Why the 5 years before retirement matter so much

Your balances are probably at their highest 5 years before retirement, so a market drop costs you more dollars than it would have at 40. You also have fewer working years left to recover from a bad stretch or a mistake. On the plus side, you still control your income, which means you still have a say in your tax bracket. That gets harder once Social Security, pensions and required distributions start.

If you're 10 to 15 years out, you have more room. You can raise your savings, move money between taxable, pre-tax and Roth accounts, and sell down a concentrated stock position a little at a time to keep the tax bill manageable. At 5 years out, the work is mostly about timing.

How to plan your retirement income

A solid income plan 5 years before retirement starts with what you spend. List the costs you can't avoid, like housing, healthcare, insurance and taxes, and separate them from the ones you can adjust, like travel and gifts. Then list where the money will come from: Social Security, a pension, portfolio withdrawals, rental income or part-time work.

Next, decide which accounts pay for which years. Taking one flat percentage out of the whole portfolio ignores the tax differences between taxable, pre-tax and Roth accounts. Choosing withdrawals account by account lets you control your bracket each year, and it's the core of retirement income planning. Plan on updating it after you retire, since tax law, markets and your spending will all change.

How to lower your taxes before you retire

Taxes are where planning 5 years before retirement often makes the biggest difference in dollars. The years between your last paycheck and the start of Social Security and required distributions usually have lower taxable income than your working years. Many people use those years for Roth conversions, which means moving money from a pre-tax account to a Roth IRA and paying the tax at a lower rate. Conversions also shrink the pre-tax balance that drives required minimum distributions, which start at 75 if you were born in 1960 or later.

Three things to know before you convert:

• Medicare premiums look back two years. Surcharges on Medicare Parts B and D are based on your income from two years earlier, so a large conversion at 63 can raise your premiums at 65.
• Each conversion has its own five-year clock. If you're under 59½, you have to wait five years to withdraw converted amounts without a penalty, which matters if you plan to retire early.
• The order you withdraw matters. Which accounts you draw from first affects your taxes for decades.

If a big share of your net worth is in one company's stock, this is also a good time to learn how to diversify concentrated stock without a huge tax bill.

How to protect your portfolio 5 years before retirement

The biggest investment risk 5 years before retirement is sequence of returns risk. Once you're withdrawing money, a market drop early in retirement does more damage because you're selling investments at low prices to pay your bills.

Here's an example. Say you retire with $2,000,000 and plan to withdraw $80,000 in the first year, which is 4%. If the market falls 25% right before that withdrawal, your portfolio drops to $1,500,000, and $80,000 is now about 5.3% of what's left. Two retirees can earn the same average return over 25 years and end up in very different places depending on whether the bad years come first or last. This example is hypothetical.

Many people handle this by keeping several years of withdrawals in stable investments, so they don't have to sell stocks during a downturn, and keeping the rest globally diversified for the long run. How much to set aside depends on your spending, your other income and how flexible you can be. If equity compensation is part of your pay, having a plan such as selling RSUs at vest also keeps your concentration from growing before you retire.

When to claim Social Security

The claiming decision gets real 5 years before retirement. If you were born in 1960 or later, your full retirement age is 67. Claiming at 62 permanently cuts your benefit by about 30%, and each year you wait past 67 adds 8% until you reach 70.

The right age depends on your health, your other income, your spouse's benefit and your taxes. For married couples, the surviving spouse keeps the larger of the two benefits, so when the higher earner waits, the income that lasts the longest gets bigger. Many people cover the years before they claim with portfolio withdrawals or Roth conversions, which connects this decision to the tax planning above.

How to cover healthcare before Medicare starts

Healthcare is a big line item in any plan 5 years before retirement. Medicare eligibility starts at 65. If you retire sooner, you'll need coverage until then, through an employer retiree plan, COBRA or the marketplace, and you should include those premiums in your spending estimate. If you have a health savings account, you can't contribute once you enroll in Medicare, so plan your contributions around that date. It's also worth deciding how you'd pay for long-term care if you need it.

What to update in your estate plan

Review your estate documents 5 years before retirement. Beneficiary designations on IRAs and 401(k)s override your will, so check them after any major life change. Most non-spouse beneficiaries who inherit an IRA have to empty it within 10 years, which can mean a large tax bill for your children if the account is mostly pre-tax. Roth conversions can help with that.

In many households, one spouse handles the money. The other spouse should know where the accounts are, who the advisors are and how the income plan works. A surviving spouse shouldn't have to learn all of it at a difficult time, which is also when salespeople often start calling. If you've recently inherited money yourself, our page on sudden wealth and inheritance covers that.

A checklist for the 5 years before retirement

Use this as a starting point and adjust it for your situation.

When it makes sense to hire a fee-only advisor

These pieces affect each other. A Roth conversion changes your Medicare premiums, your Social Security timing changes how much you withdraw, and your investments determine how much risk your withdrawals can handle. Many people hire an advisor 5 to 15 years before retirement to coordinate all of it, and that's the stretch Inclinevest Wealth Management specializes in.

Inclinevest Wealth Management is a fee-only fiduciary firm and doesn't sell products. You can read why fee-only matters and look at the firm's public Form ADV. For what advisors charge across the industry, see our guide to financial advisor fees.

To talk through your own plan, schedule a conversation or see how we work.

Sources

• Social Security Administration, Benefits Planner: Retirement Age and Benefit Reduction
• Internal Revenue Service, Retirement Plan and IRA Required Minimum Distributions FAQs
• Internal Revenue Service, Roth IRAs
• Social Security Administration, Medicare Premiums: Rules for Higher-Income Beneficiaries
• Medicare.gov, Get Started with Medicare

This article is for general informational and educational purposes only. It isn't personalized investment, tax, or legal advice, and it shouldn't be relied on as a substitute for guidance specific to your situation. Inclinevest LLC is a registered investment adviser. Registration doesn't imply any level of skill or training. Please consult a qualified professional before making decisions about your own financial circumstances.