At our firm we deal with folks that are either retired, soon to be retired, or hoping to eventually retire every single day. So it should come as no surprise that we have witnessed a number of retirement planning mistakes over the years. After all, we are all humans, right? The good thing about these mistakes is that they are very much correctable. Below you will find three common retirement planning mishaps and how to learn from them.
1) Not having defined goals.
To us, predetermined retirement plan goals are a must. How can you measure your plan’s success unless you know what you are trying to accomplish? Goals act as a blueprint for the entire retirement plan. Goals should be created early and adjusted if need be. Some examples of goals as it relates to a retirement plan could be retirement age, location, and lifestyle (income) to name a few. All decisions made in the retirement plan should be focused on increasing the probability of success that some or all of the goals can be achieved. Goals also act as the measuring stick of the plan and sometimes they have to be prioritized. To help prioritize, we like to put goals in buckets such as: needs, wants and aspirations. We start with the “needs” bucket which we say contains the “bread, milk, cheese and wellness” funds. These items are a must and act as a base for the plan. The needs bucket typically is the base retirement living expense plus (always) a healthcare goal. We breakout healthcare as a stand-alone goal by itself because it typically increases at a higher inflation rate. “Wants” could be a home in a certain location, a new car every 5 years or an annual travel budget. The wants are important, however they come after the needs. Finally the “aspirations” bucket contains items that would be nice to have, but not a requirement. For some, aspirations could be a vacation home or a goal to help the grandkids with college. The aspirations are typically the goals that require the most planning to accomplish since they come only after the needs and the wants.
2) Not starting early enough.
It is an undeniable fact that the earlier you start saving for retirement the more likely you will be to accomplish your goals. The main reason for this is by starting early you are maximizing the amount of time you have for your assets to compound. Einstein once called compounding interest the eighth wonder of the world. Basically, compounding allows you to earn interest on interest so to speak. Here’s an example: suppose you have $100,000 in your 401(k) and you earn 5% in the first year you have it. The next year, even without contributions, you will have $105,000. If you get 5% again in the second year you will have growth of $5,250, instead of $5,000 because the 5% is earned on the whole $105,000. The extra $250 earned in year two is 5% more than the $5,000 you earned in year one. The longer you have for this dynamic to play out the better. Now I am well aware that there are some that may be reading this and thinking, what about me? I can’t go back to age 25 and start over! Well you do not need to. You are right, you cannot go back to 25, but you can control what you can control. Make today the day you focus on your retirement plan. Your future self will thank you regardless of your age.
3) Unrealistic growth expectations.
It is extremely important to be realistic as to the amount of growth you can expect from your assets over the life of your plan. While it may not seem like much, the difference of just 1% per year in return can in some cases translate into hundreds of thousands of dollars not available in the latter stages of the plan. It is also extremely important, especially in today’s low interest rate environment, to not position more than you have to (based on your risk tolerance and need for short term funds) in low returning assets, such as cash or short term CD’s or bonds. Oftentimes low risk / low return assets can entice nervous investors especially if stocks or other risk assets are experiencing volatility. The safety of low risk assets can sometimes be misleading however. Focus back to your plan. What rate of return are you projecting your assets will grow at? Is it realistic? For example, if you are projecting 7% over the life of your plan, but 90% of your assets are in 1% CD’s, you may feel good knowing that your annual statement will never show a loss. What shouldn’t feel good however is your plan probably has very little chance of success long term.
We have had some great questions from clients this month. Below are three that we thought were worthy to share.
1) I’m over 70 & 1/2 and I do not need the money from my IRA Required Minimum Distribution. Can I give it to charity?
Sure you can if that is important to you. There are two ways you can go about doing it. One way is to have your brokerage firm send you your regular Required Minimum Distribution (“RMD”) from your IRA to your bank account. Then you can write a check to any charity. The downside to this route is the RMD is then considered income for tax purposes, however the contribution to charity could still be tax deductible if you itemize. Another option could be to have your brokerage firm process your RMD as a Qualified Charitable Distribution or QCD. With this option, the brokerage firm would send your RMD directly to the qualifying charity. With a QCD, the distribution does not count as income for tax purposes. The drawback however is since you did not actually receive the funds you cannot deduct the gift to charity for tax purposes. The QCD could work well for people that either take the standard deduction or have too much income and their itemized deductions are limited. It could also work well for people on Medicare that are concerned about having to pay more for Part B if they have an increase in income.
2) What is an index fund?
In its simplest form an index fund is a type of investment fund that is built to replicate the performance of a particular collection of stocks, bonds or other investments. Typically the collection of investments all have similar attributes (like stocks v. bonds and, size, location &/or sector of a company) and are created by a well respected, third party academic or research firm. The purpose of the index fund is to allow investors (like us) to be able to purchase an investment vehicle that holds similar securities as the underlying index. The most common index fund in the U.S. is the S&P 500 index. The research firm, Standard & Poor’s (S&P), created the index to highlight the performance of the largest 500 companies in the U.S. as measured by each company’s market cap (size). You cannot actually purchase the S&P 500 as it is, in theory, only a collection of companies. However there are a large number of index funds available to buy that were created to mimic the performance of the S&P 500 index. In addition to the S&P 500 index fund, there are literally thousands of other index funds available to investors. Typically index funds have a much lower internal cost than funds that actively try to pick investments. However not all index funds are created equal. Before buying any index fund, it is important to fully understand the underlying index and the internal investment expense of the fund.
3) I just received a big tax refund, I have heard some say big refunds are good and others say they are bad. Which is it?
You really could look at it either way. Some could say a big refund is good, while others could say it is bad. I could argue that either could be correct. In one sense, receiving a big refund is bad because it means that you essentially provided an interest free loan to the government. Just think of all the extra ways you could have used that money throughout the year rather than having it sit on deposit with the government. On the other hand, for some it might be good because the extra money was essentially a forced savings plan that could come in handy to pay off holiday bills or home improvements. In addition, some people also say that that it does not matter that it is an interest free loan to the government, it is not like you earn much interest at the bank anyways. We can certainly see both points as being valid. To fully answer the question of whether a big refund was good or bad you really need to look at your personal situation. Consider how much your income may vary from year to year. If you are comfortable with the refund, keep everything as it is. If you would prefer to get back less and have more throughout the year, you may want to adjust your withholding on your W-4 form if you are an employee. We would also suggest you touch base with your tax preparer as well.
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