Today I’m sharing three (3) big retirement planning mistakes and how to avoid them.
Actually, that’s not true…
I was inspired to add a fourth retirement mistake at the last minute after a recent client meeting.
So be sure to stick around to the very end. 😉
How to Listen to Today’s Episode
- The Cost of Umbrella Insurance [Wallethub]
- The 7 Most Important Types of Insurance [Define Financial]
- When to File Form 8606 [Investopedia]
- What if You Fail to File Form 8606 [Willis Johnson & Associates]
- Backdoor Roth Contributions and the Pro-Rata Rule [ThinkAdvisor]
- The Pro-Rata Rule Explained [Ed Slott]
- The Tail End [Tim Urban]
- Stay Wealthy Roth Conversion Series:
3 Big Retirement Mistakes (and How to Sidestep Them)
Taylor Schulte: Hey everyone, quick update before we start the show. My firm, Define Financial, aims to take on about 10-12 new clients per year and, if you happen to be looking to hire a retirement and tax planning expert, I’d be honored if you considered us.
To help you evaluate my firm and see exactly how we can help before paying us a single dollar, we’re currently offering a Free Retirement Assessment. This Free Assessment includes an in-depth tax and investment analysis and provides answers to your big retirement questions. It also allows you to see how we think, our approach to planning, our philosophy, the types of recommendations we make, and the value we can provide so you can determine if we’re the best fit to work together.
As a reminder, we specialize in retirement and tax planning for people over age 50 who have accumulated investments of $1 million or more, so if that’s you, and you want to learn more about our Free Retirement Assessment, just head over to www.freeretirementassessment.com. That’s freeretirementassesment.com.
And if you’re listening to this, and you don’t feel like your situation matches our expertise, just shoot me a note and I’d be more than happy to help you find the right professional. After all, you wouldn’t see a Cardiologist if you needed foot surgery.
Ok, onto today's show.
Welcome to the Stay Wealthy podcast! I’m your host Taylor Schulte and today I’m sharing 3 big retirement planning mistakes and how to sidestep them.
Actually, that’s not true. There’s actually a bonus 4th mistake I added at the last minute that was just too important not to share, so be sure to stick around to the very end.
For all the links and resources mentioned today, head over to youstaywealthy.com/153.
“I was backing out of the parking lot at work and next thing I knew, my car was smoking, and I was crawling out the passenger window to safety.”
That was part of a story being told to me recently by a friend. In fact, that friend is very much connected to this show. He’s actually the talented musician behind the intro music and the acoustic guitar segue you just heard that plays directly after the intro to every episode.
Long story short, he was in a bad car accident recently, and in addition to him being ok, one of the positives of this accident was that it revealed a giant financial mistake he’s been making. And while he listens to the show fairly frequently, I wasn’t all that surprised he was making this mistake, because most people I meet with for the first time are making the same one. Even avid listeners of this show.
So, while many of you have likely already addressed this, his story motivated me to highlight it one more time because it’s just too important to ignore. And that is umbrella insurance.
You see, this accident my friend was in could have very likely been considered his fault. It also could have resulted in the other driver being more severely injured and/or more litigious. Not only did my friends fail to max out his auto/home liability limits, but he also skipped umbrella insurance years ago when he secured his property and casualty insurance policies.
He owns a home, has two kids, and both he and his wife are successful working professionals. If this accident had been any worse, and/or the driver had been more litigious, it’s possible that his entire life could have been turned upside down. And that’s because, if your auto or homeowners liability limits are low, and you don’t have umbrella insurance to extend it, your income and/or assets can be up for grabs.
He played these scenarios out in his head while sorting through everything with both insurance companies and shared that he was terrified to learn about what could have happened. He couldn’t believe he glossed over this small, wildly important financial planning task.
Oftentimes when I bring up umbrella insurance, people say that they don’t have inexperienced drivers (ie kids) in their households anymore. Or, they aren’t doing anything dangerous or putting themselves in risky situations that would require a large liability policy. That the risk is so low that it’s not worth the added cost. Or that they grabbed a $1 million policy and QUOTE “that seems like enough.”
However, like my friend quickly learned, the risk can be as simple as backing out of a driveway, which most of us do a few times per week. But it can also be as simple as driving to the grocery store and accidentally hitting a neurosurgeon, preventing them from working for an extended period of time. Guess who they’re coming after in all of these cases. Your insurance company.
But if you don’t have the proper insurance in place, their next stop is you and your personal assets or income. So, it can be a very accidental situation that leads to complete destruction of everything you’ve worked so hard for. Just because you don’t have a pool or a trampoline in your backyard, doesn’t mean you’re safe from an accident resulting in large financial damages.
The great thing about umbrella insurance is that it’s CHEAP. Well, cheap relative to the coverage you’re getting. And when it comes to insurance, that’s what we want. WE want to insure against the big stuff, the catastrophic things (like accidentally injuring a neurosurgeon), and then skip coverage for the little things like iPhone insurance or roadside assistance. Those are things you can cover out of pocket, assuming you are financially stable and have proper emergency savings in place.
So, back to the cost, for about $500/year, you should be able to acquire around $3-4 million of umbrella insurance coverage. The average cost is around $200-$300 per year for $1 million of coverage and then about $100 per million dollars of coverage after that.
The rule of thumb is that you purchase a policy that roughly equals your total net worth. So if your net worth is $5 million, you would ensure you have $5 million of coverage. Now, you will already have – or should have – auto and/or homeowners liability coverage, usually somewhere between $250,000 and $500,000.
If we assume that your auto/home liability coverage is maxed out at $500,000, and you added a $5 million umbrella policy, then you would technically have $5.5 million of coverage which is slightly over your hypothetical $5 million net worth. You see, umbrella insurance extends your auto/home liability coverage. Your auto/home policy will cover the first $500,000 of losses and then your umbrella will kick in and cover everything above that up to the amount you have.
As you can imagine, in a serious accident, especially one where a high-income professional can no longer work, $500,000 isn’t going to go very far, hence the need for millions of dollars above that.
Lastly, while the rule of thumb is to match your liability insurance with your net worth, many clients of ours will extend it further. Instead of $5 million, they might get $10 million, especially if they feel like they are at more risk than the average person. But it’s so cheap relative to the coverage you’re getting, that people often feel good about rounding up knowing they have ample protection.
To round this all out, your action item is to simply call your auto/home insurance company and confirm you have your auto/home liability insurance maxed out – again it’s usually $250,000 or $500,000 – and then confirm you have umbrella coverage that it extends it up to your net worth, at a minimum. If you don’t, ask for quotes, and while you’re at it, shop around and gather a few more quotes from other companies to ensure you’re getting the best coverage at the best price.
I know it feels like a stretch for something catastrophic to happen, but unlike most types of insurance, the risk far outweighs the cost, and this is just one of those no-brainer policies everyone should have in place.
Ok, moving on to mistake #2. Many of you – and I know this because I get emails all the time – many of you are rockstar retirement savers. You’re maxing out your 401k, you’re maxing out your HSA, you’re participating in equity comp programs, you have a healthy emergency savings account, and you’re even making IRA contributions on top of it all.
But, as most know, when you’re making deductible 401k contributions, you aren’t also able to make deductible IRA contributions. You can still contribute to your Traditional IRA, but those contributions are what we call “non-deductible.” And rockstar retirement savers whose income exceeds the Roth IRA limits are smart to make these non-deductible contributions to their Traditional IRAs, because the investments grow tax deferred. In other words, even though you don’t get a tax deduction, it’s still beneficial to get money into a Traditional IRA so you don’t have annual taxes on dividends, interest, and cap gains dragging down your portfolio every year.
The problem that leads to the mistake I’m about to highlight is that most retirement savers do end up having Traditional IRA dollars that were both deductible and non-deductible. Some of the contributions went into the Traditional IRA pre-tax and some went in after tax. And when you go to pull money from your IRA in retirement, you definitely don’t want to pay taxes on money that’s already been taxed.
For that reason, you want to make sure that you’re tracking the after-tax contributions – the non-deductible contributions – throughout your working career so that you don’t overpay the IRS. The technical term here is “basis.” After-tax contributions cause your Traditional IRA to have basis, much like investments you make in a taxable brokerage account. You only pay taxes on the growth, because the amount you contributed has already been taxed.
However, unlike a taxable brokerage account where you can navigate each individual security and make tactical decisions as to what to sell and the most tax-efficient method of withdrawing money, Traditional IRA’s with basis don't work like that. Yes, you can buy and sell every day without tax consequences inside your Traditional IRA, but when you go to take a withdrawal, the IRS looks at all of your Traditional IRA dollars globally and implements what they call the “pro rata rule.” And this is where some people get tripped up. Because it’s truly a global look at your Traditional IRA dollars, across all accounts, and across all custodians.
For example – a very basic example – let’s say you have one Traditional IRA account with $50,000 of pre-tax contributions (i.e., you got a deduction for making the contribution) at Fidelity and you have another Traditional IRA with $50,000 of after-tax contributions at Schwab. Two separate accounts at two different brokerage firms.
If you go to take a withdrawal from your Schwab IRA that was funded with after-tax money, the IRS is still going to factor in your Fidelity IRA that has an equal amount of pre-tax dollars. In its most basic form, they are going to say that 50% of your TOTAL IRA dollars across all custodians and accounts have never been taxed, therefore 50% of your withdrawal, even if it’s coming from a Traditional IRA that was funded with non-deductible after-tax money, is going to be taxed. It’s a pro-rata calculation based on all of your Traditional IRA dollars.
So, the first thing to mention here is that if you’re making non-deductible traditional IRA contributions – or if you’ve ever made them in the past – you will want to ensure that you’re filing Form 8606 every year with your tax return. This form tracks your after-tax contributions… it tracks your “basis” in your IRA. It tells the IRS that X amount of dollars has been contributed to my IRA on an after-tax basis, I’ve already paid taxes on this amount, and I don’t need to pay taxes on it again when I withdraw it.
(A quick reminder that you do pay taxes on the growth, just like any other investment you make, but your principle contribution is not taxed again at withdrawal…if you tackle all of this properly that is.)
While it’s pretty simple to file Form 8606 – even if you DIY your taxes, software like TurboTax is smart enough to know when you can and can’t make deductible contributions – it’s still common for people to miss it. If you do forget – or realized you’ve made some mistakes here and there – you’ll be pleased to know that the IRS will ignore the typical three-year statute of limitations and allow you to submit Form 8606 and correct your mistakes without also filing a Form 1040. In other words, you don't have to amend prior year tax returns to fix this which is a huge bonus.
Also, there can be a penalty of $50 for not filing Form 8606 on a timely basis, but the penalty can often be waived if you can show reasonable cause for not filing. And, in rare cases, especially if you don’t respond to IRS inquiries asking you to explain the reason for filing a late 8606, you do run the risk of being audited.
So, step one in sidestepping this mistake is just to ensure that you or your CPA is filing form 8606. And if you think you or your CPA has made a mistake, you will want to fix it ASAP. You will also want to ensure you keep an eye out for IRS inquiries after submitting your late form 8606 to mitigate the risk of an audit.
But step two is to ensure you are tracking the basis in your own spreadsheet as well, and to keep it on your radar as you get closer and closer to retirement. I mention this because we’ve seen Turbotax returns recently that have been filed with Form 8606 year after year but the form fails to keep a running tally of the client's Traditional IRA cost basis. This tally is typically summed up on Line 2 of the Form, but we’ve seen a zero on this line for people who we know have a sizeable basis in their Traditional IRAs.
In other words, if they happened to start withdrawing money from their IRA, and they don’t have a running tally of their basis, they could end up paying taxes twice on those withdrawals.
Or, maybe they decide to finally hire a CPA to take over their taxes and they don’t have a financial planner in their life who is aware of the basis in their IRA. That new CPA would typically use the prior year's tax return to get up to speed, however, if Line 2 has a ZERO, they will assume the IRA doesn’t have any basis beyond the most recent contribution.
In some cases, Line 2 might have a dollar amount and the new CPA just has to trust it’s the correct amount – there’s no other record for them to review to double-check its accuracy. So, keeping your own tally of nondeductible IRA contributions can come in handy if you ever find yourself in this situation or just want to have your own personal backup of these contributions as you get closer to withdrawing money from your Traditional IRAs.
By the way, the pro-rata rule also comes into play when making backdoor Roth IRA contributions and doing Roth conversions – it’s not restricted to just a straight IRA withdrawal. I’m not going to go into the weeds in this episode, but just know that if you have existing pre-tax Traditional IRA dollars, making backdoor Roth IRA contributions likely isn’t going to make sense given the pro-rata rule. I’ll link to an article or two in the show notes to save you some time, but you can also do a quick Google search to learn more.
Ok, let’s move into Mistake #3.
As noted earlier, I know that many of you are great savers. You’re super savers, and you want to take advantage of every possible savings bucket while you’re still working.
As I’ve talked about a lot recently, one of the biggest pain points in retirement is taxes, and getting money out of your tax-deferred retirement accounts at a fair rate before age 72. Because, if you don’t do anything and you’re not proactive with your tax planning, at age 72, the IRS is going to come knocking on your door and begin forcing you to take money out of your pre-tax accounts via required minimum distributions. For good savers like you, this can mean six figures of taxable withdrawals every year, and oftentimes withdrawals you don’t really need.
So, in retirement, the goal is to carefully get money out of these pre-tax accounts so you don’t find yourself in a higher tax bracket at age 72 than as a working professional.
The mistake we often see is that, in those final working years, let’s say the final 3-5 years, great savers like yourself sometimes forget about this upcoming challenge of getting money out of pre-tax accounts, and they continue piling money into their pre-tax retirement accounts because it’s what they’ve been doing for 30 years.
In other words, in many cases that we come across, they are just making their upcoming challenge, even more challenging. They are piling more pre-tax money into their pre-tax retirement accounts when they’re going to need to turn around and work carefully to try and get that money out in the very near future.
Now, as discussed during my Roth conversion series, much of this depends on your current tax rate vs your future expected tax rate. If you’re in the 35% federal bracket in your final working years and expect to be in the 22% bracket throughout your entire retirement, then piling more money into your pre-tax retirement accounts until the very end likely makes sense.
But, oftentimes, in those later working years ahead of retirement, people either tend to slow down and work part-time, or take a lower-paying role, or even find themselves working in a new field that puts them in a lower tax bracket than what they had experience for most of their professional career. If they’re in the 22% bracket during those final working years and expect to be in that same bracket (or higher!) throughout retirement due to their projected RMDs, then maybe piling more money into pre-tax accounts isn’t the most prudent thing to do.
Again, in that scenario, you’re just making your upcoming challenge…even more challenging. You’re adding more money to the very account you will need to begin trying to get money out of tax efficiently.
So, instead, a person in this situation, if eligible, might consider making Roth contributions. Or they might contribute to a plain vanilla taxable brokerage account. Or, knowing they will be doing some proactive tax planning between the date they retire and age 72, they might start to build up some cash reserves to pay the anticipated tax bill on annual roth conversions.
Getting a tax deduction can be a positive, but we have to be careful about getting trapped into looking at these deductions in a vacuum. We also have to be careful about being on autopilot all the time. Rockstar retirement savers often are just so used to maxing out their pre-tax 401k account, that they don’t think twice about it as they make that final lap and head toward the finish line.
We have to take a longer-term approach with our retirement savings and tax planning, just like we do with our investments. And since everyone's situation is a little different, I would just urge everyone to hit the pause button when you’re 3-5 years out from your projected retirement or work optional date. Hit the pause button and do a thorough review of your investments, retirement plan, tax plan, insurance, estate plan, everything. Those 3-5 years prior to retirement and the first 3-5 years in retirement are the absolute most critical years of your financial life.
Ok, so I said I had 3 retirement mistakes to share with you today, but I actually have one more.
A couple of weeks ago, a client joined us for their bi-annual review meeting, and like all meetings, we always start off by asking about any big updates we should know about. Together, over the last 12 months, we helped them make the big transition into retirement after the husband finally stepped away from a very long career at a public trade company.
And throughout his career, he and his wife followed the saving for retirement textbooks perfectly. The ability to retire was not in question. They were not worried about running out of money. They had been great savers, no debt, multiple income sources, expenses under control, etc.
The challenge for them, as some of you might be able to relate to, was what to do with the next chapter of their life. What to do with this money they worked so hard to save? Most people really struggle to make major life changes at this stage and eventually just kind of settle into this new normal, enjoying time with grandkids, picking up a new hobby or two, sleeping a little later, reading more books, traveling 1-2 times per year, you know the stereotypical retirement.
And that’s kind of what we expected for this client based on what we knew and what we had discussed in previous meetings. But when we kicked off this meeting a few weeks ago and asked them if they had any updates for us, I couldn’t have had a bigger smile on my face when I heard their answer.
“We sold our house and everything in it, sold our second car, and just signed a 12-month lease on a townhome by the beach.”
Now, as their financial planner, you would think that they would have wanted to discuss this major life decision and with us before taking action. But most of the time, that’s all people do, they discuss and discuss and discuss and never actually take action.
This client knew through all of our planning together that their retirement was secure. That they had more money than they would be able to spend. They didn’t need us to tell them that over and over again. What they needed was to just take action, shake it up, make a big change, and enjoy the money they worked so hard to accumulate and save.
Contrary to how I thought I might feel in this situation – being left out of what most would argue is a big decision that warrants a conversation with your trusted advisors – I was actually grateful that they woke up one day and just did it. That they didn’t call us to talk through all the what if scenarios and run the risk of getting paralyzed by the analysis.
When I was gearing up to leave the big wall street firm I was working for to launch my firm, a mentor of mine said, “just hold your nose and jump.” Sometimes that’s what we need to do. Sometimes we just need to set the analysis to the side, ignore the opinions, and just jump. Take action. Do something that feels scary and hard and different.
The unfortunate reality of retirement is that you likely only have a solid 10 (maybe 20) years before you’re forced to start slowing down. You’re likely not going to be traveling overseas into your 80s and 90s. You’re likely not going to be bouncing around Airbnb’s throughout the year, experiencing different cities around the country. And you may not want to be living in a condo near the beach for the rest of retirement.
Most really good retirement savers have a difficult time transitioning into spenders. And I’m, of course, not suggesting you go and carelessly spend money. In fact, sometimes these big decisions (or changes) have nothing to do with spending more money. Tim Urban shares this uncomfortable statistic that, for most of us, after graduating from high school at 18, we’ve already spent 90% of our life with our parents. Because we go from spending every waking hour with them when we’re young to maybe 10 full days per year. He elaborates by saying:
“Being in their mid-60s, let’s continue to be super optimistic and say I’m one of the incredibly lucky people to have both parents alive into my 60s. That would give us about 30 more years of coexistence. If the ten days per year thing holds, that’s 300 days left to hang with mom and dad. Less time than I spent with them in any one of my 18 childhood years.”
Anyhow, I was inspired by this client taking action. We just don’t see that type of life-changing decision being made every day and I told them that. So I’m sharing it with you in the chance you’re inspired by it as well. Because one of the biggest mistakes we can all make is not taking the time to enjoy the fruits of our labor, or simply enjoying time, time with friends, time with family, and time doing the things that make us happy. Like living by the beach for a few years.
I’ve linked to a handful of the helpful resources around each of the four retirement mistakes discussed today, including Tim Urban’s eye-opening article, in the episode show notes which can be found by going to youstaywealthy.com/153.
Thank you as always for listening, and guest what, you won’t have to wait very long to hear from me again. Keep your eyes peeled for a second bonus episode this Thursday (two days from today) on TIPs (aka treasury inflation-protected securities) and why they are losing money.
Episode Disclaimer: This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial, or other professional services.