What Should You Do in the Last Five Years Before Retirement?

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Those last five years could make or break your retirement plan, and many people get them wrong. In this post, I'll explain why the last five years prior to retirement could possibly be more important than any other time period when it comes to retirement income planning.

If you're new here, my name is Michael Baker, and I am a financial planner who's been helping couples prepare and plan for retirement for nearly two decades. Here are five things you should think about in the five years before you retire.

Create a Formal Retirement Income Plan

It should come as no surprise that I am a firm believer you should have a retirement income plan in place—or at least begin the process of creating a formal retirement income strategy. This is where you're going to map out all your different sources of income: Social Security, pensions, rental income, annuities, and anything that could potentially be an income source for you in retirement.

Part of this process is identifying whether there will be a gap between your income and your lifestyle in retirement. This plan or strategy doesn't have to be rigid. In fact, I think it's very smart to build flexibility into your plan because, while five years doesn't seem like a long period of time, a lot can happen. We like the idea of flexibility, but more importantly, it's crucial that we start having an actual strategy in place.

Understand Your Healthcare Coverage

Healthcare is a huge topic in retirement. First, because most people move on to Medicare, so it's going to be a shift at some point from a traditional workplace retirement plan. Second, Medicare can be quite confusing, so you want to understand exactly what your plan is going to be for healthcare. More importantly, you want to understand exactly what coverages you're going to have and if you're going to have any gaps in coverage.

The last thing we want is to identify a gap in coverage when we're having a health emergency. For most people, Medicare coverage is going to start at age 65, but Medicare Part A and Part B don't cover everything, which is typically why you need to have a supplement. There's also Medicare Advantage and many different types of options available, so understand what your options are.

I highly recommend working with someone who specializes in Medicare so they can explain every option available to you in detail and answer all of your questions. In my opinion, cost is going to be an important factor, but it's not the most important factor to me. The most important factor is making sure that you have the type of coverage you need so that you don't have any significant gaps. As I said earlier, the last thing we want is to identify a gap in coverage when we're having a health emergency. That's the worst thing that can happen, so it's important to do your due diligence on the front end.

Address Debt and Align Your Lifestyle

Many people are still bearing down on their retirement years with high-interest consumer debt. Now, unlike some wealth gurus out there, I personally don't believe that all debt is bad debt. In many cases, I tell folks that debt is an issue to the same extent that cash flow is an issue. There are many people who have multiple real estate properties with notes on those properties, but their cash flow is completely sufficient. But if that's not you, then we need to talk.

High-Interest Credit Card Debt

First, let's discuss high-interest credit card debt. This is one of those things that you absolutely want to take care of as quickly as possible. Whatever the reason—whether it was a major unplanned expense, some type of financing where your only option was using a credit card, a big graduation party, a senior trip for your kids, or a wedding—it doesn't matter. We do not want high-interest credit card debt to follow us into retirement. So if you have credit cards, we want to begin getting those things paid off as soon as possible, or at least get a strategy in place for how we're going to attack that debt.

The Mortgage Payoff Question

Now this might be controversial, but I have to be honest and tell you how I feel. Lots of people move into their retirement years and they are accelerating a mortgage payoff, meaning they have a fixed payment, but they're paying over and above that fixed payment because they're trying their hardest to get that mortgage debt paid off.

I completely understand the peace of mind of knowing that your home is paid off, free and clear, and that you own your home with no mortgage. I totally get that. However, sometimes the highest and best use of that excess cash flow isn't necessarily paying down your mortgage debt. There could be other things—like the high-interest credit card debt we just talked about, or some type of student loan or personal loan that you need to address before you retire.

Secondly, if you don't have an adequate cash war chest or you've got thin emergency funds saved up, it might be a better idea instead of paying down extra on the mortgage to boost your cash or build your cash savings. I won't necessarily say that we should be investing excess dollars because the last five years of retirement could be a coin toss when it comes to market returns. But if we're low on cash or we don't have adequate emergency funds, this could be a better way to use some of that excess cash and build those savings.

One of the things that a lot of people overlook is that if you are late in your amortization schedule—meaning you are in the last several years of a 30-year note or a 15-year note—you've likely already paid most of the interest costs and now you're mostly paying down principal. So those extra cash payments, while yes, they would get the principal paid down faster, they're not necessarily saving you the interest cost.

So that's my opinion. If it's controversial, I'd love to hear your thoughts in the comments. Do you think it's wise to really accelerate a mortgage payoff if there are better opportunities to use that cash elsewhere, or do you think it's just better to get the thing paid off so you have peace of mind? Let me know in the comments.

Lifestyle Alignment

The second part of this step is lifestyle alignment. Many people don't really know exactly what their lifestyle in retirement is going to look like. Now, they may have a good idea. In fact, most of the folks that we talk with say, "Hey, the lifestyle that we have right now is the lifestyle we want to have in retirement. We want to protect and defend this lifestyle." So first we have to understand exactly what we're spending, so we know how much that lifestyle costs. But for many people, this is still somewhat of a gray area.

Here is a great test that you can give yourself, and it's super easy to do. Sit down with pen and paper, you and your spouse, and map out what you think you spend every month. Then once you have that number, maybe one to two years prior to retirement, begin living on that number. That's one way you can find out if this is the real cost of your lifestyle.

If you can meet that test, then in my view, you're ready. You have a good understanding of what your lifestyle costs, but this also gives you a relatively low-pressure way to see if you need to make some

adjustments. Maybe you overestimated the amount of money you need, or maybe you need to make those adjustments so that you have a little bit more income in retirement. I think it's best to do this while you're still working.

Of course, if you remember what I said in step one, we want to have some flexibility in our plan. That's why flexibility matters, because you may retire and realize, "Hey, you know what? We actually need a little bit more," or "Actually, we are not spending what we thought we would spend."

But here is the cardinal sin: What we don't want is to go into retirement and be afraid to spend money because we don't have a good plan or a plan that gives us the confidence to spend. That's why we want to leverage these five years prior to retirement to create a good plan so that when you do retire, you don't feel bad about spending your money.

Plan for Taxes and Consider Roth Conversions

Taxes will likely be part of the retirement income equation for the rest of your life. Most people have deferred portions of their income into qualified retirement plans, and if you know about qualified retirement plans, when we put money into the plan, we actually get a tax deduction. But when we start making distributions or we start using those dollars, that's when we have to pay taxes. We pay taxes on the distribution.

In retirement, that means taxes are going to be a factor, especially if you're using qualified retirement dollars as part of your income. So we want to understand exactly what our taxes are going to look like or are projected to look like throughout our retirement.

Now, if you know anything about me, my philosophy on taxes is that nothing's permanent. In fact, the tax code, in my view, is written in pencil. This means that taxes can and will likely change over the course of a 30-year retirement. So we have to be diligent and look for opportunities to be tax-efficient.

This is where tax bracket strategies come in. Roth conversion strategies come in. We want to make sure that we pay the lowest lifetime tax bill that we possibly can.

These are your hard-earned retirement dollars. Yes, we have a partnership with Uncle Sam. He wanted to incentivize us to save for retirement. We are under no obligation to make sure we pay high taxes in retirement, so let's plan for a tax-efficient retirement as well. This could include things like Roth IRAs, so if you're interested in that, you want to make sure that you build in proactive tax planning and tax strategies to your retirement income plan.

Three Key Tax Considerations for Retirees

Required Minimum Distributions (RMDs)

If you've got money in an IRA, 403(b), or 401(k)—one of those qualified retirement plans—even if you don't need the money, there comes an age (either 73 or 75 if you were born after 1960) when you have to start taking distributions from those accounts. So if you have income from other sources or you're using other funds, eventually you're going to have to take money out of these qualified retirement income plans. And as I mentioned earlier, these distributions are going to be taxable, so they have the potential to put you in a higher tax bracket than maybe you would have thought if you're not prepared for this season.

Social Security Taxation

Social Security has an interesting tax calculation, and these dollars, while they do have some great tax advantages, as we receive other sources of income, it could potentially drive up the tax on our Social Security. So we want to understand the impact of things like pensions, interest, dividends, capital gains, and distributions from IRAs. All of those dollars as they flow through to the 1040 also go into the provisional income calculations for tax on Social Security. So we want to understand: if we're going to do anything discretionary or we're going to have other sources of income, what kind of impact does that have on the tax of Social Security?

Medicare IRMAA

This is somewhat of a means test that is applied to Medicare premiums depending on your income, whether you are single or married filing jointly. You want to know and understand how Medicare IRMAA is calculated if you are going to be in higher income brackets in retirement or if you're going to have certain years in retirement where you see yourself being in a higher income bracket. Maybe you've had an inheritance or maybe you're going to sell some assets like a home or a second home, and you're going to realize some capital gains. Any of these big income years could potentially impact Medicare IRMAA.

So you want to understand, especially when you're building out your retirement income map, not just your income taxes, but how these other areas—RMDs, Social Security tax, and IRMAA—will impact you in retirement.

Reassess Portfolio Risk and Update Your Estate Plan

Now you might be thinking, "Wait. Portfolio risk. Shouldn't we be thinking about portfolio risk before we do these other things?" And you're absolutely right. Most likely the time that you're going to be looking at portfolio risk and assessing what type of risk you're taking with your dollars is going to be during step one when you're actually creating or thinking about your formal retirement income planning strategy.

But I didn't put it number one because a lot of people make this key mistake: they think that their portfolio is actually the plan. That's not true. A plan is a plan. The portfolio could simply be the tool or the tools that are used to implement the plan. So a lot of people think that the portfolio is actually the plan, and that's not the case. I saved it for last because while it will be important and we do want to understand it early on in the game, I don't want people thinking that the portfolio is all that matters, because that's not the case.

Understanding Portfolio Risk in Retirement

For retirees specifically, risk is different. Your risk profile as someone in retirement is going to be different than younger generations. If you've got adult children that are working and starting to earn money, the level of risk in your portfolio shouldn't be looked at the same way as someone who's younger, who's got many years left for their investment journey.

For retirees, the five years prior to your retirement date and possibly five to six years after your retirement date—this is the key area where you are most susceptible to sequence of return risk. This is a very acute market risk that is present for people who are looking to retire. (I did an entire video on sequence of return risk that you can watch to learn more about that topic.)

For people about to enter retirement, let me sum up risk this way: Risk to you is permanent loss of capital. Now you might say, "Hey, wait, that's risk for everybody." Of course it is. But if you're younger and you're working and you're putting money into a portfolio, you're actively saving. You have time on your side for any type of significant market downturn event to actually reverse and recover.

However, if you're nearing your retirement date and you're looking at that portfolio of assets to be some kind of supplement or to help you actually retire, permanent loss of capital could mean a significant downturn, and you start needing those dollars to help you support your lifestyle. We're using dollars in a portfolio that is down and we're not able to allow it to recover. That is a very acute risk that is present for people who are getting ready to retire.

So we want to reassess our portfolio risk and understand exactly how that portfolio could react or respond during various types of market stress. This is why I highly recommend, if you're planning for retirement, you want to stress test that portfolio multiple ways so that you understand exactly the risk that you're taking, but also how that portfolio would be expected to respond.

I stress the portfolio risk piece because so many people that we meet with don't fully understand the risks that are present. They think that their portfolio is diversified or they think that their portfolio has an appropriate asset allocation, and in many cases, these are just buzzwords that a lot of folks don't fully understand. When we break down portfolio risk, we actually want to break down what it looks like with loss of capital, sequence risk, inflation risk, or whether we have assets that are high-cost, high-expense assets that don't give us great returns. There are multiple ways to unpack this, so this is a critical component, but I've saved it for the end because I didn't want you to think that it was the only thing that mattered.

Estate Planning Documents

Now, let's talk about your estate planning docs. I know, I know—this is one of those times where it just gets morbid because we start thinking about estate docs, we start thinking about wills, and then somehow we think that if we talk about our will, the universe now has permission to take us out. That's not true. Good estate planning is just good planning.

Update Your Beneficiaries

First, we want to make sure that we have appropriate beneficiaries on all of our accounts: IRAs, 401(k)s, annuity contracts, life insurance contracts—anything that would have a beneficiary form. We want to make sure that you've named the appropriate beneficiary on those forms. If you are in a second marriage or if you are in some type of blended family situation, you want to make sure that the person on the beneficiary forms is who it's supposed to be. This may mean you have to go back and find old accounts, maybe decades old, but make sure that the beneficiary forms are updated and correct.

Update Your Estate Planning Documents

Secondly, you want to make sure that you have updated and appropriate estate planning documents. A lot of people have wills or wills and trusts from when their kids were first born and they never updated them, or they had wills and trusts created when they lived in a different state and now they live in a new state. These major life events—birth of a child, marriage, divorce, death of a family member, moving to a new state—these are all points that should trigger an estate planning document review.

We have a great team of people that help us with this, but we want to make sure you have updated estate docs. And if you don't have estate planning documents, we want to make sure you absolutely do have estate planning documents.

Why This Matters

Now, why is all of this important? One of the things that we see commonly in our practice is we have two different types of spouses: we have a non-CFO spouse, and they almost always are married to a CFO spouse. So we almost always have a CFO spouse and a non-CFO spouse, and they get along great.

We want to make sure that we have a plan for the surviving spouse. And for the CFO spouse out there, I'm talking to you: You want to make sure that you have a plan in place for the non-CFO spouse because while you may be doing it yourself, or you may be spearheading things and you have things under control, I can almost guarantee you that if something happens to you, your spouse is going to hire a new CFO to take care of them. You want to make sure that you've got things in place so that transition is smooth or that you know, like, and trust who they are most likely going to call.

This is why the estate planning component is critical, because it allows you to put things in place so that for the surviving spouse, there's a very smooth transition, and for your heirs, there's also a smooth transition. The last thing we want is for all this hard work that you've done—you've lived a long time, you've enjoyed it, you've had a great lifestyle full of memories, and we're passing on assets—to result in a giant mess because appropriate estate planning wasn't done. We don't want a plan that we've put together that's worked so well to fall apart at the very end.

BONUS: Five Big Mistakes to Avoid

Maybe you've already done these five steps and you've said, "Hey, I've already got a good grip on these things and I've got these things taken care of." Here are five big mistakes that you want to avoid:

1. Claiming Social Security too early. It may be right for some people. For a lot of people, claiming early is a big mistake.

2. Ignoring healthcare costs. Healthcare inflation tends to be higher than every other type of inflation in retirement, so make sure you're building in adequate inflation assumptions for healthcare.

3. Waiting too long or not being aggressive enough with Roth conversions. You have a limited window of time to actually implement Roth conversions where you have the most flexibility. That's between ages 60 and your RMD age. That's the golden period to do Roth conversions. It doesn't mean you can't do them post-RMD age, but there are some constraints once you start having RMDs.

4. Underestimating inflation and market risk. These two things will be with us throughout the duration of our retirement, so we don't want to take them lightly.

5. Not involving your spouse or family in your planning. Some people try to plan for themselves and by themselves. I do not recommend this. Get your spouse involved. Even if they say, "No, I don't care. I'm not interested," trust me, they care. They just don't know how to tell you.

Take Action Today

Use these guidelines, but definitely if there are certain things that are specific to you, make sure you don't ignore those planning topics either. That starts with number one: creating your plan.

The last five years prior to retirement are key years. Do not let them go to waste. And if you're already inside of five years and you haven't started, there is no time like today to get started. Take that first small step, whatever the next step is for you. Take that first small step and begin planning for your retirement.

This is your chance to protect your income, your healthcare, and your lifestyle. And if you'd like help creating your own personalized retirement plan, or you're not quite sure where to start, click the link below to schedule a retirement vision call with our team today.

Investment advisory and financial planning services offered through Advisory Alpha, LLC, a SEC Registered Investment Advisor. Insurance, Consulting and Education services offered through Vertex Capital Advisors. Vertex Capital Advisors is a separate and unaffiliated entity from Advisory Alpha, LLC. All written content on this site is for information purposes only. Opinions expressed herein are solely those of Michael H. Baker, unless otherwise specifically cited. Material presented is believed to be from reliable sources and no representations are made to another parties’ informational accuracy or completeness. All information or ideas provided should be discussed in detail with an advisor, accountant or legal counsel prior to implementation. This website may provide links to others for the convenience of our users. Michael H. Baker has no control over the accuracy or content of these other websites. Please note: When you access a link to a third-party website you assume total responsibility for your use of linked website. Links and references to other websites and third-party content providers are offered for your convenience. We do not necessarily prepare, monitor, review or update the information provided by third parties. We make no representation or warranty with respect to the completeness, timeliness, suitability, or reliability of the referenced content.