How To Manage Liquidity Risk In Retirement
It goes without saying that having access to your money is crucial, for many different reasons. But, where you keep your money will determine how easy you can access it when needed.
Did you know that some of the most often-used retirement vehicles like 401(k)s and traditional IRAs, will only give you full control of your own money for around 10 years?!
Below, we’ll provide you with answers to the following questions:
Can I access my retirement savings prior to age 59 1/2?
Do I have to take withdrawals from my retirement account?
Will I have to pay a penalty for accessing my retirement money?
How can I avoid liquidity risk in retirement?
By the way, if you’d like to increase your retirement savings while also eliminating stock market risk, then be sure to watch this free video and read our article “how to avoid market risk”.
What is liquidity risk?
If an asset is referred to as liquid, then that means it can be quickly converted into cash. So, when liquidity risk is discussed during retirement planning, it’s referring to whether or not your portfolio is made up of these easily-accessible assets. If it takes too long to convert an asset into cash, or if you have to take a sizable loss in order to convert it quickly, then this would be liquidity risk. This retirement risk should be planned for in advance to avoid any future issues.
Measuring liquidity risk can be done in many ways, and it’s best to avoid relying too much on any financial institution. To measure liquidity risk in your plan, it’s helpful to start by reviewing your cash and collateral obligations. You can use a balance sheet, track your cash flow, or use whichever method you prefer.
History tells us that when a global financial crisis happens, it’s good to be liquid and have funds available. Credit risk is real, as financial institutions can take away your credit lines at any time. To give you an idea of liquid vs. non-liquid assets, here are just a few examples:
Liquid assets:
•Cash
•Savings/checking accounts
•Stocks, bonds, mutual funds
Non-liquid (illiquid) assets:
•Real estate
•Vehicles, equipment
•Art, collectibles
Can I access my retirement savings prior to age 59 1/2?
Accessing your traditional IRA or 401(k) before age 59 1/2 is likely going to cost you an early withdrawal penalty. There are only a small number of exceptions to this rule. These accounts are also tax-deferred, so you’ll have to pay taxes on your withdrawals. You can learn about how to eliminate tax risk from your retirement plan here.
It’s a best practice to eliminate as many liquidity risks as possible, and market liquidity risk (within traditional retirement accounts) is an important one to avoid. With diversification and the correct funding liquidity risk can be avoided.
Tip: there are some retirement plans that do allow penalty-free access before age 59 1/2.
Do I have to take withdrawals from my retirement account?
You’ve maybe heard about RMDs (required minimum distributions). This is where the government will force you to take withdrawals from your retirement accounts, such as traditional IRAs and 401(k)s. Whether you want to or not, once you reach your early 70’s, you’ll have to start taking money out of these accounts.
Tip: there are some retirement plans that don’t force you to take out required minimum distributions.
Will I have to pay a penalty for accessing my retirement money?
Accessing your traditional IRA or 401(k) early will incur a 10% early withdrawal penalty. Also, if you don’t take out your required minimum distributions, there will be a hefty 50% penalty. You may have noticed that you’re being penalized for taking money out before age 59 1/2, and then again if you don’t take your required minimum distributions after age 70. So, you only have a little over 10 years for full control of your own money! How do you feel about that?
Liquidity risk management should be a part of every financial plan, so it’s worth considering any long term or short term financial obligations that you may have. Have a plan in place, then follow those steps for a sound liquidity risk management process.
By the way, if you’d like to know how you can create your own guaranteed lifetime income stream, then watch this free video here.
How can I avoid liquidity risk in retirement?
You’ll need to find the right balance for your own personal needs. You must have some liquid assets, but you also don’t want to make the mistake of having too much money in low interest accounts, as that’s when liquidity risk occurs. This would bring up another one of our top 10 retirement planning risks, which is inflation risk.
Here are a few quick suggestions:
You could use an income “laddering” strategy, so that you’ll have enough guaranteed income throughout each part of your retirement.
Have at least one asset that is 100% liquid. At an absolute minimum, you should have enough liquid funds to cover approximately 6 months of expenses.
Have an asset that you can access before age 59 1/2, without early withdrawal penalties.
Include an asset in your retirement portfolio where you aren’t forced to take required minimum distributions after age 70.
Liquidity risk is another big retirement risk that you must clearly understand and have a solution ready for. If you’re unsure on how to do this with your retirement plan or want to evaluate your current solutions, then let a financial professional help you and schedule a free retirement consultation today.
