Some affluent millennials and Gen Zers are oversaving for retirement. Getty Images
Nearly half of Americans who retire at age 65 are at risk of being short of money, according to a Morningstar survey.
Single women are 55% more likely to run out of funds than single men and couples.
Experts recommend better tax planning and diversification to reduce retirement risks.
If you’re aiming to retire at the standard age of 65, this is definitely something you’re going to want to hear, so prepare yourself.
About 45% of Americans who retire at age 65 could be short of funds when they retire, according to a simulation model that takes into account factors such as changes in health, nursing home costs and demographic trends.
The model, conducted by Morningstar’s Center for Retirement and Policy Research, showed that single women are at higher risk, with a 55% chance of running out of money, compared with a 40% chance for single men and a 41% chance for couples.
People who haven’t saved for retirement are more likely to find themselves in this situation, said Spencer Look, vice president of the center. Yet retirement advisers say even people who think they’re ready aren’t actually ready.
That’s a big question, says Joepat Rupp, president of Belmont Capital Advisors, which has helped clients secure retirement income. It may surprise many people, but one of the biggest mistakes people make isn’t how much they save, but how they plan around it.
More specifically, Loop says it’s taxes and the lack of planning around them that catches retirees off guard. Many people assume their tax rate will go down once they no longer receive a paycheck, but in Loop’s experience, retirees often find their tax rate stays the same or even goes up.
“It’s wrong in a lot of ways,” Loup said. Most people’s spending habits stay the same or increase after they retire. More leisure time means more money for entertainment and travel, especially in the first few years of retirement. That can result in higher withdrawal rates and push people into higher tax brackets, he said.
People invest in 401(k)s and IRAs throughout their lives because they can contribute before paying taxes. The ability to reduce and defer taxes seems like a great perk. The downside is that you have to pay taxes on withdrawals.
His solution is to add a Roth IRA, where after-tax gains grow tax-free, so if you need to withdraw a large amount in one year, you can fall back on that account instead, he noted.
Another big mistake people make is moving their funds in an inefficient way, which can result in them paying more tax than necessary or missing out on future benefits. This includes choosing to withdraw large amounts of money from investment accounts to pay off a mortgage or buy a home.
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“There are rules that the IRS sets out for us, and they’re there to pay the government, not you,” Loop said.
A prime example of a big tax mistake made recently by one of Mr. Loop’s clients (let’s call him Bob) was cashing out part of his IRA to buy a home.
According to Loop, Bob was a man of modest means who was retiring this year, but after an abrupt breakup with his girlfriend led him to cash out some of his IRA to buy a house. He decided to withhold taxes on what would have been $30,000 to $40,000.
“When he told us this, my mouth dropped,” Roop says. “I said, ‘Bob, you have the down payment money in a separate account where it’s not taxed. We’re going to roll over your IRA and put it into a tax-deferred account.'”
In this case, Loop planned to transfer funds from Bob’s IRA into an annuity that would have allowed Bob to receive a 10% bonus, or $15,000.This mistake potentially cost Bob $45,000 to $55,000 in unpaid taxes and bonuses he did not receive.
Moral of the story: don’t be like Bob.
The next big mistake is sequence risk, or exiting your portfolio when the stock market is falling.
“The S&P 500 has risen nearly 10% on average over the last 50 years,” Loup says, “so it’s a fair guess that it’s probably going to rise 9% to 11% over the next 50 years. But when people get to retirement, the sequence of returns is unclear.”
Simply put, if you retire next year with a $1 million investment portfolio and the market falls 15% that year, you’ll now have $850,000 left. If you need to make a withdrawal during that time, it’ll be very hard to get back to breaking even, Loup said.
In other words, just holding stocks and bonds isn’t enough diversification, he said. You also need to hold CDs, fixed annuities, Treasury bonds, and other things that offer guaranteed principal, so you don’t have to dip into your portfolio during market downturns.
Another big reason people run out of money is because they don’t take appropriate risks when they have income, says Gil Baumgarten, founder and CEO of Segment Wealth Management.
A low-risk approach is to earn interest on cash, but that’s the worst form of compounding because it’s taxed at high rates as ordinary income and the returns are low, he noted. Stocks, on the other hand, offer higher returns and aren’t taxed until you sell them, or at all if you choose a Roth IRA.
“People don’t take into account how much prices will rise over time and don’t realize that they have another 40 years of life left in retirement. Investing at a 5% rate of return isn’t going to make you rich,” Baumgarten said.
For those who do take risks, it’s often the wrong kind of risk. They chase the hype and bet on highly speculative investments. They end up losing money and assuming risk is bad, Baumgarten said. The right kind of risk is to increase exposure to stocks through mutual funds or index funds and buy blue chip stocks, he noted.
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