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Don’t put all your eggs in one basket when you’re near retirement

by retirebyforty on November 4, 2013 · 20 comments

in asset allocation, early retirement, investing

Last week, I chatted with Andrew, a long time reader, about his early retirement plan. He is planning to retire at 51 and has only a few years left to go. His expense is very low at about $12,000* per year and he probably can retire right now if he wants to. He mentioned that he plans to roll over his 401k into his Roth IRA and put a large percentage into a REIT. He thought he’d be able to take the dividend payout tax free from his Roth IRA for his cost of living. This is alarming in a number of ways.

*Note: Andrew has a partner to share living expense with. $12,000 is his share.

  • He would have to pay income tax when he rolls over his 401k to a Roth IRA. This is a conversion. Anytime you move money from a traditional account to a Roth, it is a conversion. This could be quite expensive depending on how much money he made the year the conversion occurs. *I just found out that some qualified plan like the 403(b) don’t have to pay tax when rolled over to a Roth. All the more reason to consult a tax professional.
  • He would have to wait 5 years before taking money out from the Roth IRA to avoid the 10% early withdrawal penalty and taxes on the earnings. This is just the part that was converted from the 401(k).
  • He’ll put a lot of eggs in one basket if he puts a large chunk into one REIT.

Roth IRA ladder

A better way to do it would be to rollover his 401k in to a traditional IRA. Then convert 20% (or less) of the traditional IRA to Roth IRA every year for 5 years. This way, he will minimize income tax from the conversion and after 5 years he can start taking distributions without having to pay the 10% penalty.

While he waits for his Roth IRA ladder to kick in, he can live off his taxable accounts and previous Roth contributions. Andrew updated me that he already has a substantial investment in his Roth IRA so he could withdraw his contribution to that part without any penalty. He also mentioned the possibility of consulting part time to earn some income.

Don’t put all your eggs in one basket

A more worrying part of his retirement strategy is the plan to put a large part of his investment (12% of projected net worth at retirement*) into one REIT. REITs are attractive income investments because they can throw off 5-10% dividend income and Andrew could generate all of his living expense from just his Roth IRA.

*Note: I thought Andrew planned to invest about 25% of his net worth in one REIT, but he clarified that it will be about 12%.

However, this sounds like a risky plan to me. Andrew’s living expense is already so low and he should be able to easily generate $12k/year with all his accounts. By trying to generate $12k/year from just one REIT, he is taking on a lot of risk. What happens if the bottom drops out of the REIT sector again like it did earlier this year?

Andrew should reach Financial Independence soon if not already. Why take a lot of risk if he doesn’t have to? Once he retires, his income will drop and it will be difficult to recover from a big setback. It’s better to invest conservatively and diversify his investments.

Have you heard of this old adage – “If you already won the game, why keep playing?” When you are near or in retirement, it’s better to conserve your wealth than try to grow it. I still think it’s good to invest in the stock market, but you need to be diversified. Most experts recommend no more than 5% of your total portfolio in one stock.

Check if you’re diversified

If you are near retirement (or FI), then there are a few things you need to do. The first thing is to figure out your asset allocation. Once you retire, your risk tolerance, investment horizon, and goals will change. There are many resources online to help you do this. I collected a few in this asset allocation article a few weeks back.

The next step is to check if your investments are diversified. There are a couple of good tools on the internet.

1) Personal Capital. You can sign up with Personal Capital and keep track of all your investments in one place. You can link all of your investment accounts and Personal Capital will keep track of the asset allocation for you. It’s very helpful to get a quick visual when you want to make a trade.

don't put all your eggs in one basket when you retire

You can click through each section to see more detail at Personal Capital.

2) Morningstar Instant X-Ray has been one of my favorite tools on the internet for many years now. You manually input your holdings and it will show your asset allocation, stock style diversification, stock sector, fees, geography, and more. It’s a bit of a pain to manually enter your holding though.

You need to diversify your portfolio

This is from my dividend portfolio. It looks like I have too much concentration in consumer products and energy. I need to pick up some utilities and communication stocks.

These tools are great because they will show you where your investments are concentrated. Diversification doesn’t just mean buying different stocks. If you buy 5 REITs, then you are still overweight in the real estate sector. Ideally, you’ll want to be diversified in asset class, sector, and internationally as well.

Diversification is not easy. It can take many years to figure out your asset allocation and risk tolerance. It’s definitely not good to put too much of your assets in one stock though. One bad setback and you might have to go back to work. Luckily I learned this pretty early on in my investment career. At one point I had over 25% of my portfolio in Intel stock. Then the dot com bubble burst and it became an expensive lesson.

What do you think about Andrew’s plan? What’s the maximum that you would invest in one stock? Is 12% too much? I like the 5% rule of thumb. 

Disclaimer: I’m not a tax professional and our reader will probably have to consult a tax professional before retiring. The whole Roth IRA thing can be a bit tricky.

{ 20 comments… read them below or add one }

Maverick November 4, 2013 at 1:25 am

And why the emphasis in dividend producing stocks. You can sell a small portion (less than 4%) of your portfolio each year of retirement just as easily, correct?

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retirebyforty November 4, 2013 at 4:06 pm

I like dividend stocks because the principal will be intact unless you need a lump sum. I think most people use the draw down method though.

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Jane Savers @ Solving The Money Puzzle November 4, 2013 at 7:33 am

I want about 50% of my money in different dividend paying ETFs. The other 50% will be in GICs (guaranteed investment certificates). The older I get the more I will move to the GICs because the principal is guaranteed and when I stop working I cannot afford anything risky.

I am not sure if I can stick to this plan because I just saw the October dividends that I earned and that makes me want to put everything in to ETFs.

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retirebyforty November 4, 2013 at 4:07 pm

The interest rate is just so low at this point. I’m sure it will come back up someday.

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writing2reality November 4, 2013 at 8:42 am

Wow, pretty interesting scenario for Andrew. I would imagine that he has a fairly reasonable sized nest egg, and any well diversified portfolio should cover his low expenses fairly easily. Certainly I wouldn’t advocate him having to sell any equities to cover his expenses like Maverick mentioned above, but a sound portfolio of dividend stocks, REITS, peer-to-peer lending, and a variety of ETFs should do the trick nicely.

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Done by Forty November 4, 2013 at 10:19 am

I am glad you at least gave the advice to roll over funds into the Roth slowly, so as to minimize the tax burden. With expenses around $12k a year, he may be able to roll over funds in one-year-spending amounts, small enough to more or less avoid federal income taxes altogether. That’s kind of an ideal set up: expenses low enough that, even with just the standard deduction and exemption, that one’s taxable income is around zero.

I can’t speak to the REIT but I have seen some asset allocations with 10% or more in that asset class. Why not spread it to a few REITs though?

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mary w November 4, 2013 at 12:56 pm

I suggest that he see his CPA ASAP and not wait until he retires. Converting 20% a year to Roth’s isn’t necessary the exact perfect speed. He should try to minimize taxes over the long haul. If he’s well into 25% bracket now and will have lots of room in 15% bracket when he retires then he should probably wait and then use up his 15% bracket. This could be more or less than 20% of his 401k (by then IRA). If his tax bracket is the same then he might be able to convert some now. (If his company allows an in-service rollover at his age. Or maybe he has other IRAs that he could convert.)

His CPA should be able to come up with a custom plan.

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retirebyforty November 4, 2013 at 4:10 pm

He definitely need to talk to a professional. It’s just too complicated and you don’t want to mess it up.

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Bryce @ Save and Conquer November 4, 2013 at 2:09 pm

I agree with you and others that Andrew needs to carefully consider his tax situation. Depending on what he is currently earning, any Roth conversion could kick him into a higher tax bracket where his conversion costs could also jump up. As you mentioned, converting over a longer period of time would probably be more beneficial.

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The Dividend Guy November 4, 2013 at 4:27 pm

I guess it all depends on which stage you are at. Since I’m young and I don’t plan to retire right away, I don’t mind having 10-15% in one stock. However, I would not select a REIT as my core income. REITs are good income producers as you mentioned but they are limited to the real estate market.

A 10% in a well diversified company such as Johnson & Johnson for example makes more sense to me. Even then, at retirement, I think that 5% should be more than enough. If Andrew really wants to have 12% of his portfolio in REITs, he could select 3 different companies instead of 1 :-)

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retirebyforty November 5, 2013 at 8:38 am

Thanks for your comment. I think investing in 3 companies is the way to go too.

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Alice November 4, 2013 at 6:58 pm

Thanks for the article! I didn’t realize that in some cases, a 403b can be rolled into a Roth without taxes and am curious where you heard about this? I was thinking about rolling my old 403b into my current 401k but I would definitely prefer rolling this into a Roth if that’s possible. Will look into this some more but any direction you can provide would be most appreciated. Thanks again!

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retirebyforty November 5, 2013 at 8:43 am

I read it on investopedia – http://www.investopedia.com/articles/retirement/03/030403.asp
A Roth conversion or rollover of nontaxable assets (Traditional IRA assets for which there was no tax deduction and after-tax assets from employer plans such as qualified plans and 403(b) plans). These assets are not subjected to income tax when distributed or converted to a Roth IRA.)
It sounds like if you already paid tax, then you don’t have to pay tax when you convert. Good luck.

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Alice November 5, 2013 at 6:25 pm

Thanks, Joe! I’ll take a look at the link. This is very exciting as I had no idea this might be an option.

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Squirrelers November 4, 2013 at 7:42 pm

$12,000 per year in expenses? $1,000 per month seems incredibly low. More power to Andrew for being able to live on that!

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AB November 4, 2013 at 10:03 pm

Impressive indeed. Here I am living in Asia, in what is supposed to be a low cost country, and as a small family of 3, we are spending twice that, about $25K/year! Makes me feel envious of Andrew. Hopefully, he can share his tips in a guest article on how he can live on just $12k/year in the U.S.!

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retirebyforty November 5, 2013 at 8:43 am

I updated the article a bit. He is living with his partner so the living expense is shared. $12k is his share.

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Pretired Nick November 5, 2013 at 1:40 pm

I think this advice is pretty sound. There is no right answer although there could be several wrong answers. I think it’s more just finding a balance and correcting continually to optimize as best you can.

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Micro November 5, 2013 at 4:35 pm

If I remember the recommendation from The Investor’s Mannifesto, it was no more than 10% of whatever your stock allocation was. So if you put 60% of your money into stocks, no more than 6% should be in REITs. I liked the system because it allows for people to adjust it based on their risk tolerance.

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retirebyforty November 6, 2013 at 9:28 am

I like that too although I’d still go with 5%. 10% is a pretty big slice of your portfolio.

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