Last updated : Wednesday, October 13, 2010

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Preparing for Retirement: 3 Big Financial Mistakes

With a weak economy, widespread unemployment and dwindling social security, retirement isn't what it used to be. With people living longer, the average age of retirement has gone from 62 to 67, making it crucial for people to save as much as they can while they're employed. So, how can you know when you should retire and how can you make sure you'll have everything you need? We went to Bill Losey, retirement expert and certified financial planner, to get tips on planning for your future.

What are the three biggest mistakes people make when they retire?

1. Retiring Too Early
One mistake people make is retiring when what they need is a break. Lots of folks in their late 50s and early 60s are just tired and burnt out from having to wake up to the alarm every morning. So they might get an early incentive from their company and decide to leave. Then three to six months later, they are bored. You better make sure you are both financially and mentally ready. So maybe in lieu of full-time work, do a phased retirement where you're getting say, a 20 percent pay cut for three or four days a week of work instead of five. This gives people all the free time they need. Remember, once you retire, it's hard to go back. Age discrimination exists, so you should stay employed as long as you can.

2. Taking Social Security Too Early
Another mistake is taking social security at 62, when you can access it. For some reason, people think when they retire they have to take social security as well. But those are two separate decisions. If you believe you'll live for 17 or 18 more years, postpone taking social security until a few years later until you're 65 or 66. If you go to ssa.gov, you can find out your "normal retirement age" based on the year you were born. If you take social security before your assigned "normal retirement age", your benefits are reduced. Conversely, if you postpone it, you'll get credit. And keep in mind there are income limits for singles and couples, where you are either taxed on 50 or 85 percent respectively of your social security.

3. Understand Your Investments
A huge mistake is not knowing what you're invested in: You should know your asset allocation, risk taking, investment costs, etc. I think a broadly diversified portfolio in both U.S. and foreign stocks and bonds with exposure to 50 or more countries. You probably want up to 65 to 75 percent of your money in stock and no less than 30 to 40 percent for conservative investors.

What is the "catch-up" provision for your 401K?
There is a special IRS provision that allows people who are 50 and older additional contributions to their 401K as long as you have been employed a certain number of years and haven't maxed out your 401K or IRA. For instance, this year, the maximum amount you can contribute to your 401K is $16,500, but if you are 50 or older you can contribute $22,000. With IRAs, the maximum is $5,000, but for people 50 and older it's $6,000. These contributions are pre-tax, so when you cash in on them they are seen as ordinary income. However, around age 70 you are required to take money out of your 401K. This is called the Required Minimum Distribution Law. If you don't take the required minimum out, the IRS penalizes you at 50 percent of that amount. So suppose you have to take out $10,000 a year and you don't take it out, the IRS will take $5,000 from you.

Should you ever take out a loan on your 401K?
Studies show that people who take loans on their 401Ks do it out of financial necessity. Some people do it more casually, but it should be an absolute last resort. Tread very, very carefully because every dollar you take out is one less dollar that gets tax-deferred growth – in 30 years that one dollar might be worth four dollars, so you're losing a lot of money.

What are pensions and how do they work?
Somewhere between 20 to 30 percent of the population has a pension. It's a monthly periodic payment for a certain period of time. There are a couple of options: a single life pension, which might pay you $1,000 a month for the rest of your life, but when you die, payments stop. There is also a joint and survivor pension, which might pay you $750 a month, but when you die, your spouse still receives the monthly payment. It's really up to the person to choose what type of pension to get, but people often make mistakes. A lot of people look at the single option because they get more money out of it up front, but they don't necessarily plan ahead. Conversely, people choose the joint option when really, they enough assets to cover the spouse so they could have chosen the single option.

How much should I have saved up?
General rule of thumb: for every dollar you pull out of retirement every year (for 25 years), you want to have 20 times that amount of money saved. So say you come to me and say, I have a pension, savings and social security, and you think you'd only need $10,000 a year from your investment portfolio, I would tell you that you'd want to make sure you actually have $200,000 in your investment portfolio.

Is there a rule for setting up a budget?
Most people don't set up a budgeting plan, which is a big problem. You should leave a lot of wiggle room in your budget because you have no idea what the future will bring, i.e. cost of living, health issues, inflation, etc. You should budget at 20 percent above what you currently spend.

What about equity loans?
In your 50s and 60s pay down all non-deductible debt, including credit cards, auto loans and your mortgage if you can. This will give you peace of mind and you won't have to take out equity loans in retirement. Studies show that happiest retirees downsize and are debt-free.

Any retirement advice for people in their early careers?
For younger people, your ability to earn an income is your greatest asset. Think about your own intellectual capital. Go back to school, continue your education, network; make sure your skills have the potential to take you through your 70s.

For more retirement tips, click here. For a guide to the best places to retire, click here.

 

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