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As a financial planner who specializes in helping people prepare for retirement, I have lengthy conversations with prospective clients about their expectations for life after work. Their responses often reflect popular rules of thumb or preconceived notions.
These nuggets of conventional wisdom, however, are not always the perfect prescription for a healthy retirement. Here are five things you may have been hearing for years that may be entirely wrong.
‘If you invest the maximum in your 401(k), you’ll be fine’
Most Americans think their “maximum” 401(k) contribution is the amount they need to put in to get their full employer match. In reality, the maximum you can contribute to a traditional 401(k) is much higher. For 2015, you can defer $18,000 of your salary into a 401(k), plus an additional $6,000 in catch-up contributions if you are age 50 or over. You can invest additional money if you are also making after-tax contributions, so check with your plan administrator if you are truly committed to investing the maximum allowed for your plan.
Investors who do contribute the maximum might still be short if they have high spending habits. These folks will have to supplement their savings. It is not uncommon to find people with $2 million in savings who are only three years from retiring, yet they are used to spending $400,000 a year. Even with Social Security and a moderate pension, it will be tough for the math to work to provide them with 30-plus years’ worth of income to support that kind of spending.
‘Saving 10% of your gross income is enough’
Most people have heard they should save 10% of their gross (before-tax) income each year to have enough money for retirement. Since most people no longer have a traditional defined-benefit pension plan and are concerned about the future of Social Security, the 10% figure probably won’t be adequate — especially for those who have delayed saving for retirement until their 30s and 40s. A more appropriate savings target for a young person just starting out would be 15% of gross salary. This should be adjusted higher for those who start saving later in their career.
‘Your spending will decline in retirement’
Most people approaching retirement have no idea what their annual spending needs are and will plunge into retirement without a clear understanding of how much they’ll need to pull out of their savings. While some expenses will indeed be eliminated or reduced in retirement, there will be new ones to consider. For example, medical expenses in the form of Medicare Part B and supplemental insurance premiums, dental care and out-of-pocket costs can average approximately $15,000 a year for a couple in retirement.
Many retirees also have ambitious plans to travel or visit their kids, which can add upwards of $20,000 to the annual budget, depending on their goals. It is wise for pre-retirees to accurately determine what they’re spending now and examine how that will change in retirement based on their bucket list and lifestyle. Generally, when we explore post-retirement spending needs with clients in detail, we find that their spending is about the same as pre-retirement levels.
The first few years, often called the “go-go years,” will be most active and require higher costs for travel and entertainment. Flexible spending on travel, eating out and entertainment can be adjusted downward over time to reflect the “slow-go” and “no-go” years of later retirement.
‘You’re a failure if you don’t retire by 65’
Many clients feel peer pressure to retire. Their friends look at them as if they are crazy if they want to work past 65. Once they reach age 62, suddenly everyone is asking them when they are going to retire.
Retirement is not a number; it’s a mentality. When I ask clients if they love what they do and enjoy going to work each day, they often say yes — and that they would be willing to work longer, but they feel they should retire earlier because it is expected.
Engaging in something you enjoy that is both intellectually and socially stimulating is the essence of life. Our work connects us to passion, people and purpose. Working later in life can help prevent cognitive and physical decline. According to a study by the National Bureau of Economic Research, “complete retirement leads to a 5-16 percent increase in difficulties associated with mobility and daily activities, a 5-6 percent increase in illness conditions, and 6-9 percent decline in mental health, over an average post-retirement period of six years.” One needs only to look at role models like Warren Buffett and Betty White to find inspiration to stay employed and engaged well past “retirement age.”
‘Defer taxes now, since you’ll be in a lower tax bracket in retirement’
We’ve all been told to defer taxes into the future as much as we can. Americans tend to put almost all of their retirement savings into traditional 401(k) plans and IRAs. Then they ask how they can save on taxes in retirement. Unfortunately, there is little flexibility if all your savings are in tax-deferred accounts.
I call this the tax torpedo. We delay taxation for years, then get hit with a huge tax bill once Social Security, required minimum distributions and possibly pension income are realized in retirement. Furthermore, tying up money in tax-deferred accounts like traditional 401(k)s and IRAs can make an early retirement less feasible because of penalties for early withdrawal.
In an ideal world, we would hedge our tax situation by having a third of our money in after-tax investments, one third in tax-deferred retirement accounts and one-third in Roth IRAs. It may be wise to invest in a Roth account while you’re in the 25% tax bracket or lower. Once you exceed the 25% marginal tax rate, you may want to invest funds in traditional 401(k)s and IRAs. This tactic is especially important to consider if you believe tax rates will rise considerably in the future. Investing in a Roth when you first start out, with a lower tax rate and many years of tax-free growth, is a smart choice.
Rather than blindly adhere to rules of thumb, create a plan that will get you to your goals. If you are serious about building wealth, invest at least 20% of your income for retirement; spend adequate time planning for a career that you love so you can engage in fulfilling work for the majority of your life; and spread your investments in different types of accounts to hedge your tax situation over your lifetime.
There are no hard and fast rules. Do what makes sense for your situation. You may want to seek the counsel of a financial planner to help you navigate the intricacies of your plan.
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