You work hard for 30+ years hoping to enjoy your retirement. But if you make some of the top retirement planning mistakes, your so-called golden years may not be so golden. Understanding how to plan for retirement and the mistakes to avoid is important if you have your eye on a stress-free, comfortable retirement.
Check out the top mistakes most people make and what you should avoid.
Not Planning for Taxes
A lot of people think that planning for taxes is all about your tax bill on April 15th. The focus on your taxes for the current year – minimizing your liability as much as possible, but what about in retirement? It’s a mistake millions of people make – forgetting about taxes in retirement.
For example, if you have an IRA or 401K (not Roth), you’ll face Required Minimum Distributions once you hit age 72. You’ll have no control over how much you withdraw, which could bump you into a higher tax bracket when you can least afford it.
You also need to consider that your Social Security benefits could be taxed, as I discussed in a previous episode of this podcast.
Third, we also need to consider that given the financial situation in our country, taxes might be rising in the future. I personally feel like that’s what will happen, as I’ve shared on this podcast before.
What is your overall plan to lower the taxes you’ll owe before and during your retirement?
Not Understanding the Tax Benefits of Retirement Accounts
Each retirement account has different tax benefits. Here’s how it works:
- Taxable investments – These are investments you hold in a ‘standard’ investment account. You pay taxes yearly on any capital gains (money you earn on investments you sell). You don’t pay taxes on the investments you hold, but any money you put in your bank account from selling investments incurs a tax liability at your current rate.
- Tax-deferred – As the name suggests, you pay taxes ‘later’ on tax-deferred accounts including a traditional IRA and 401K. You get the tax deduction in the year you contribute (it lowers your taxable income), but when you withdraw the funds during retirement, you pay taxes on the amount withdrawn at your retirement tax rate. Since we don’t know what tax rates will be when you retire, it’s a bit of uncertainty on how much you will be taxed on your distributions in the future.
- Tax-free – The Roth IRA, Roth 401K, and HSAs are all examples of tax-free retirement accounts. Unlike the traditional IRA and 401K, you don’t get the tax benefit the year you contribute, but your contributions and earnings grow tax-free. When you withdraw the funds (following all the proper rules), you pay no taxes and Roth IRAs and Roth 401Ks don’t have Required Minimum Distributions since you already paid the taxes on those contributions.
Tax planning works best when you put your money in all three ‘tax buckets.’ Investing your money in taxable, tax-deferred, and tax-free accounts can potentially offset a larger tax liability you’d incur if you put everything in taxable or tax-deferred accounts. This will give you much needed flexibility to withdraw money from certain accounts at certain times, and help you lower your lifetime tax bill.
For instance, if tax rates are lowered temporarily (like they are from 2018 to 2025), then it might make more sense to take money out of tax deferred accounts.
On the other hand, if tax rates are increased, which I think is likely, then it might make more sense to take money out of accounts that have already been taxed, so you won’t have to pay that increased tax liability.
The main point here is to practice tax diversification, give yourself the option to withdraw money from accounts when it makes the most sense to do so.
Not Taking your Employers Benefits (401K Match, HSA, Estate Plan)
Everyone must save for retirement and there are many ways to do it, but it’s a no-brainer to take advantage of your employer’s 401K match.
For example, if your employer matches 3% of your salary dollar-for-dollar and you make $75,000 a year, that’s $2,250 in FREE retirement money if you contribute at least $2,250 per year. Don’t skip it.
Another option is the employer Roth 401K. Many employers offer this option, yet many employees don’t understand the difference. A Roth IRA doesn’t give you a tax break the year you contribute, BUT your money and earnings grow tax-free. This means in retirement, you pay no taxes on the money you withdraw from your Roth 401K, unlike the traditional 401K withdrawals, which you’d pay taxes at your tax rate.
Unlike the Roth IRA, there are no income limitations for the Roth 401K. If you’re ineligible for a Roth IRA because your income is too high, you can contribute to a Roth 401K.
Many employers also offer an HSA – Health Spending Account. Any money you contribute to an HSA is before taxes and as long as you use the funds for qualified medical expenses, the distributions are tax-free too.
Lastly, I’ve seen some employers offer discounts on Estate Planning Services. Lawyers are expensive! So if your company will split, or completely cover the cost of creating a Will, Trust, Powers of Attorney, etc, I highly recommend you take them up on it.
Over Reliance on Social Security Benefits
Social Security benefits cover 35 – 40% of your past income. On average, retirees earn $18,170 per year. Chances are you can’t live on that small amount even if you don’t have a mortgage or any debt. The cost of living alone makes it impossible to live on that low of an amount.
While you may count on receiving Social Security benefits, having savings to supplement the income will help you live your golden years without financial stress.
As we all know, the Social Security system isn’t stable. The government continues spending more money than it takes in, which could leave anyone relying solely on their Social Security benefit at risk if the government were to lower benefits in the future.
So in addition to your Social Security benefits, make sure you have a sizeable nest egg that you can also use to create additional income. You also need to make sure you have a reliable strategy to distribute that money, which I discuss in this blog post: 3 Ways To Create A Retirement Paycheck.
Cashing out your 401K Early
Changing jobs, a financial crisis at home, or even buying a home may seem like a good idea to cash in the money you’ve saved in your 401K or IRA.
Don’t do it.
Early withdrawal (before age 59 ½) incurs a tax penalty of 10% plus the taxes you’d owe on the income itself. The additional income could also push you into a higher tax bracket.
One big exception: The IRS Rule of 55 allows an employee who is laid off, fired, or who quits a job between the ages of 55 and 59 1/2 to pull money out of their 401(k) or 403(b) plan without penalty. This applies to workers who leave their jobs anytime during or after the year of their 55th birthdays.
Don’t Make the Top Retirement Planning Mistakes
These top retirement planning mistakes could have detrimental effects on your finances in retirement. Planning (and saving) early, having a plan for your taxes, knowing your tax liabilities and consequences, and figuring out how to maximize your savings for your golden years is essential.
We’ve covered the most important retirement planning mistakes here. If you’re interested in putting all of the pieces of the puzzle together, so that you can avoid any big mistakes and have a comfortable, fulfilling retirement, you can book a Start My Retirement consultation with me where we will put together a one page retirement plan outlining everything that you need to do as you approach retirement.