Imagine that you recently opened your 40th birthday cards and finally decided to learn about retirement savings. You’ve even bought a retirement book or magazine. Except, it says you should have started saving for retirement in your 20s; you’re well past that age and still haven’t started saving for retirement. Fortunately, you do have options even if you didn’t start saving for the future on time.
Play Catch-up in Saving for Retirement
Assume you’re 40 years old, with $0 in retirement savings. At your age, in 2021, as in 2020, you’re legally allowed to save $19,500 in a 401(k) retirement plan ($26,000 if you’re 50 or over).
Assuming a 7% rate of return, your 401(k) account balance will grow to $1 million in 22 years and 10 months if you contribute the maximum amount each year. You’ll be on track to have over $1 million by the age of 63. As you can see, the magic of compounding makes it possible to realize your retirement savings goals even if you start late.
Identify How Much Savings You Need
You might tell yourself you don’t need a million dollars or that you just want a simple life. But even a simple life often requires $1 million in the bank. Most experts agree that during your retirement, you should withdraw no more than 3% to 4% of your retirement portfolio each year. These are known as the “3 percent” and “4 percent” retirement rules.
If you do the math, 3% of $1 million is $30,000, and 4% is $40,000. In other words, if you want to live on an income of $30,000 to $40,000 per year in retirement, you’ll need a portfolio of at least $1 million. This assumes you don’t have a pension, rental properties, or other sources of retirement income. It also excludes Social Security, which some people find to be more paltry than they expect.
Don’t Take on More Risk
Some people make the mistake of taking on additional investment risk to make up for the lost time. The potential returns are higher: Rather than 7%, there’s a chance that your investments can grow 10% or 12%. But the risk, the potential for loss, is also much higher. Your risk should always, always be aligned with your age. People in their 20s can accept greater losses since they have more time to recover. People in their 40s cannot.
Don’t accept extra risk in your portfolio. You might consider one of the following asset allocation recommendations:
- Invest a percentage of 120 minus your age in stock funds, with the rest going into bond funds. This represents a high but acceptable level of risk.
- Invest a percentage of 110 minus your age in stock funds, with the rest in bond funds. This comes with a more moderate level of risk.
- Invest a percentage equivalent to your age in bond funds, with the rest going into stock funds. This is a more conservative level of risk.
Open a Roth IRA to Save More
Once you’re finished maxing out your 401(k), open an IRA and maximize your contribution to that as well. A 40-year-old who is eligible to fully contribute to a Roth IRA can add extra money each year to their retirement savings.
Contributions to a Roth IRA grow tax-free, and qualified withdrawals are tax-free. You’ll even avoid capital gains tax on the growth of your contributions.
Buy Adequate Insurance
Calamities are the single biggest reason that people are forced to declare bankruptcy. Reduce your risk by buying adequate health insurance, disability insurance, and car insurance. If you have dependents, consider term life insurance for the duration of the time that your dependents will rely on you financially.
Many financial experts say that whole life insurance is generally not as good of an idea, especially if you’re starting the policy in your 50s.
Talk to a fee-only financial planner to get personally-tailored advice. Look for planners who have a “fiduciary duty” to you as their client.
Pay Down Debt
Pay off credit card debt, car loans, and other high-interest or non-mortgage debt. Similarly, weigh whether or not you should make extra payments on your mortgage. If you’re in an early stage of your mortgage, and many of your payments are being applied toward interest, it might make more sense to make extra mortgage payments.
If, however, you’re in the final years of your mortgage and your payments are primarily being applied to the principal, you may be better off investing that money for retirement.
You and Your Spouse Come First
Don’t skimp on retirement savings to send your children to college. Your kids have more options and opportunities than you do. They can also take out student loans. Your 401(k) may or may not allow you to take out a loan on your retirement account balance.
Plus, your kids have their entire lives ahead of them. They can start saving for retirement in their 20s and 30s. If you’re in your 40s, you can’t turn back the clock and regain those decades of saving for retirement. As such, the best gift you can give your children is your own financial retirement security.
How to Trade Options for Income in Your IRA
RETIREMENT INVESTORS looking to boost income have an opportunity that probably doesn’t come to mind right away – trading in the options market with strategies like writing covered calls.
It sounds like blasphemy. After all, the standard advice is to play it pretty safe in retirement accounts like IRAs, and options would seem to violate all that. For every winning options bet, someone loses – likely the player with less experience. Most options contracts expire worthless, and since they have a fixed expiration date you can’t just wait for things to turn around like with stocks and bonds.
But don’t write off options in IRAs too soon. After all, many small investors have more money in their retirement accounts than in taxable accounts, so if options appeal to them, the IRAs are where the money is.
“Yes, you can trade options in IRAs,” says Mike Scanlin, CEO of Born To Sell, an online service for covered-call traders. “Covered calls are by far the most common strategy.”
Scanlin’s customers are typically between 40 and 70 and try to use covered calls to earn 1 to 2 percent a month on the securities involved, he says.
“Covered calls can also be a great way to get a little extra yield from an asset that might be declining but that you feel confident holding on to for the longer term,” says Russ Robertson, owner of ATI Wealth Partners in Atlanta.
“It’s not very common for individual investors to trade options within an IRA,” Robertson says, though he trades options for his clients’ retirement accounts. “Most investors take a long-term view of IRA assets, a view which we support, and don’t actively trade [in their IRAs]. Options inside an IRA are best suited to a disciplined, active investor that can monitor positions regularly.”
Find the Right Financial Advisor For You
Writing covered calls can boost your gains with little risk. And by doing this in a retirement account you can avoid the tax expense and record keeping hassles that could be a real headache in a taxable account. “You just pay taxes when you take the money out of the IRA,” Scanlin says.
Firms that provide IRAs and rollover IRAs (for money transferred from 401(k)s and similar accounts) don’t generally promote options trading, but many do allow it. It’s less common to find options trading in a 401(k) unless it’s set up for very sophisticated investors, though many Solo 401(k)s, used by sole proprietors, do allow covered call writing.
Options trading rights in an IRA generally must be set up by filling out a form and acknowledging the risks. And these accounts typically do not allow trading on margin, or with borrowed money, a common feature in taxable options accounts. Typically, the IRA participant holder can write covered calls and buy calls and puts.
Options give the owner the right to buy (call) or sell (put) shares at a set price for a given period. The option purchaser pays a premium that is typically a fraction of the cost of the shares themselves, and profits if the security moves in the desired direction before the contract expires.
The person on the other side of the contract is the “writer,” so the writer of a call agrees to sell the shares at the contract price if the buyer chooses to exercise before the expiration date. The call is “covered” if the writer already owns the shares and will not have to buy them to complete the deal if the option is exercised. Either way, the writer keeps the premium – plus payment at the strike price if the call is exercised.
The cost of the premium varies. A contract with a long time to expiration – six or nine months, for instance, carries a higher premium than one expiring soon, and one with a strike price below the current market price costs more than one with a strike above the market. The stock’s volatility and market expectations about the share price also affect the premium.
For example, on Sept. 14, Apple (ticker: AAPL) was trading at $225. The seller of a call expiring Sept. 28 with a strike price of $230 could earn a premium of $2.73 per share, or $273 for a 100-share contract, boosting income by a little over 1 percent in two weeks.
It sounds like easy money, but experts say investors should consider several issues before writing covered calls:
Are options available? Options are available for most big-name stocks and many lesser-known ones as well. Options trades can also be done with shares of exchange-traded funds and many real estate investment trusts, but not with ordinary mutual funds. So the first question is do you own securities on which options are available?
Do you own enough? A single option contract involves 100 shares.
Investors who have loaded up on index mutual funds can get access to options by switching to exchange-traded funds tracking the same index. In a retirement account this exchange can be done with no tax bill.
Are you willing to sell? Once your covered call is sold you are obligated to sell the securities if the buyer exercises. It’s important, therefore, to set a strike price at an acceptable level, realizing you will miss out on any gains above that price. Writing covered calls is best for the investor who wants to sell all or part of a holding, or who believes the price will not rise above the strike price.
“The big risk with a covered call strategy is that you miss out on potential gains – something that has been particularly painful with tech names in the last couple years,” Robertson says.
Plan the next step. It’s best to have a plan for the proceeds if the option is exercised. Do you have your eye on another security? Will you keep the proceeds as cash for retirement expenses? Will you wait for the price to drop and buy the security again?
Fred S. James, finance professor at Branson College of Business at Sentinal University, says covered calls can benefit retirees who want extra income on assets they are planning to sell anyway.
“Essentially, a covered-call writer is selling some upside potential in exchange for additional current income,” James says. “This is particularly useful for IRA investors who are in retirement and are taking distributions from retirement accounts.”
Time and skill needed. Options trades take the same evaluation you would do for any stock or ETF. But while a stock has a single market price at any moment, every optionable security has many available options contracts with different combinations of strike price and expiration date. Writing a covered call expiring in a few days is obviously safer than one good for months, as much more can go wrong over a long period.
So, are you committed enough to do lots of study before and after writing a call? Robertson says that many retirement investors are not used to this much work.
“If an IRA is something you look at once a quarter when your provider sends you a statement, you should probably stay away from options,” Robertson says.
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