expectancy and retirement planning.

3.  Inflation will remain steady at 3%. I think this is wishful fantasy. Although the White House is trying to move into deficit control mode, the economy is too precarious to really do anything significant. In a few years, we will be begging for a return to 3% inflation. All the more reason to be thinking about investing for inflation protection.

4.  Your annual income will keep pace with inflation. This is probably not a reasonable assumption for baby boomers. For many of us, the income plateau or even downhill slide has begun.

5.  Your savings will grow at an average annual rate of 8%. I’m not even sure I understand this assumption. If they mean that we can expect an 8% annual return on our retirement savings, who are they kidding? That’s what we thought in 1999, when the Dow first cracked the 10,000 mark.

6.  You will earn an average of 5% annually on your savings during your retirement. This is probably a reasonable assumption as a pre-inflation return. Given present and anticipated future economic conditions, I’m more concerned about the real (inflation-adjusted) rate of return.

7. You will use your employer sponsored retirement savings plan (401, 457, etc.) to save for retirement. Makes sense although there is an outcry from many interested parties that the 401(k) is doomed as a viable retirement savings vehicle for most Americans. A new organization – Retirement USA – is working to completely revamp how we provide for our retirement income. Whatever they are able to accomplish, it’s probably too late for most baby boomers to benefit from it.

I’m curious, readers. How did you fare in the “Five-Minute Retirement Check-Up?”

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