Another classic article updated for the SECURE Act.
If you’re retired or are nearing that milestone, you may be worrying about whether the retirement accounts that you’ve built over a lifetime will someday unravel like a loose yarn on a cardigan sweater.
You can increase your chances of holding it all together, however, if you avoid these common retirement train wrecks.
Selling out for a doughnut.
If you qualify for senior discounts, you’ve probably been invited to a free financial seminar. Perhaps lots of them. Older Americans are routinely bombarded by these offers. To get you in the door, seminar sponsors routinely offer free lunch or dinner and sometimes a heaping tray of Do-Rite Donuts. In return for the free food, your financial hosts would like your business. They may start the process by asking you to fill out paperwork that requests all your financial information. Securities regulators worry that the motivation of too many seminar sponsors is to convince their guests to buy investment products that aren’t appropriate for them. And even if selling you something isn’t on the agenda, you need to take an objective view of the person or company presenting the seminar.
Of course you can always ask the presenter how he or she is compensated. But that answer can be complicated. To clarify it further, you’re going to have to do a little detective work. One way to start is to request and read the ADV disclosure document that all advisors must file with the SEC and/or the states in which they do business. You can learn a lot through the ADV–whether the advisor has ever had any run-ins with regulators or the law, for example. You can read about the advisor’s educational background and what services they offer. You’ll also see how they structure their fees.
If you need help finding a qualified advisor, you can get recommendations from The National Association of Personal Financial Advisors (NAPFA). This group only permits fee-only (meaning not commission based) advisors in its organization. You can find local NAPFA members by visiting the organization’s Web site at www.napfa.org.
Many mutual fund companies also offer various types of financial planning. Vanguard, Fidelity, T. Rowe Price, and Charles Schwab all offer low-cost retirement planning. But buyer beware. You still need to do your background investigation work to know the experience and credentials of the person you will be working with. Most larger brokerage firms have a variety of people who provide financial-planning advice. Some will be experienced, but some may be “green-beans.” And your advisor should be a fiduciary—which means they put your interests first. If a brokerage only sells their own products, are you sure that’s in your best interest?
Forgetting about taxes in retirement.
Many people assume that taxes will become far less of an annoyance once they retire. But you may be among the unlucky souls who end up paying taxes on 50%, or even 85%, of their Social Security benefits. New retirees also often overlook the potentially huge tax liability they may face as they spend down their nest eggs. You could have $500,000 tied up in retirement accounts, but if you’re in, say, the 24% tax bracket, the after-tax value of this cash is just $376,000. And it may shrink further once the state rattles its tin cup.
Remember to watch out for those nasty retirement-related tax penalties. There’s the 10% penalty if you withdraw money from a retirement account before age 59 1/2. And the really nasty one is a 50% penalty if you forget to take your required minimum distributions after age 70 1/2. With the SECURE Act passage, you’ll now have until age 72 before you have to take distributions.
Conventional wisdom suggests that you should dip into your taxable accounts first. The tax rates you face on the profits and dividends generated by your taxable money are much lower than what awaits you when cracking open a retirement account, particularly if you’ve contributed pretax dollars. You’ll pay a maximum of 20% for any long-term stock market profits when you take withdrawals from your taxable accounts. You’d drain your retirement accounts next. The withdrawals will be taxed as ordinary income, which top out at 37%. Only withdrawals from Roth IRAs are tax free. But you may want to leave those for your heirs.
Following conventional wisdom, however, can sometimes pose future problems. Suppose a couple drains their taxable accounts in the early years of their retirement so by the time they reach their 70s, nearly all their cash is holed up in retirement accounts. Shortly after reaching the age of 70 ½ (now 72), retirees must begin drawing down these accounts through required minimum distributions. These mandatory distributions push some retirees into higher tax brackets, as well as trigger taxes on their Social Security checks and up their Medicare premiums.
To avoid this tax Armageddon, you might want to begin withdrawing some retirement assets before reaching 70 1/2. Be careful that the withdrawals don’t bump you into a steeper tax bracket, however. Consider investing those withdrawals in tax-efficient mutual funds inside a taxable account. Another alternative is using some of the money to convert a portion of your IRA assets into a Roth IRA.
Inflation can also be a nasty surprise for retirees. Think about this for a minute: With a historical inflation rate of 3%, the value of $100 drops to $76 after a decade. Wait 20 years and the value shrinks to a mere $56. While Social Security checks are indexed for inflation, many pensions and fixed annuities aren’t.
To combat the bite of inflation, consider holding a portion of your portfolio in inflation-linked bonds, like Treasury Inflation-Protected bonds or I-Bonds (a type of U.S. Savings Bond). Holding some of your assets in stocks, which have the potential to generate higher returns than bonds, can also help stem the loss of purchasing power in the face of increasing inflation.
Note: inflation has been lower than historical rates lately, but no one knows how long that may continue.
Overestimating how much you can spend.
Running out of money is one of two deep-seated fears for retirees (the other is health). But too many retirees push themselves to the edge of solvency by withdrawing too much money from their nest eggs.
If you want your money to last for 30 years, many financial experts suggest that you should only withdraw 3% to 4% of your cash during the first year of retirement. For the second year, you adjust the initial amount you took out by the inflation rate. And you will continue doing that each year for the rest of your life. This is one of several approaches to determine whether you’ll have enough money throughout retirement. What’s important is that you work through a method that gives you confidence that your money will last.
Sometimes it’s hard to accept that if you expect your portfolio to return 7% or more, why should you limit your spending to 3% to 4%? Part of the reason is that no one knows if the markets will tank during your retirement. To guard against that possibility, you have to act as if the grizzly bear is already in your driveway tipping over your trashcans. To keep a consistent withdrawal rate, you’ll need to take less than your total return in some years (and more in others).
In examining some of the most ferocious bear markets in modern times, including those that struck during the Great Recession of 2008, the Great Depression in 1929 and World War II, retirees would have survived if they had followed that 3% to 4% admonition.
Playing it too safe.
Plenty of retirees have their savings tied up in certificates of deposits, savings accounts, U.S. Treasuries and other investments that they consider ultra-safe. If that sounds like your portfolio, however, you may be facing far greater risks than you ever imagined. That’s because bonds, much less CDs and savings accounts, can’t possibly provide the kind of growth your portfolio will need to last three decades. In fact, if your portfolio doesn’t devote at least 50% to stocks, preferably in mutual funds, a 3% to 4% withdrawal rate is probably too high.
The best advice?
Find a financial advisor that you trust. Don’t wait until retirement to begin that process. Give yourself a couple of years at least to work with someone to see if you’re comfortable. Work with your advisor to find a happy medium between investing for growth and preserving your portfolio. Set up regular times to review how things are going in retirement: revisit your retirement projection every couple of years to make sure you are still “on track,” find a way to monitor your spending to guard against overspending (or underspending), and seek help sooner rather than later to avoid a full-blown retirement train wreck.
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