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Opening Your Nest Egg without Breaking It


When John and Janet Nelson of Englewood, Colo., began thinking two years ago of retiring in their mid-50s, they had more than $1 million in their two individual retirement accounts. They needed to tap that money for living expenses but were worried about early withdrawal penalties from the Internal Revenue Service. Then their financial planner told them of a strategy for using their IRA funds without losing a big chunk to taxes. They could take money out in "substantially equal payments" for five years or until age 59 1/2, whichever is longer.

Today, the Nelsons are using their semi-annual IRA checks to cover most of their estimated annual expenses of $110,000. In a few years, when they start receiving about $42,000 a year from Social Security, they'll reduce their IRA withdrawals accordingly. In the meantime, John, 58, who bowed out a few weeks ago as a vice-president of Earth Tech, a Long Beach (Calif.) engineering consulting firm, and Janet, 56, who retired from health-care provider Kaiser Permanente in Denver last year, are spending their time hiking, gardening, and volunteering at the Denver Botanical Garden.

As many working Americans approach retirement, they too will grapple with the problem the Nelsons faced: how to parlay retirement savings and other assets into income that will support the lifestyle they desire for the next 30 years or so. Most wait until retirement is only a few years off before plotting a financial exit strategy. But ideally, you should start pinning down crucial decisions at least 10 years before retirement. When you retire, you will have to address such key issues as how much money you will need, which asset sources you should tap first, and how to allocate your investments to produce an adequate income stream.

To estimate the cash flow the Nelsons would need, their financial planner, Joseph Janiczek of Greenwood, Colo., had them itemize all the costs they could incur--from housing and taxes to clothing and entertainment. Then he tallied their expenses based on 3.5% annual inflation. Janiczek warns against the rule of thumb that says you can live on 80% of your pre-retirement budget. "Many of my clients end up spending just as much or even more money than they did before retiring," he says. To reduce the Nelsons' expenses, he advised that they refinance their home to cut the monthly payment from $3,200 a month on a 15-year mortgage to $1,500 on a 30-year loan.

For many people, a big chunk of their retirement savings is in a 401(k) or similar account. Their crucial decision becomes whether to withdraw the money in a lump sum, as an annuity, or in some other form that their employer may offer. One advantage of an annuity is that you have a good idea of your taxable income. But often, experienced investors want to maintain control of their money, so they opt for a lump sum, which they roll over into an IRA. Of course, if your money is now in a regular IRA and you're not yet 59 1/2, you'd have to pay not only income tax but also a 10% penalty on any withdrawal. The way around the penalty is to do what the Nelsons did: set up a "substantially equal payments" plan. As long as you follow one of three IRS-approved formulas, you can make penalty-free withdrawals. But this method is complex, so it pays to seek professional advice.

THORNY. Another thorny decision is how to reallocate your investments to get an adequate cash flow. As people live longer in retirement, experts question the traditional strategy of shifting most of your portfolio to bonds or other fixed-income vehicles, because the earnings from those securities aren't likely to keep pace with equity investments. "Maintaining a very conservative portfolio is one of the biggest mistakes investors make at retirement," says William Howard, a financial planner in Memphis. "Inflation is a bigger risk over the long run than volatility risk." So, despite the stock market downturn, Howard suggests this allocation for a person two to five years away from retirement: 10% cash equivalents, such as U.S. Treasury notes or a money-market fund, 30% in bonds, and 60% in large-cap, small-cap, and international stocks.

The cash is important: Advisers say you should have enough (including guaranteed income from a pension or Social Security) for up to two years of expenses, so you needn't sell investments during a downturn.

Your home is a potential source of cash. If you're faced with an emergency, you can use a home-equity line of credit. Based on your equity, "the bank will give you a checkbook to keep on your desk. If you need the money, you can start drawing on it," says Washington (D.C.) real estate attorney Benny Kass. "If you don't use the money, you don't pay anything." Set this up before you retire, he advises. It's easier to get approval while you still have a salary.

Another real estate strategy is to sell your home--as long as it has been your principal residence for at least two of the past five years--and collect tax-free profit of up to $250,000 for an individual and $500,000 for a couple. Invest the money or buy a smaller home.

David Barry, 70, employed a reverse mortgage to salvage his finances, which were hit by both the market downturn and a huge tax bill. Barry, who retired in 1995 as an insurance broker in Los Angeles, and his wife Isabel, 60, had sold their home two years ago and used the proceeds, plus $1 million from his $4 million IRA, to buy their dream house: a 3-bedroom, 3-bath townhouse "with a tremendous view of the beach" in Santa Monica, Calif. Barry knew he would owe income tax on the IRA withdrawal, but he didn't anticipate that the bear market would further shrink his IRA to about $1.5 million by the time the $450,000 tax bill came due.

So the Barrys took a reverse mortgage, available to those 62 years or older who have substantial equity in their home. Interest isn't due until you leave your home or die. Usually, people with reverse mortgages collect the proceeds in regular cash payments or via a credit line. The Barrys took a lump sum of $360,000 to pay the IRS and added $90,000 from their IRA. When they sell the house or pass away, they or their heirs will have to pay off the mortgage plus accrued interest.

As the Barrys' predicament shows, there's more to retirement planning than saving. Figuring out the right way to get money out of your nest egg is almost as important as having one. By Ellen Hoffman


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