Planning for a Labor-Free Life
The three-day Labor Day weekend looms ahead, which means my extended family already is staying at our house to share in the festivities. While I load up on BBQ supplies to celebrate the traditional end of summer, the discussion with my elderly parents has turned, of course, to money.
Don’t get me wrong, I love my folks, but… well, they’re always fretting about whether they’ll outlive their retirement savings.
Because I’m an investment analyst, mom and dad constantly pester me for financial advice, even while I’m just trying to relax with a burger and a couple of holiday beers.
Actually, who can blame them? We all worry about retirement. We’ve spent years building up a nest egg, but the wrong moves can set us back.
5 Ways to Ruin Your Retirement
To help soothe my parents’ fears (and maybe your own), I’ve pinpointed five common mistakes that can torpedo anyone’s golden years.
Maybe you have the day off on Labor Day or maybe you’re working anyway. Regardless, the holiday break is an opportune time to ponder these blunders that can wreck your financial independence and perhaps force you into a lifetime of labor.
- Claiming Social Security Benefits Too Soon
If you can afford it, you should delay claiming Social Security benefits. It’s a widely prevalent error to start too early.
Every year you put off claiming Social Security translates into an annual hike in benefits of 7% to 8%. Try to withdraw from your 401k, Individual Retirement Account (IRA), or other savings first before tapping Social Security. It’ll take discipline, but you can better leverage your Social Security payments if you wait.
When you start taking your monthly Social Security checks, consider if traditional IRA distributions will affect your tax bill. Those distributions count as taxable income and help determine whether your Social Security benefits should be taxed.
For tax year 2021, single filers with a combined income of $25,000 to $34,000 must pay income taxes on up to 50% of their Social Security benefits. For combined income in excess of $34,000, you must pay taxes on up to 85% of benefits.
For married couples filing jointly with a combined income of $32,000 to $44,000, you must pay taxes on up to 50% of your Social Security income. If your combined income exceeds $44,000, you must pay taxes on up to 85% of your Social Security benefits.
- Neglecting to Conduct Proper Estate Planning
Retirees who sell taxable assets with substantial unrealized gains will forfeit the advantageous boost in cost basis that their heirs would have received. In such a case, drawing first from a traditional or Roth IRA confers larger tax savings for heirs.
Tapping a traditional IRA rather than a Roth is more desirable when a retiree’s tax bracket is lower than the beneficiary’s. Although the money in an IRA grows tax-free, contributions are taxed as ordinary income for you or your heirs.
The opposite is true for a Roth IRA, which you should tap first if your tax bracket is higher than the beneficiary’s. Savers fund Roths with taxable dollars, which means the money is tax-free for both you and your beneficiary, but that benefit is more valuable for the person in the higher tax bracket.
- Not Protecting Your Existing Tax Breaks
If you retire before age 59.5, you should live on non-retirement plan savings, because early withdrawals from traditional IRAs and 401k plans incur a 10% penalty in addition to being taxed as income.
When you turn 59.5, you should rely on a traditional IRA and 401k in your lower-income years, preferably before Social Security or a pension comes into effect, and withdraw non-taxable savings from a Roth IRA for those years when your income is higher.
Beware of a scenario that often surprises unwitting retirees: hefty withdrawals from a traditional IRA or 401k can generate unintended tax liabilities by hiking your taxable income high enough to preclude your eligibility for other tax breaks that you’d ordinarily have coming to you.
One of the surest methods to reduce the bite of income taxes on dividend payments is to own dividend-paying stocks in tax-advantaged retirement plans, such as 401k plans and IRAs. Dividends paid by investments held in these accounts are not subject to dividend taxes.
- Under-weighting Stocks and Over-weighting Bonds
We currently suggest the following all-purpose portfolio allocations for readers (see pie chart below). Consider these allocations to be guidelines; you may want to tweak the percentages based on how close you are to retirement.
Generally speaking, investors should get more conservative as they get older, mainly because they have fewer working years in front of them.
If your portfolio takes a turn for the worse when you’re in your 40s, you still have plenty of time to bounce back.
However, if your investments take a nosedive when you’re 65, you’re in a far worse predicament. That’s why, as you get older, you should increase your portfolio’s bond weighting.
That said, it’s a common mistake to get too conservative. By taking on some equity risk, you’ll put your assets on a path to not only outpace inflation but also grow in real terms.
- Ignoring the Cost of Fund Fees
Keep a vigilant eye on fund fees. Many investors blithely ignore fees, which erode wealth over time. It’s just money down the drain.
Case in point: Imagine investing $100,000 in a fund that charges 0.3% in annual fees and in which your money grows an average of 9% a year.
Compare that to another fund that also returns 9% a year, but with an annual fee that’s one percentage point more, or 1.3%. Over 25 years, that first fund will grow to $800,000, whereas the second fund will reach only $621,000. That’s a whopping difference of $179,000, which any intelligent investor recognizes as big money.
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In the meantime, enjoy the forthcoming Labor Day holiday. If you make the right investment moves now, one day you can celebrate the freedom from labor.