By Randy L. Thurman, CPA, CFP®, PFS and Carol Ringrose Alexander, CFP®, AIF®, CDFA™
You’ve heard the saying “learn from your mistakes.” However, we think it’s better, and less expensive, to learn from other’s mistakes. For 24 years, we have helped people planning for retirement to avoid costly yet common mistakes. This article lists the most common mistakes, but is not exhaustive. We also suggest resources to gather additional information.
Retirement is not a dress rehearsal. It should be a time of great fulfillment when you reap the rewards of saving over your lifetime.
Unfortunately, most people spend more time planning their vacation than their retirement. The right choices make it possible to enjoy retirement without worrying about money. The wrong choices mean paying unnecessary taxes, running out of money or purchasing power, and additional stress. Many retirees will have made life-changing, irreversible mistakes due to lack of knowledge or fear. Do not be one of them!
Mistake #1: Not having a plan!
If you fail to plan, you are planning to fail. No doubt about it, most people don’t plan for retirement, they simply … do it. If they take the wrong fork in the retirement river, by the time they see the waterfall, it’s too late. The Marines have a saying: “Prior Planning Prevents Poor Performance.” This is true for retirement as well. How much income will you need in retirement? What investment return do you need to maintain purchasing power? Is it realistic? How long will your money last with conservative assumptions? How do you protect yourself against inflation? Develop a sound, written financial plan; avoid the following mistakes and work your plan.
Mistake #2: Not making the right distribution choice
You generally have two choices when you retire: you can take a lump sum, or you can annuitize. If you take a lump sum, you can choose to make a tax-deferred rollover into an IRA (generally the best choice), or not roll it over and pay taxes (usually a lousy choice). If you annuitize, you usually choose the payment calculation based on one life, two lives, or a percentage benefit for the survivor.
The choice is irreversible. You and your survivor will have to live with it. The right choice depends on what is offered and what you need, with about a dozen variables. Make sure you know what you are doing and the trade-offs of your choices.
Mistake # 3: Not knowing the three key pieces of information retirees need to know to make good decisions
Most people don’t understand the combined impact of (1) inflation and (2) taxes on retirement income. On top of this, people are often unaware of (3) their life expectancy. Not understanding and planning for the combination of these three factors is the single biggest reason retirees run out of money. If you are 65, you have a life expectancy of about 20 years. You should have a plan that is expected to last LONGER than your life expectancy (and your spouse’s). Purchasing power is a huge, generally unplanned and very real problem for retirees. Think back to the costs of things 25 years ago. Now think about what that will mean for you 25 years from now. You must protect yourself against inflation and reduce taxes.
Mistake #4: Taking income from the wrong type of investment first
If you’re like many retirees, you have money in various places. You may have retirement packages from different employers, a stock portfolio, some bank CDs, different types of IRAs, maybe some cash value life insurance, etc. Deciding where you take income can save you thousands of tax dollars. You want the maximum, AFTER-TAX income stream possible. For example, if you have an after-tax portfolio and an IRA, and you are under age 70½, you generally want to take income from your after-tax portfolio first. This strategy results in a lower tax rate for capital gains, and part of the distribution would be tax-free because it is considered return of principal.
Mistake #5: Not knowing the tax laws for retirees and using them to help you
Entire books have been written on retiree tax strategies. It’s a shame our tax laws are so complex that we often hire someone to figure them. Many taxes could be avoided if people would take the time to learn strategies … but who has time? For example, did you know tax-free municipal bonds can cause you to pay MORE in taxes? They can for those who receive Social Security income. Don’t fall into this retiree tax trap! A great book to read is “Tax Planning Strategies: Tax Savings Opportunities for Individuals and Families” by CCH Tax Law Editors.
Mistake #6: Not prudently investing for a comfortable retirement, regardless of outside events
The goal is to build a portfolio to maximize the probability so no matter what happens, good economy or bad, high or low inflation, Republican or Democrat … whatever … you’re going to be okay. Your goal isn’t the highest investment return, but to be comfortable for the rest of your life. Your investment strategy should be based on sound principles, such as Nobel prize-winning economist Harry Markowitz’s work. You need to do some reading here. Three books we recommend are: “Asset Allocation” by Roger Gibson, “Investment Policy – How to Win the Loser’s Game” by Charles Ellis, and “Simple Wealth, Inevitable Wealth” by Nick Murray. If you read these books, you will know more about investing for retirement than 98 percent of retirees.
Mistake #7: Not understanding the Social Security rules
Social Security raises many issues – how it’s calculated, when you should take it (less now or more later), how it is taxed, how to avoid tax traps, and the little known rules for widows, widowers and divorcees that can increase their Social Security income dramatically. Some rules defy logic, like tax-free income causing additional Social Security taxation. Even if they aren’t logical, you need to know the rules or you’ll pay additional tax. Our favorite book on this subject that won’t put you to sleep (at least not immediately) is “Social Security, Medicare and Government Pensions: Get the most Out of Your Retirement and Medical Benefits” by Joseph Matthews.
Mistake #8: Depending on Medicare to cover long-term care bills
In a recent study, one of the top concerns of retirees is the cost of long-term care. Understandably, long-term care expenses are a big risk to your retirement nest egg. Many retirees think Medicare will cover the cost. WRONG! Medicare coverage is generally limited to 100 days of skilled nursing care. You need to evaluate your risk here. First, calculate the income generated from all your sources, then subtract the potential long-term care needs. The result is your risk exposure. You then should evaluate the cost of a solid long-term care insurance policy that fits your needs.
Mistake #9: Not planning your estate
It’s been called the impossible dream: to pass your wealth to your family without substantial attorney fees and excessive taxation (excessive to us means any). A will may be important, but it’s a misconception that a will alone avoids probate and estate taxes. There are many other misconceptions; for example, did you know that life insurance, while currently income tax-free, is almost always subject to estate tax? Although the estate tax is CURRENTLY eliminated in 2010, it is scheduled to return in 2011 for estates valued at $1 million or more.
Many retirees will lose a substantial amount of their estate to taxes and attorney fees at death. Most, if not all, of this waste could be eliminated through proper planning. Our favorite book on this topic is “AARP, Crash Course in Estate Planning” by Michael Palermo.
Mistake #10: Not knowing how to find a TRUSTED retirement advisor
You want three qualities in an advisor: competence, integrity, and someone who cares about you. While there is no perfect way to evaluate the good ones from the bad, there are 13 questions you should ask an advisor before hiring. To get a free report, go to www.wealthtrac.com and ask for “The Consumer’s Guide to Hiring a Financial Advisor.” This includes a scorecard so you can compare advisors. We believe you should seek a fee-only advisor who is paid by you (instead of product companies) and is compensated based on the relationship (not on transactions).
There you have the 10 most common, costly mistakes for those planning retirement. We’ve just hit the highlights, but hope we have given you valuable information and resources to clarify your most pressing questions. Plan first, avoid these mistakes, and you can retire in comfort.