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Finance 101: May 2024 Thumbnail

Finance 101: May 2024

In May the financial advisors at Ruedi Wealth Management wrote four more columns for The News-Gazette’s business extra section. Make sure to look for them every Saturday in the weekend edition of the paper, but in case you missed any in May all four are below.

Replacing Your Income

Paul R. Ruedi, CFP®

People entering retirement and transitioning to life without a paycheck face a challenge: they must replace the spending they were used to before retirement. Though a person may intuitively think they need to replace 100% of their income during retirement, some expenses drop off when a person is no longer working and people usually need to replace less than they think. But how much will a person need and where will this spending come from?

The most common guideline replacement rate you will see cited on the internet is 70%. But how much of their income a person needs to replace in retirement is really one of those “it depends” financial decisions. In this case, it depends primarily on your pre-retirement income.

People who earn high incomes are in high tax brackets. As a result, the government takes a larger portion of their income before they even have a chance to spend it. Because of this, high-income earners need to replace a relatively lower portion of their pre-retirement incomes to spend the same amount they did before retirement. A lower-income worker is just the opposite. Since they are used to having a lower amount taken out of their paychecks, they are used to spending a higher proportion of their income and thus need a higher replacement rate in retirement.

Social Security will replace some pre-retirement income, but it may not be enough depending on the income level before retirement. Social Security is progressive and people who had lower incomes tend to receive a higher proportion of their income in Social Security. The lowest wage earners may see as much as 75% of their pre-retirement income replaced by Social Security. The highest income people, on the other hand, may see as little as 20% of their pre-retirement income replaced by Social Security.

Because Social Security may not completely replace a person’s income, the shortfall must be made up with withdrawals from an investment portfolio. Though a lower-income person may have most of their spending covered by Social Security, a higher-income person may need to rely on investment portfolio withdrawals for the majority of their spending.

It is important to understand where you fall on the spectrum and be aware of how much spending you will need to maintain your lifestyle in retirement. If you aren’t sure how much of your income you will need to replace during retirement or where that spending is going to come from, you may want to consider working with a retirement planner.

Paul R. Ruedi is a CERTIFIED FINANCIAL PLANNER™ professional with Ruedi Wealth Management in Champaign, Illinois.


Smoothing Out Wrinkles

Paul Ruedi

Though we expect to deal with wrinkles in our skin as we age, a lot of people are unprepared to “smooth out the wrinkles” in their children’s finances. Parents with multiple children with different economic circumstances have an even tougher dilemma: how do you help a child who needs help without seemingly punishing a child who worked hard to have better economic prospects?

First of all, I want to point out this this situation is the norm. It is very unusual for children to all end up in the same financial circumstances. More often than not parents have one or multiple kids they know will need some help. But when something comes up in that child’s life that he or she can’t afford, can a parent just bail them out?

If you want to help a child financially, never give more than you can afford, and emphasize it is a one-time deal. A parent must emphasize that just because they gave a child $10,000 to replace an air conditioner this year, that child is not entitled to a $10,000 allowance each year. You don’t want bail-outs from the parents becoming an expectation, as this can be a recipe for children to live beyond their means and cause even more problems.

Then is the equally difficult matter, the matter of fairness. When you give one kid $10,000 to replace an air conditioner, even siblings who aren’t typically jealous will feel like parents are showing some favoritism to that less successful sibling. For many families, it is important to keep things fair and to communicate exactly how things are going to be made fair to all children.

One way to keep things fair is to adjust the amount of assets that pass to each child in the estate. If one child ends up needing financial help from the parents, the amount of money that will be given to him or her through the estate can be reduced to account for the fact that money was given in advance. This should be very clearly communicated to each child so that everyone has appropriate expectations, and nobody feels resentful.

Parents aren’t wrong for wanting to help their children. But they shouldn’t go so far as to enable bad financial choices and should consider fairness between children. It sounds simple, but can be very tough to navigate yourself. If you think you may need help with this, you may want to talk to a financial advisor. 

Paul Ruedi is the CEO of Ruedi Wealth Management in Champaign, Illinois.


How Much House Can I Afford?

Paul R. Ruedi, CFP®

The combination of high interest rates and high home prices has driven home affordability down to levels we have not seen in decades. This has left many people wondering what kind of a house they can afford based on their income and budget. Since most people will use a mortgage to purchase a home, I think a good starting point is figuring out how much a bank will actually lend you.

When a bank is deciding how much they can loan you, they will look at your total monthly debt payments compared to your monthly gross (before tax) income. Banks prefer to keep this ratio, called the debt-to-income ratio (or DTI for short), below certain thresholds. First, they like to keep total housing payments (including taxes and insurance) below 28% of your gross monthly income. A person or couple making $120,000 per year ($10,000 per month) could therefore afford to borrow up to the point where their mortgage payment is $2,800.

On top of that, banks prefer to keep the total of all debt payments below 36% of monthly income. The same couple making $10,000 per month will therefore be limited to $3,600 of monthly debt payments. If that couple already has $1000 of monthly car payments, they would only be able to have a $2,600 monthly mortgage payment.

With at least a ballpark number for how much you can spend on mortgage payments each month, you can look for houses within your budget. Real estate listing websites will often include an estimate of your monthly payment, including mortgage, taxes, insurance, and HOA fees. Though it won’t be exactly perfect, you can adjust the down payment, interest rate, and other things to get a good concept of what your housing payments would be.

Though initial debt-to-income ratios determine how much a bank will lend, they do not guarantee a person will be able to afford their house forever. For example, if a person purchases a house while their income is high and then receives a massive pay cut, he or she may have a real problem making payments. Increases in taxes and insurance could also make the same home less affordable over time if the homeowner’s income doesn’t rise.

When deciding how much home you can afford, you should consider what the bank will actually lend you but should also take a look at how your income will support housing costs over time. If you aren’t sure how to do that yourself, you may want to talk to a financial professional.

Paul R. Ruedi is a CERTIFIED FINANCIAL PLANNER™ professional with Ruedi Wealth Management in Champaign, Illinois.


401(k) Rollover Options

Paul R. Ruedi, CFP®

People who are considering moving the funds from a previous employer’s 401(k) plan to a new home have three options: roll over to a new company 401(k) if possible, roll the funds into an Individual Retirement Account, or simply distribute the funds. There is no “best” option for everyone so people making this decision need to consider the pros and cons of each option.

If a person’s new employer offers a low cost 401(k) plan with good investment options, he or she may want to roll their previous 401(k) into that new employer’s plan. There are many benefits to this, the first of which is that a rollover does not count as a taxable distribution and therefore won’t trigger any taxes or early withdrawal penalties if everything is done correctly.

A person who plans to retire early may prioritize having the “golden 55” feature in 401(k) plans. This feature allows people who have left their employer at age 55 (or later) to start withdrawing from their 401(k) without paying early withdrawal penalties, that are otherwise imposed by an IRA before the age of 59 ½. Many people also like the simplicity of having all their retirement assets in one place.

If the new company’s 401(k) plan isn’t particularly great or a person isn’t moving to a new job, he or she may want to consider rolling an old 401(k) into an individual retirement account (IRA). A rollover to an IRA will not trigger taxes or an early withdrawal penalty. Many large companies like Vanguard, Schwab, and Fidelity make it easy to open an IRA, and investors with IRAs will enjoy many more investment options than just the handful of investment options provided by a 401(k) plan.

The final option is to simply distribute the funds. This will trigger taxes and possibly an early withdrawal penalty if the person is younger than age 55. One of the few situations where this could be a good idea is if a person has company stock in their 401(k) that has a very low cost basis, he or she may want to take a lump-sum distribution to take advantage of special rules regarding Net Unrealized Appreciation to lower the taxes paid on the stock’s appreciation. This is a complicated topic that will need its own column to be adequately explained.

Savers with money in an old 401(k) should consider all their options, weigh the pros and cons, and decide which option is best for them. If you aren’t sure how to do that yourself, you may want to talk to a financial advisor.

Paul R. Ruedi is a CERTIFIED FINANCIAL PLANNER™ professional with Ruedi Wealth Management in Champaign, Illinois.


Disclaimer: Past performance is no indication of future results. You should not make any investment decisions without first performing your own due diligence and consulting your financial advisor.