It was supposed to be enough: a nest egg sufficient in size to cover your living expenses during retirement. So where did it all go?
One bad decision as you convert your savings to income can undermine a lifetime’s worth of good ones, draining your hard-earned retirement funds and leaving you in a financial lurch.
Here are five of the most common and costly distribution mistakes—from overly aggressive spending habits to unbalanced portfolios and inefficient tax moves—that, with proper foresight and know-how, can easily be avoided.
1. Spending too much. Perhaps the biggest blunder when it comes to retirement plan distributions is spending too much, said Dave Richmond, a financial consultant and president of Richmond Brothers.
Many new retirees get lulled into a false sense of security when they see the size of their nest egg, forgetting that they may need that money to last up to 30 years, based on current life expectancies. They forget, too, that their expenses will likely rise as they age due to health-care costs.
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Fidelity Benefits Consulting reports that a 65-year-old couple with traditional Medicare coverage retiring this year will need an average of $220,000 to cover out-of-pocket medical expenses during retirement—not including the costs of nursing-home care.
“Especially if they get a lump-sum dollar amount from a pension, that looks like a lot of money sitting there, and they think they can take $20,000 here and $20,000 there, plus their annual draw, and the next thing you know, they’re taking 10 percent a year,” said Richmond, noting retirees who are no longer collecting a paycheck must stick to a budget if they hope to outlive their savings.
It’s even worse when investors retire into a bull market, as has been the case over the last few years. Many labor under the illusion that they can safely take more of their profits off the table than their projections would allow.
“Over the last few years, the markets have been so good that people think they can get away with taking more,” said Richmond. “You have to be careful.”
Taking too much from your savings too soon, he said, has a disproportionately negative impact on future returns, since it denies those dollars the opportunity to continue earning compounded interest.
2. Forgetting your RMD. This one stings. The Internal Revenue Service does not allow you to leave your money in a traditional individual retirement account indefinitely.
Generally, you are required to begin taking withdrawals when you reach age 70½. Your required minimum distribution, or RMD, is the amount you must withdraw from your account each year as taxable income. (There are no RMDs associated with Roth IRAs, since they are funded with after-tax dollars.)
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“I’ve seen this happen a lot,” said Allan Katz, a certified financial planner and president of Comprehensive Wealth Management Group. “They turn 70½, but they don’t need the money, so they forget about taking the RMD. I’ve seen people come in in their 80s and say, ‘I’ve never taken that.'”
In addition to the regular taxes you will owe on the distribution, the government will impose a 50 percent excise penalty on any portion of your RMD not withdrawn. Ouch!
“One of the most important predictors of a successful financial retirement is what the markets do during the first three to five years of your retirement.”
3. Neglecting the 4 percent rule. Retirees also frequently forget to adjust their withdrawal rate from their IRA based on market performance.
As a general rule, financial planners recommend an initial withdrawal rate of 4 percent of one’s portfolio value during the first year of retirement, with annual pay raises thereafter to match the rate of inflation.
When the markets produce above-average returns, however, you may be able to convert slightly more of your earnings into income. Likewise, when market returns are lean, you should give yourself a pay cut and live on less.
“One of the most important predictors of a successful financial retirement is what the markets do during the first three to five years of your retirement,” said Richard Salmen, a CFP and manager of financial planning services at BOK Financial. “If we have good investment markets during the first years, you’re off to a really great start. But if you retired in 2007, when the S&P [500 Index] was down 30 percent, that’s a big hole to dig yourself back out of. You need to either go back to work or reduce your spending.”
To avoid selling into a bear market, said Salmen, consider banking one to two years’ worth of cash in a liquid interest-bearing account, from which you can pay the bills while your stock portfolio recovers.
4. Shortchanging Social Security. Many retirees fail to consider the impact that retirement plan distributions may have on the taxability of their Social Security income, said Salmen.
If you and your spouse file a joint return with a combined income below $32,000, your Social Security benefits are tax-free. If your income from wages, self-employment, interest, dividends or retirement plan distributions falls between $32,000 and $44,000, however, up to 50 percent of your benefit may be subject to tax. And if your total household income is above $44,000, up to 85 percent of your benefit may be taxable. The thresholds for single taxpayers are $25,000 and $34,000.
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“If you’re in a situation where your total income is $30,000 and you take $15,000 from your retirement plan, you just went from Social Security not being taxable to all of it being taxed at 85 percent,” said Salmen. “It’s a big deal, and not many retirees are aware of it.”
Wealthy retirees who already have income above $44,000 need not worry about the added impact of distributions, as they already pay the maximum tax on their Social Security income. Likewise, those with income well below the minimum threshold for taxation are generally in the clear.
It’s the millions of taxpayers who fall somewhere in between who should factor taxes into their distribution plan.
If you’re younger than age 70½, when RMDs begin from your IRA, you can potentially minimize the tax you will pay over the long run by doubling up your distribution one year and not taking one the following—thus ensuring your Social Security checks will only be taxed every other year.
5. Retiring too early. It can be equally costly to cash out early from your 401(k) plan or IRA.
Before age 59½, any money you withdraw will not only get taxed as ordinary income but incur a hefty 10 percent penalty, as well.
Mistakes related to when, how and how much you distribute from your 401(k), IRA and other retirement plans can derail your financial future faster than you can say “zero account balance.”
To ensure your hard-earned savings go the distance, keep your spending in check, factor in tax implications, and avoid penalties at every turn.
—By Shelly Schwartz, special to CNBC.com