Retirement savers who’ve paid off their mortgage or have made their last college payment should take a moment to celebrate. Then they should get busy putting their newfound windfall to work.
Given that mortgages and children’s education are two of the biggest budget items for many people, making the last payment on a home or student loan, or ending college savings contributions, can free up a significant chunk of money. Combined with government efforts to encourage catch-up retirement savings, this extra cash can turbocharge 401(k)s and individual retirement accounts.
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Yet many people who vow to catch up on their retirement savings goals once they’re empty-nesters don’t do so, recent surveys suggest. Part of that could be not knowing how to allocate their newly freed up cash flow, or even how much has been freed up. Consider this example: If parents contribute the tax-free maximum $16,000 each annually to one “529” education savings plan and have a monthly mortgage of around $2,000, that’s $56,000 a year combined, or about $4,700 a month. Even if they’ve only paid off college or the mortgage and still have the other payment, there still could be a lot of extra cash to put to use.
“For most people, once home and college costs are relieved, it’s almost like getting a raise,” says Jim Colavita, senior wealth advisor at GenTrust in New York City.
Having a disciplined plan is critical to using that free cash flow wisely, and how to use it may depend on when money becomes available. Here are some suggestions on how to redeploy those assets:
Financial advisors target two main goals for people this age range: boosting retirement savings and paying down debt, particularly high-interest variable debt.
Start by increasing contributions to 401(k) or other employer savings plans. Ideally savers will max out their contribution, but at a minimum, they should save enough to receive any employer match, says John Campbell, senior vice president and senior wealth strategist for U.S. Bank Private Wealth Management in Chicago. Currently a person 50 years or older can stash as much as $27,000 into a 401(k). Additionally, people over 50 can contribute $7,000 annually into a traditional individual retirement account or, if their income allows, a Roth IRA.
If near-retirees have maxed out their 401(k) and other accounts, another option may be to fund a health savings account, says Laura Davis, a financial planner at Baird in Nashville, Tenn., which is available to people with high-deductible health plans. These can be appealing because the contributions reduce taxable income, like a 401(k), withdrawals used for medical purposes are tax-free, and money not spent that year rolls over and if the account accrues interest or has investment options, the earnings are tax-free. The maximum contribution for single people is $3,650 annually, or $7,300 for a family plan. HSAs have a catch-up contribution for people over 55 of $1,000.
Another good use of free cash: Tackle high-interest debt, defined as debt that has an interest rate of 10% or higher, Colavita says. Savers can hold off paying debt that’s in the lower single-digits and instead put that money toward retirement savings to take advantage of the long-term market returns that typically exceed the rate on low-interest debt.
Davis adds a third option is to start saving for major home improvements to be done before retirement, especially for people who might be staying in their homes, or want to age in place. Campbell agrees, saying this type of fund could accumulate savings for future use, similar to an emergency fund.
“You can tap into that fund and it has no impact whatsoever on your cash flow needs,” he says.
Near-retirees in this age range could choose to tackle one of the three options, especially if high-interest-rate debt is a heavy burden. For savers who want to divide up their cash flow into different goals, Campbell suggests this: allocating at least 50% to retirement investments, 10% to 25% to paying down variable debt, and 10% to 25% to home repair savings.
For people who become empty-nesters or mortgage-free in this age group, the question is about when they want to retire. If that time horizon is 10 years or longer, the advisors’ allocation advice remains the same, save at least half for retirement, pay off debt and save for home improvements.
But for those who would like to retire within 10 years, now is the time for people to meet to discuss the transition to retirement and to start or update a financial plan. An financial advisor can lay out the saver’s sources of retirement guaranteed income, including Social Security and pensions, how to supplement that income to meet fixed expenses, how to allocate according to their risk tolerance, retirement goals and objectives and ideal retirement age.
“Between 55 and 60, I would say start thinking about the things that can be done to preserve and protect more of your assets,” Campbell says.
That could include rebalancing portfolios to reduce risk or starting to build a cash cushion for the person to who is five years or less from retirement. Starting looking at the cost of long-term care insurance, especially if near-retirees are on track with retirement savings. The advisors suggest investigating hybrid solutions that can be used for long-term care or have death benefits, which are similar to annuities.
A potential savings breakdown for freed-up cash for someone with a nearer-term retirement goal would be at least 50% in retirement savings, with the rest divided depending on needs, 10% to 15%, between home maintenance savings, debt reduction, and long-term care.
In this age group, savers should direct some freed-up cash flow to building liquid accounts. Depending on a person’s comfort in holding cash or tolerance for market volatility, a saver can have a cash cushion of as much as four years of fixed living expenses, minus whatever guaranteed sources of income the near-retiree has, Davis says.
Long-term savings are still important, too, the advisors say, since retirement could last at least 20 years. Campbell says retirees should think of retirement lasting three phases and line up their savings with those phases. Phase one lasts from the moment of retirement to about age 75, phase two ranges from 75 to 85, and phase three is 85-plus.
At stage one, 25% to 50% of extra cash flow should be allocated first to building cash and toward long-term savings. Any extra money can be earmarked for home maintenance or other big-ticket items and debt reduction.
Campbell says it’s also possible that people need to use all of the money that was originally allocated to their children’s college education or mortgage to support themselves in retirement. But if they can set aside 10% toward long-term savings, savers are still making progress for their future.
“That’s the key. It’s the little, incremental progress that can have a disproportionate impact later on,” he says.
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