“I am an old man and have known a great many troubles, but most of them never happened.”
– Mark Twain
Based on the reaction to my last post, I must have touched a nerve.
Risks in retirement and investing seem to be on many people’s minds.
Readers were especially concerned about Required Minimum Distributions (RMDs) in Traditional IRAs. The lack of payout control can mean that you may be forced to liquidate part of a traditional IRA at the bottom of the market. If that is coupled with a large expense at the same time, it can mean trouble.
Now, that did not happen to me. But it nearly did. This post relates the real-life story of what happened, my mistakes, and how I protected myself.
ROTH IRA RECAP
I think you can make a good argument that Roth IRAs are a little safer than traditional IRAs. To recap, here are the reasons why I like Roth IRA accounts:
- There are fewer penalties if you need the money for an emergency. With a Roth IRA, you can withdraw your contributions (principal) at any time, tax-free and penalty-free. However, the earnings (gains) on those contributions may be subject to taxes and penalties if withdrawn before the age of 59½ and before the account has been open for at least five years unless an exception applies.
- Tax-free compounding.
- Withdrawals in retirement are tax-free.
- No forced withdrawals at retirement—you withdraw when needed if you are beyond age 59.5.
That last factor is one of the reasons I rate a Roth account slightly higher than a traditional account for many people, especially those in a high-income tax bracket.
AN EXAMPLE OF RISK IN A TRADITIONAL IRA
How dangerous is a forced RMD withdrawal at the bottom of the market?
It does not happen often—but the possibility is there.
Let me tell you what happened to me–and a disaster I barely avoided.
In 2007, I decided to retire at age 50 from my full-time job–but only after cashing in and having savings and guaranteed income to protect myself.
Those precautions turned out to be a good move.
At first, there was no sign of trouble at all. My spouse was about to return to work full-time, increasing our income. I also did a little consulting to help bring some income. We had stability in our finances and enough liquidity to solve any problems.
And then the roof fell in.
The Great Recession struck in 2009, and the national economy imploded for about four years. We came very close to having a second Great Depression.
My spouse lost her part-time job, and no full-time jobs were available. So, she was forced into early retirement, and her retirement income was a pittance.
My consulting work completely dried up. The economy crashed, and real estate plunged by an average of 33% nationwide—and many homeowners were wiped out.
More important for this discussion, the stock markets tanked. I was forced to return to work part-time in a menial and often unpleasant job because I did not want to sell my retirement accounts to make ends meet.
We managed somehow. However, it turns out that many were not as lucky. Many families lost everything.
THE DANGER OF FORCED IRA WITHDRAWAL AT THE BOTTOM OF THE MARKET
Shortly after I retired, the highest point in the U.S. stock market during 2007 was on October 9, 2007, when the Dow Jones Industrial Average (DJIA) closed at 14,164.53.
The lowest point during the market downturn that followed was on March 9, 2009, when the DJIA closed at 6,547.05.
It was a drop of 54% in value.
Hypothetically, suppose that before the Great Recession, I had parked $1,000,000 in a traditional retirement account, put everything in a stock index fund, and made that my sole source of income during retirement.
That would probably work if I expected to withdraw $40-45,000 to maintain myself during retirement. But I would soon run out of money if I suddenly had an account worth $460,000 and needed $45,000 a year to survive.
Similarly, a forced withdrawal from a traditional IRA can work the same way, especially if you need more than the minimum withdrawal to live on.
That is a risk in itself. But if you also have a large medical expense, a massive property repair bill, or any other loss you must cover at the same time, it can badly damage your finances.
STOCKS AND IRAs
Many Americans have a large portion of their IRA retirement savings in stocks.
You may be saying to yourself, what are the odds of having outsized stock-based losses? Are they really that high? Wasn’t the Great Recession a once-in-a-lifetime event?
Yes, however, it does not take a one-in-a-lifetime event to create problems.
For instance, in 2022, the return of the S&P 500 was negative at 19.4%, and the Nasdaq’s value was down by about a third.
Other assets can lose value, too, and have risks. As I noted above, real estate has lost massive value during certain periods.
WHY PEOPLE PUT VOLATILE STOCKS IN IRAs ANYWAY
IRAS are long-term investment accounts. They can hold many different sorts of investments, but stock investing figures prominently.
Stock investing has returned around 10% per year over the last 90 years, so it has been a smart long-term investment choice.
As you might expect, the likelihood of losing money in the stock market decreases significantly as the investment period lengthens. It pays to stay invested over long periods.
Here’s a look at the probabilities over different time spans of losing money in the stock market:
- 10-Year Period–According to historical data from the S&P 500, the likelihood of losing money over ten years is relatively low. Research from the Schwab Center for Financial Research shows that between 1926 and 2018, the S&P 500 had a negative return in only 6 out of 83 ten-year periods, indicating a roughly 7% chance of losing money over the period.
- 20-Year Period–The probability of losing money is even lower over 20 years. Historical analysis reveals that the S&P 500 has not had a negative return over 20 years since 1926. This circumstance suggests that the probability of losing money over such a period is near zero.
- 30-Year Period–For 30 years, the chances of losing money are minimal. The S&P 500 has consistently provided positive returns over every rolling 30-year period in its recorded history since 1926.
STRATEGIES TO RIDE OUT THE UPS AND DOWNS
Stocks are a good long-term investment but volatile in the short run. You could avoid this risk by having a significant cash cushion to backfill paper losses until your asset values recover.
That liquidity can be inside or outside your IRA accounts. For instance, many people invest in bond funds within their IRAs.
But safe, liquid assets can come at a cost, too. Short-term investments are vulnerable to inflation, taxes, and other factors that can erode their value. They often yield far less than longer-term investments.
Consequently, a second strategy is to have different income streams to mitigate risk. Most millionaires do that. See here.
And having non-stock assets helps, too. Rental real estate or different businesses diversify and shield owners from stock market ups and downs—diversification matters.
Here is a story about handling market risk differently. It’s the same basic idea but with different means.
THE SILVER LINING
Besides not wanting to tap my retirement accounts, there is another reason I briefly unretired.
I had given up on buying a property for a family member who desperately needed it. It appeared we could never achieve that goal.
However, while the Great Recession was a terrible period, opportunities arose too. Property values plunged, and properties could be purchased for a fraction of their former value.
But taking advantage of the once-in-a-lifetime opportunity to buy was not easy. Banks would not lend to a retiree, even one with massive equity. They only lent to someone with a regular job. That was how paranoid they were about making a bad loan or refinancing after giving loans to people with little income for years.
But with a job, even a bad one, I could refinance my existing properties after rates plunged. And I yanked out enough equity to purchase a tiny place outright for a family member.
Disclaimer: consult with a financial fiduciary before taking any steps outlined here. Not all advice may be suitable for your circumstances or investment style.
Photo: Aaron Burden
License: Unsplash