Avoiding the Most Common Retirement Mistakes

Q. My wife and I are on target to retire in five years. We want to make sure we don’t make any major mistakes along the way. What, in your opinion, are some of the most common retirement mistakes and how can we avoid them? Thanks for your help!

A. As many of you know, besides being a Certified Elder Law Attorney, I am also an experienced retirement planning advisor and long-term care financial advisor through my affiliation with Protection Point Advisors.

In my dual roles, one of my most important tasks is preparing clients financially and legally for the unexpected. It’s certainly easy for unforeseen costs to deplete a hard-earned nest egg too quickly for comfort, so both types of planning are of utmost importance.

Avoiding the Worst Retirement Mistakes

To avoid the worst retirement mistakes, you have to be realistic about your future plans and think ahead. These are five of the most common retirement mistakes, and how you can avoid them:

1. Not Saving Enough: When planning for retirement, it may be important to cut back on expenses and prioritize saving. Save as much as you can by contributing to IRAs, 401(k)s, and Roth 401(k)s. If your employer offers a 401(k) match, always take full advantage of it. Most experts suggest at least 10% to 15% of total income should go into retirement savings over your working life.

  • 401(k): If your company offers a 401(k) and/or Roth 401(k), try to contribute as much as you can. Contributions to a traditional 401(k) are made on a pre-tax basis, meaning it reduces your taxable income in the year of your contribution. Also, the interest and earnings grow tax-free until you withdraw the funds in retirement, but at that time of course you’ll pay income taxes on the distribution amount. If you die and leave a traditional 401(k) or IRA to your kids, they will be forced to pay income tax on it within 10 years after your death, and they might be in their highest earning years and in very high tax bracket compared to if you took the distributions out during your lifetime. Remember, you can contribute a maximum of $19,500 per year in a 401(k) for 2021. If you are aged 50 or older, you can make an additional catch-up contribution of $6,500.
  • IRAs: For 2021, someone may generally contribute up to $6,000 into their IRA ($7,000 for someone age 50 or older), provided they have earned that much income, any time before the tax-filing deadline.The rules change if you are married and your spouse is participating in an employer’s retirement plan.

2. Not Considering Roth Retirement Plans

If your employer offers a Roth 401(k), in the long run this might be a better investment. Although you pay income tax on your contributions in current dollars, Roth account allow you to build a tax-free nest egg for retirement. With a Roth 401(k), all growth over the years will be tax-free, unlike the traditional 401(k) where you’ll pay income tax on the entire amount you withdraw once you withdraw it.

Some Roth considerations:

    • The Roth 401(k) is a heavier hit to your current annual income. If you’re cash-strapped, that could be a factor.
    • If you’re close to retirement, you might find the immediate tax break more beneficial than the prospect of tax-free withdrawals in the future.
    • If you expect to be in a lower tax bracket after retiring, the immediate tax break of a traditional 401(k) may be more useful. Just don’t automatically assume that you will be in a lower tax bracket after retirement. Many people are not, and the reality is you never know what the future tax rates will be.

3. Not Considering Regular Roth “Back Door” Conversions

People who earn too much to contribute to a Roth IRA can still perform a Roth IRA conversion each year. Sometimes this strategy is called creating a “back door” Roth IRA. Many people do not understand that there is no limit on the amount of money that can be converted from a traditional IRA into a Roth IRA. This very simple strategy allows you to take advantage of the Roth IRA’s many significant benefits even when you’re not eligible to contribute directly to a Roth IRA.

Who should consider doing annual Roth conversions?
A Roth IRA conversion is a great idea for many people. Here are some  common scenario where it often makes sense:

  • You earn too much: Regular Roth conversions can be a great strategy for those earning too much to contribute directly to a Roth IRA. You make a contribution to your traditional IRA first and then convert it into a Roth IRA, using tax dollars outside of the traditional IRA to pay the taxes due on the conversion.
  • You may pay higher tax rates later: You may be in a lower income tax bracket now (especially given today’s extremely low income tax rates) than you’ll be in later when you are forced to take distributions from your traditional IRA. This could be because tax rates go up. This could be because you might move from a state with no income tax to a state that does have income tax.
  • Your income is low this year: Maybe you have your own business and it’s an off year. Doing a Roth conversion during a year when your income is unusually low can be very desirable. Maybe you are one of the millions of people who quit their jobs this year to take time to consider new career moves, so you have less income this year. Now could be the perfect time for a Roth conversion.
  • You want to leave your beneficiaries tax-free income: A Roth conversion means that you can leave your beneficiaries tax-free accounts. This is especially beneficial if you’re unmarried or divorced, or if your spouse predeceases you, and your Roth IRA will to go to your children instead of spouse. With a traditional IRA, a spouse could roll it over and continue to defer taking taxable distributions, but as stated before, your children would have to take taxable distributions from your traditional IRA within 10 years after your death because of the SECURE Act that became law at the beginning of 2020. Depending on the size of the account and the tax brackets of your children that time, this can have significant negative tax consequences. The Roth IRA eliminates all the tax consequences to your children. They will still have to take out all the funds in your Roth IRA over the 10-year period after your death, but they won’t owe any income taxes on the withdrawals.

Consider converting over a period of years, starting as young as possible.

It’s very important to understand that you can start doing annual Roth conversions at any age. It doesn’t matter if you are under age 59 ½ at the time of the conversion, because the 10% early distribution penalty does not apply to any amounts converted from a traditional IRA to a Roth IRA.

Spacing out your Roth IRA conversions over many years may allow you to avoid ever jumping up to a higher tax bracket when you make the conversion.

The more time you have between making the conversion and using the money, the better off you will generally be, because the money can continue to grow tax-free inside the Roth IRA after you pay the tax bill on the conversion, especially beneficial if you are able to pay that tax bill with money outside of the IRA.

Be aware of the five-year rule when taking distributions from a Roth IRA

You can always withdraw your contributions (meaning money you directly contribute from your salary/earnings) from a Roth IRA with no penalty, and at any age.

At age 59½, you can withdraw both contributions and earnings on those contribution with no penalty, provided your Roth IRA has been open for at least five tax years.

This five-year rule also applies to all Roth conversion funds … if you do a Roth conversion and and then withdraw that money in less than five years, you may be charged taxes and/or penalties on the withdrawal.

A conversion may affect government programs

If you receive Medicare or other government benefits that look at your taxable income, such as senior citizen real estate tax relief, it’s important to note that a Roth IRA conversion could affect your eligibility for those programs or their cost.

if you still have college-age children, note that the money you convert from your traditional IRA to a Roth IRA is counted as taxable income in the year of the conversion, and this income can affect your children’s eligibility for student financial aid. If you are 63 or older, you need to know that you Medicare premium may be higher two years after you convert to a Roth IRA, because Medicare looks at your income from two years ago to determine your current Medicare premium, and if you cross a certain Income threshold, you may have to pay a higher Medicare Part B and Part D premium then the base premium.

The standard Part B premium amount in 2021 is $148.50. If your modified adjusted gross income, as reported on your IRS tax return from 2 years ago, is above $88,000 for an individual, or above $176,000 for a jointly filing household, then the IRMAA (Income Related Monthly Adjustment Amount) assessment increases the 2021 Part B and Part D premiums to the amounts shows in the Tables on this page of our website.

Convert before December 31

You must complete the conversion by December 31 of the specific year you want it to count towards.

Beware the pro rata rule on conversions

If you have traditional IRA accounts with both deductible and nondeductible contributions, you’ll need to factor that in if you convert any nondeductible amounts into a Roth IRA. The IRS’s pro rata rule requires you to calculate the tax consequences considering your IRA assets in total.

It’s a complex calculation and can create significant confusion.

Consider using an advisor

This is all very complex, and all of this tax planning impact your estate planning an asset protection planning as well, so it’s best to work with a financial advisor  and your attorney to help you make the best decision for you.

4.Consider Taxes and Penalties with traditional IRAs

Be sure to keep taxes and penalties in mind if you are considering withdrawing money from your traditional retirement accounts.

    • If you withdraw money from a traditional IRA before you turn 59 ½, you must generally pay a 10% tax penalty (with a few exceptions), in addition to regular income taxes. Plus, the IRA withdrawal would be taxed as regular income, and could possibly propel you into a higher tax bracket, costing you even more. In general, money you take out of a traditional IRA cannot be replaced, since you would still be restricted to yearly contribution limits for future contributions. However, if you just have a temporary need for liquidity, you can take a withdrawal from a traditional IRA and the IRS gives you 60 days from the date you receive an IRA or retirement plan distribution to roll it over to another plan or IRA.

5. Plan for Healthcare Costs in Retirement

Experts estimate that an average 65-year-old retired couple in 2021 would need about $300,000 in after-tax savings for health care costs in their post-work life, even with Medicare, according to Fidelity.

You can take steps to keep costs as low as possible with the right planning, good insurance choices, and a good understanding of your conditions and coverage. Consider these strategies — now and in retirement — to help control your health care bills:

    • Take advantage of a health savings account to put pre-tax money away for medical expenses. You can invest the funds, and both the principal and earnings are tax-free if you use them for eligible medical costs, today or in the future. This can create a good savings tool.
    • Plan for long-term care: A person turning 65 today has about a 70% chance of needing long-term care at some point, according to the Department of Health and Human Services. One of the best ways to approach this issue is to plan for it: How long do you intend to stay in your home? Where will you go when you can’t live there anymore? Who will help you with financial and health care decisions? Helping individuals and families plan for long-term care is a huge part of what elder law attorneys such as those of us here at the Farr Law Firm do for clients every day.
    • Get the right Medicare plan– Choosing the best Medicare policy once you turn 65 means finding one that includes your preferred doctors and your regular medications, helping you avoid high out-of-network and out-of-pocket costs. You’ll also need to consider whether you want access to all doctors who accept Medicare — as with an Original Medicare plan — or whether you want a plan that comes with extra benefits but a more limited provider network, such as a Medicare Advantage plan. As a general rule, if you can afford it, you should always go with Original Medicare and a Medicare supplement plan so that you have access to all doctors; this is especially important if you’re planning to travel in your retirement years, or if you want the ability to seek treatment at specialized hospitals or with specialized doctors that may not be in your home state.

6. Taking Social Security Early

The longer you wait to file for Social Security, the higher your benefit will be. You can file as early as age 62, but full retirement occurs at 66 or 67, depending on your birth year. If you can hold off, it’s best to wait until age 70 to file to receive maximum benefits.

As a general rule, the only time you should consider taking Social Security early is if you are in poor health. Also, if spousal benefits are an issue, it may be better to file at full retirement age so that your spouse can also file and receive benefits under your account.

7. Not Having a Financial Plan

Make retirement planning and saving a financial priority! Work with an experienced retirement planning expert, such as myself and my team, to create a plan that considers your risk tolerance, expected lifespan, planned retirement age, preferred retirement location, general health, and the lifestyle you would like to lead in retirement.

Prioritize Planning for Retirement and Saving Money

No matter where you are in your retirement planning, you may have made mistakes along the way. If you don’t have enough saved, try to save more starting now. Update your plan regularly as your needs and lifestyle change.

In addition to avoiding the problem areas above, seek advice from a trusted financial adviser, such as myself and my team, to help you stay or get back on track.

Planning for Retirement

Retirement planners generally work with people ages 55 and older, who are within 10-20 years or so of their desired retirement age. To get started on retirement planning, estate planning, or long-term care planning, please contact us to make an appointment for an initial consultation.

Retirement Planning Fairfax: 703-691-1888
Retirement Planning Fredericksburg: 540-479-1435
Retirement Planning Rockville: 301-519-8041
Retirement Planning DC: 202-587-2797
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About Evan H Farr, CELA, CAP

Evan H. Farr is a 4-time Best-Selling author in the field of Elder Law and Estate Planning. In addition to being one of approximately 500 Certified Elder Law Attorneys in the Country, Evan is one of approximately 100 members of the Council of Advanced Practitioners of the National Academy of Elder Law Attorneys and is a Charter Member of the Academy of Special Needs Planners.

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