For many Americans, the question, “Are you prepared for retirement?” prompts dread. Even the most prudent planners worry that their post-work journey will take unforeseen turns. After all, so much of life is beyond our control.
With careful planning, we can provide insulation against the vagaries of life after work. It’s critical when developing such a plan, however, to avoid some common mistakes. As you prepare for the day you step away from full-time work, be wary of these five pitfalls. With proper preparation, you can sidestep them and launch into retirement with confidence.
1. Not Creating a Realistic (and Honest) Budget – Estimating your monthly expenses in retirement is the cornerstone of effective planning. When I work with clients, I ask them for their post-career budget. If they have one, we start there. If they don’t and they’re approaching retirement, then we examine their current spending habits to create a realistic budget.
It’s much easier to look at necessary expenditures and work backward from there. Once you know how much you are likely to spend in retirement, you can easily total your monthly income streams – from things like Social Security, pension benefits and income investing – and then determine if you have a viable retirement budget, or if you need to make some tweaks.
If you are a decade or more away from post-career life, it’s probably too early to make a retirement budget. Think about how your financial situation could change in 10-plus years – kids could go to college (or not), you could get a huge raise, you could move, etc. however, no matter your age, it can’t hurt to start working on a lifestyle budget. Putting these numbers on paper will help you when you work on your retirement budget down the road.
If your target retirement date is looming, build a budget based on the previous two to five years of expenses. This will give you a good idea of what you’ll be spending, so long as you plan to keep the same standard of living. Be sure to consider things that will change in retirement, such as more travel or a less expensive home.
Be honest in this process. You may want to believe you can get by on $500 a month for groceries, but if you currently spend $800, you have to ask if $500 is realistic.
2. Not Accounting for Uncontrollable Increased (Or Increasing) Expenses – We can’t predict the future, but we can plan for the unknown. The two most significant unknowns, or variable expenses, in retirement are health care and taxes. While we won’t necessarily know just how these expenses, and others like them, will fluctuate during retirement, we can make an educated guess as to how much to budget each year.
According to a 2017 report from a national retirement plan provider, the average estimated cost of health care for a retired couple age 65 and older was $275,000 for the duration of retirement. That number excludes the cost of any long-term care.
Many people mistakenly believe that Medicare covers all of your medical costs in retirement. This is not the case. There are still premium, co-pay, and prescription drug payments, among other out-of-pocket expenses. Additionally, health care costs are continuing to rise across the board; that $275,000 number from 2017 is up $15,000 from 2016. Since 1960, the cost of medical care has risen nationally from $27 billion to over $3 trillion.
Don’t let this information scare you, though; just keep it in mind as you plan for retirement. You can prepare for these ever-escalating medical costs by building some extra health care money into your retirement budget.
Now on to taxes. Tax brackets are not static, nor are they a straight line. Your taxes could decrease or increase during retirement based on your family’s individual situation.
Depending on where you live, there may be county exemptions, or reduced millage rates, that give you a break on your property taxes once you’ve hit a certain age. Check with your county to see what reductions are available.
Be mindful of income tax rates, as they can take an unexpected bite out of your retirement income. For example, if you and your spouse make a combined annual income of less than $44,000 only 50% of your SS benefits are subject to taxation. If your benefits increase or if you receive other compensation that puts you at or over the $44,000 threshold, however, 85% of your total SS benefits will be subject to tax. Your combined annual income is determined by taking your Adjusted Gross Income plus any nontaxable interest plus ½ of your Social Security benefits. This nuance can have a significant impact on your bottom line.
3. Not Understanding Withdrawal Rates – Remember the old adage about not eating into the principal of your savings and, instead, simply living off the interest? This is what we are talking about here.
In my work, I’ve found that some people have a misguided perception of how much they can withdraw from their nest egg each year without running out of money mid-retirement. What’s your guess? 7%? 10%.
How about 4%? That’s the research-driven withdraw rate that, with proper planning and diligence, assumes your nest egg will last for decades, not years.
Let’s look at an example of the 4% Rule in action, courtesy of my colleague Wes Moss:
Jane starts with $1 million in her retirement account on Day 1, in Year 1 of retirement. She takes 4%, or $40,000, out for living expenses. Let’s assume Jane has a 50/50 allocation of stocks to bonds.
Inflation goes to 5%, so in Year 2, Jane takes the same $40,000 (which was 4% of her initial portfolio balance) plus 5% to account for inflation that year. Her withdrawal in Year 2 is $42,000.
In Year 3, inflation soars to 10%. Jane takes her Year 2 amount ($42,000) and adds another 10% to account for this inflation.
Each year she works with her financial advisor to rebalance her portfolio back to the original 50% allocation to stocks.
Jane’s worst-case scenario is enough cash for 35 years.
4. Not Consolidating Accounts – Over an average working career, people accumulate, on average, ten different 401(k) accounts. Even for the most detail-oriented among us, it’s difficult to keep track of the various accounts. That’s why it might be a good idea to consolidate these accounts prior to retirement.
By distilling your accounts down, you could gain simplicity in managing your funds. Imagine that maintenance of your accounts becomes easier to execute – so much so that you see an increase in returns. Of course, this is not a guarantee, but it certainly is a possibility. Of course, it might make sense to keep accounts separate for various reasons. It is smart to evaluate what you have and where, and to simplify if possible, prior to retirement.
5. Not Consulting a Qualified Financial Planner – I honestly believe that research would show most Americans spend more time researching a new TV than they invest considering who will help manage their life savings.
When making important life decisions – executing an estate plan, for instance – most individuals consult with professionals. Why should planning for living comfortably during retirement be any different?
I would invite people who are actively planning for retirement to consider working with a financial professional. Among the benefits are savings in time and stress, coaching for new investors, and advanced help for seasoned investors. An advisor can also serve as a dispassionate, rational voice when things get scary, and can help you shop for assets. To me, it’s a partnership worth exploring.