Dec. 23, 2008 — -- A 71-year-old Arkansas woman looking to retire in a few months is worried about her financial security after watching her investment portfolio plunge more than 55 percent in the recent market collapse. She can't decide whether to cash in everything now or wait for a rebound.
Question: I feel that the market will come back sometime in the future, and I don't expect to need my money for several years, but I don't want to lose everything that I have saved all these years for retirement. If I stay in the market for at least three to five years, do you think there is a good possibility that I will lose everything? I hate to take it out, at this low point, but something is better than nothing. Also, are these losses tax deductible in any way? I am very uncomfortable about my retirement, but I am also 71 years old, and want to retire! Will we all be forced to work until we die?
- C.E. Marion, Ark.
Answer: Despite current conditions, I doubt we will all be forced to work until we die. But the fact is this year's market plunge does mean many people nearing retirement will be working at least a few years longer than they planned. For those in their early 60s, I'm not sure that's a bad thing.
With average life expectancies growing longer, it is plain unrealistic for many of us to think we can stop working entirely at 63, the age by which most Americans retire, according to U.S. Census Bureau data. After all, in 1935, the average 65-year-old could expect to live until age 77½. Today, an average 65-year-old can expect to live until age 83, the Social Security Administration says. The money for those five and a half extra years needs to come from somewhere.
That said, retirement by age 71 should be a realistic goal for every American. The question is can you make it happen amid the current economic turmoil?
There is not enough information provided in your question to say how you will fare yourself in retirement, given the investment losses you describe. However, let me offer a few observations.
Managing Your Portfolio at Retirement
First, if you indeed did lose 55 percent of your portfolio's value in this year's market decline, then it's clear to me your asset allocation was way off for somebody so close to retiring. Even if you had been invested 100 percent in a portfolio tracking the Standard & Poor's 500 Index -- a broad measure of U.S. large company stocks -- then you'd be off about 38 percent over the past 12 months.
And given I would never recommend an all-stock portfolio for a 71-year-old investor, your losses should have been even less than what the S&P 500 has suffered, maybe something more in the range of 20 percent to 25 percent down if you had an appropriate mix of cash and bonds.
This all means you should first review your current asset allocation and settle upon something that includes a good mix of conservative investments, such as short-term bonds and bank CDs. I wouldn't give up entirely on stocks because those are what protect us against inflation over the long haul. For most investors in their 70s, a stock allocation of less than 50 percent is appropriate. Depending on your situation, you might go as low as 30 percent on stocks.
You ask if it's possible you could lose everything if you stay invested in the stock market over the next three to five years. The honest answer is "I don't know," given that I don't know the details of your portfolio.
If you're invested in just a few individual company stocks, then yes, it's quite possible a portfolio could fall to zero. Imagine if your sole holdings consisted of U.S. automakers, a couple large banks and some struggling retailers. I can think of some companies in those categories that could see their stocks turn worthless.
Finally, you ask about tax deductions on investment losses. Yes, you can deduct losses on investments, but there are restrictions.
First, you can only deduct losses on assets held in a taxable account. Losses inside an IRA, 401(k) or other tax-advantaged retirement account are not deductible.
And even if the losing assets are held in a taxable account, the amount you can deduct is not unlimited. I won't go into all the details of deducting investment losses, but here are a few things to know.
Realize Your Investment Losses
To deduct a loss, you must first "realize the loss," meaning you have to sell the investment in question. Then you can use that realized loss to offset any gain in another investment that has been sold in the same tax year. There is no limit on the size of gain you can offset with a loss.
However, once you've fully utilized your losses to offset gains, then your deduction on remaining losses is limited to $3,000 per year and you carry over additional losses to future tax years. That means if you have a $5,000 loss after offsetting gains, then you can take a $3,000 deduction in one year and then take an additional $2,000 deduction in the following year.
One way to mitigate the investment losses suffered this year is to sell a money-losing asset in order to capture that $3,000 deduction and then reinvest the proceeds in a similar investment. But be careful not to violate what's called the "wash sale" rule by buying the same or what the IRS calls a "substantially identical" security within 30 days before or after the sale.
For more information on deducting investment losses, consult IRS Publication 550, "Investment Income and Expenses," and see the section on capital gains and losses in Chapter 4. You can find the publication online at www.irs.gov.
This work is the opinion of the columnist and in no way reflects the opinion of ABC News.
David McPherson is founder and principal of Four Ponds Financial Planning in Falmouth, Mass. He previously worked as a financial writer and editor for The Providence Journal in Rhode Island. He is a member of the Garrett Planning Network, whose members provide financial advice to clients on an hourly, as-needed basis. Contact McPherson at firstname.lastname@example.org.