11 Money Traps to Avoid When Retirement Planning
Retirement is something that most working people hope to eventually achieve, but planning for retirement isn't always easy. Many different variables,...
Retirement is something that most working people hope to eventually achieve, but planning for retirement isn't always easy. Many different variables, such as the future cost of living, your life expectancy, the housing market, etc., need to be accounted for. It can be challenging to know just how much you'll need in order to live the rest of your life comfortably.
There are many different financial strategies, products, services, and investment opportunities that will be presented to people planning to retire. But, as you might expect, while some of these investments will make a lot of sense, others will not be nearly as lucrative.
Money Traps to Avoid When Retirement Planning
Finding ways to avoid these common "retirement money traps" will inevitably make the entire retirement planning process much easier. The more you know, read, and ask about — and understand the financial sector — the better off you will be.
So, what are the most common retirement traps being faced today?
This article will discuss some of the most common challenges, money pits, and ineffective strategies affecting the modern worker. We will review if it’s smart to invest in a business for yourself or discover more about the people you should trust to help you make end-of-life financial decisions.
By making a deliberate effort to understand these common hazards and avoid them throughout the retirement planning process, you can better position yourself to achieve your long-term financial goals.
Waiting to Save for Retirement
When you are young, you likely have many expenses, which makes having early financial goals crucial. For example, in the class of 2019, about 69 percent of students graduated with some type of student loan debt (averaging about USD 29,000 per person).
Other early-life expenses, such as weddings, a down payment on a house, and childcare, can also quickly begin to add up. You might also want to spend your younger years traveling, which can be both fulfilling and expensive.
With many potential expenses being faced by people under 40, long-term financial goals like retirement are often pushed to the backburner.
However, waiting even just an additional few years to save for retirement can be very consequential down the road. For example, a million-dollar retirement portfolio, growing at five percent per year, yields fifty thousand dollars per year.
This means that waiting one year to begin saving effectively takes away fifty-thousand dollars from your future self (not that you currently have a million dollars — just sayin’).
Starting small — even just a few hundred dollars per month — can deliver big dividends in the future. Additionally, be sure to see if your current employer offers any retirement contribution or matching programs.
Choosing to forego these programs essentially leaves free money on the table.
Extending your Debt
Many people wrongly assume that just because they can access higher debt levels, it must be in their best interest to actually do so. However, maxing out all sources of borrowing will negatively affect your credit score, but it will end up costing you significant amounts of money over time. According to Experian, debt held by American consumers is approaching 4 trillion dollars — a problematic all-time high.
Having access to debt can be useful in case of emergencies and to help build your credit over time.
Some types of debt, like a mortgage, are seemingly unavoidable. However, to the greatest extent you possibly can, you should try to quickly pay down your debt. This is especially true if the amount the debt is growing (measured in APY) is greater than the returns you can receive from investing in the market—when this is the case, you will be effectively losing spending power as time goes on.
Many people engage in day trading and other short-term trading strategies to beat the market and build wealth over time.
New platforms like Robinhood and WeBull have helped spark a trading revolution, especially among young people. The S&P 500 produces an average annual return of about 14 percent per year. Beating this average return is something that many active traders can certainly do, but choosing an overactive trading strategy can create unforeseen issues for aspiring savers.
To start with, short-term trading is taxed as ordinary income rather than being taxed as capital gains.
If you engage in too many trades, you will quickly begin to accumulate near-term tax obligations, which as a result, will decrease your actual rate of return. I’m not suggesting you never engage in any sort of short-term trading or active trading strategies. However, it is important to be mindful of the risks you are taking and the obligations you are pursuing when doing so.
If doubling your money overnight was really so easy — just about everybody would be doing it.
In finance, risk and reward are typically correlated with one another, meaning that you will need to accept lower rates of return if you want your money to be safe. Likewise, anyone who wants their money to grow at a faster rate will need to be willing to take some risk.
Because few people want to "risk their life savings" when planning for retirement, it is not uncommon for people to choose investments (and wealth storage vehicles) with minimal downside.
Usually, this results in people distributing their wealth in accounts that offer very low, but guaranteed rates of return, such as a savings account, federal bonds, or certificates of deposit (CD).
However, some accounts issue rates of return that are so low; they are hardly even worth considering. For example, in the United States, the average savings account distributes a dismal 0.07 percent interest rate. Considering that the average annual inflation rate is around 2.46 percent (for all years 1990-2018), this means that choosing a traditional savings account will cause to effectively lose money over time.
Some accounts, particularly online banking options, offer much better rates. But even still, it is important to realize that low-return, "risk-free" investments actually carry with them a tremendous opportunity cost.
Lack of Liquidity
When saving for retirement, many people will become entirely fixated on "their number." They will come up with a number (or asset allocation strategy) that they believe can last them for the rest of their predicted lives and then once they have reached this number, they will consider themselves "ready to retire."
Having a ballpark estimate of what your lifetime expenses might be can obviously be very helpful. However, not all large sums of money should be considered equally. In addition to the number itself, there are other factors, like liquidity, that will need to be considered.
Liquidity is a term used to describe how easily a prospective asset can be converted into spendable cash.
Your home, which likely represents a very significant portion of your total wealth, is generally considered an illiquid asset because it would take time to convert your home into any sort of cash you could actually use.
Of course, I’m not suggesting you not invest in or live in a permanent home. But, ask yourself, “If the answer is a clear no, then you may want to reconsider how you structure your portfolio.”
Not Preparing for the Required Minimum Distribution (RMD)
According to the IRS, "Your required minimum distribution is the minimum amount you must withdraw from your account each year." The RMD that applies to any given individual will depend mostly on their age, along with a few other possible factors.
The IRS specifically addresses several different types of retirement plans the RMD affects.
The RMD affects traditional IRAs, SEP IRAs, 401(k), 403(b), profit-sharing plans, and other defined contribution plans. Therefore, if you currently have one or more of these types of plans, you must account for the inevitable RMD.
People that ignore the RMD will often count on their current wealth for generating future wealth.
However, because a withdrawal (and corresponding tax) will be required by law, this current wealth may not be able to grow at the rate you are initially counting on. The ability for wealth to stay within a specific account is not something you should readily overlook.
Not Having a Solid Withdrawal Strategy
In addition to liquidity, the RMD, and other factors, one of the most important components of retirement planning is determining how you plan to exit — whenever that might be. Your withdrawal strategy, ultimately, will be what directly affects paying for and owning the things you'll need throughout the course of your retirement.
If you are heavily invested in a specific stock, for example, you are exposed to the possibility that this stock will be at a low point the day you want to retire. Do you plan on selling some of it anyway? All of it? What do you plan on doing with the money, and will you be prepared to pay all corresponding taxes?
The answers to these questions will naturally vary, depending on your specific situation. However, the absolute need to have a solid withdrawal strategy still remains.
Be sure to speak with a financial planner about how to turn your current wealth into something you can actually use (and preserve, at least to an extent) in the future.
Having an Undiversified Portfolio
Diversification is a fundamental investment principle and one that has continued to prove itself to be necessary over time.
When a particular asset class is doing well, such as tech stocks in the late 1990s, it is okay to follow your instincts and make some investments. However, putting all of your eggs in one basket can be reckless and inefficient. Unfortunately, too many investors have had to learn this lesson the hard way.
There are many different ways to diversify your current holdings.
Like the S&P 500 Index, an index fund allows you to enjoy the general growth of a corresponding asset class without needing to make any overly active investment decisions.
Pursuing other asset classes, including real estate, bonds, foreign currency, and even cryptocurrency, will help further reduce your exposure to specific types of risk.
Expensive 401(k) Accounts
While the fees attached to your 401(k) are easy to overlook at first, the difference between a high-fee and a low-fee account can really begin to add up.
Currently, there are nearly 6 trillion dollars in American 401(k) accounts, which, according to CNBC, represents "about 20 percent of the total retirement pie in the U.S."
Contrary to what your employer might tell you, not all 401(k) funds are the same.
About five percent offer no fees, whereas 95 percent include a fee, averaging about 0.45 percent. Some accounts have fees around one percent or even higher.
Though this sounds small at first, the fees can really begin to add up and cost you tens of thousands of dollars in the future. So, if possible, be sure to compare multiple options before making any firm commitments.
Mixing business and your personal life can often be very problematic. As you establish yourself as someone who is ostensibly nearing retirement, it is not uncommon for those close to you to begin pitching "potential investment ideas."
You might, in fact, have the money needed to help your nephew start his own business. And his business idea might, in fact, be great. However, personal investments are categorically unnecessary and risky if things go wrong.
Don’t watch the amount of money you have worked so hard to build will begin to dwindle. Only in the rarest of circumstances should you pursue these sorts of "late in life" investments. Those close to you will understand.
Saving instead of Investing
Ultimately, retirement planning strategies can fall into one of two categories: saving plans and investing plans. While savers are concerned with preserving the wealth they've already accumulated, investors are more focused on having their money work for them.
Obviously, both the pursuit of returns and the avoidance of risk will need to be carefully balanced.
However, some things remain universally true: developing a comprehensive tax-saving retirement plan can help shield you from risk.
Taking time to understand the market and financial sector so that you can make better-informed decisions. Use the correct data when distributing your wealth to deliver quantifiably better results.
There is no single universally "best" way to prepare for your retirement. But by avoiding these common traps, you can put yourself in a much better financial position.
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