4 Mistakes to Avoid with Your Retirement Plan
Retirement norms are changing. Retirees can no longer rely on the old mechanisms for generating sufficient retirement income such as the 4% withdrawal rule or returns on market investments. People are also living longer, which means that finding a sustainable source of retirement income is now more crucial than ever.
What's worse — advisors are becoming wiser at manipulating retirees into making financial moves that, in a matter of years, can deplete what took decades to build. Here are four things retirees need to be wary — and aware — of when it comes to their investments. (For related reading, see: Should I Invest in a Hybrid Fixed Indexed Annuity?)
High Fees
One of the first careless mistakes retirees make is neglecting to thoroughly read and vet financial product contracts to ensure that they will not lose significant funds in hidden fees. Advisors lure their victims in with promises of higher or guaranteed returns (or sign-up bonuses which typically take years to obtain, a detail they may forget to highlight), and in return retirees roll their money into investments that may cost more than their current investments. For example, advisors like to suggest variable annuities for IRA rollover dollars or pension funds, which they will probably suggest you take out in a lump sum before investing. These insurance products let the investor pay into mutual fund sub-accounts, letting returns grow tax-deferred until withdrawal.
However, what advisors don't emphasize are the high fees associated with variable annuities, which are normally 2% to 3% or more of your assets to cover the costs of investment management or offer return guarantees. What's more, advisors might suggest cashing in one annuity and buying into another. While these turnovers bring advisors near 5% or higher commissions (for index annuities this commission may be up to 8%), that may mean penalty costs for the investor. These penalty costs come from the surrender charges associated with cashing out an annuity within the first several years. These penalties and fees can significantly erode a retiree’s retirement savings. (For related reading, see: Why Investors Can Be Their Own Worst Enemy.)
Using the 4% Rule
Many people are familiar with the 4% Rule, the age-old advice for retirees who were told to withdraw 4% of their retirement accounts since the market averages a 7% return every year on investment accounts. The problem is that the 4% rule no longer applies to retirees in the current market. Research (Finke, Pfau and Blanchett 2013) has shown that the rule worked during historically higher interest averages, but that in this day and age, a retiree would be more than 50% likely to run out of money utilizing that rule.
Besides the historically lower interest averages and lower averages of returns from stocks and bonds, the market has had too many fluctuations for the rule to work as well. When one averages out the stock market over the last almost century, investment return has indeed been close to or above 7%. But when one adds in adjustments for inflation, returns drop too close to or under 4%, before readjusting for any reinvestments of returns and inflation again. Therefore, this rule could work if a retiree were wealthy or young enough to withstand the volatility of market fluctuations. But for the average retiree who is now also living longer historically than previous retirees, the 4% rule can lead to a non-existent nest egg. (For related reading, see: 5 Financial Strategies to Last a Lifetime.)
60-Day IRA Rollover
There are several mistakes retirees can make when it comes to their IRAs. The first would be cashing out their IRAs completely. Retirees may choose to do this based on advice from their advisors, but it is not recommended. Not only can this generate severe penalties — one being an early distribution penalty at 10% of your account right off the bat for those under the age of 59½ — but retirees will also need to pay income taxes on those funds which, depending on their tax bracket, can be a hefty sum. Instead, with careful preparation, there is a process to rollover the funds tax-free.
There is a once-per-year (every 365 days) rollover that retirees can use, however they cannot rollover from the same account more than once in the same year. Also, if they do not complete the move within a 60 day window, they will be subject to the same penalties as if they had cashed out the account (i.e. 10% penalty and income taxes). Instead, a knowledgeable retiree should use a direct transfer where the funds are sent directly to the new custodian (trustee-to-trustee), where there are no restrictions (in comparison to the 60-day rollover) on how many times it can be completed.
Taxes
Finally, retirees should be aware of how taxes can impact and drastically reduce their retirement savings. Those in a low enough income tax bracket can withdraw a portion of earnings from their IRAs or taxable accounts and will have little or no effect on overall taxation. (For related reading, see: How Do I Calculate My Retirement Savings Percentage?)