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Hey everyone, quick update before we start the show. My firm, Define Financial, aims to take on about 10 to 12 new clients per year. So if you happen to be looking to hire a retirement and tax planning expert, I would be honored if you considered us. To help you evaluate my firm and see exactly how we can help you, we are currently offering a free retirement assessment.
This free assessment includes an in-depth tax and investment analysis, and it provides answers to your big retirement questions. Most of all, and the reason that we do this is to help you see how we think, our approach to planning, our philosophy, the types of recommendations we make, and the value that we provide so you can truly determine if we're the best fit to work together.
As a reminder, we specialize in retirement and tax planning for people over age 50 who have accumulated investments of $1 million or more. So if that's you and you want to learn more about our free retirement assessment, just head over to www.freeretirementassessment.com. That's freeretirementassessment.com.
And if you're listening to this and you just don't feel like your situation matches our expertise, no problem. Just shoot me a note and I'd be more than happy to help you find the right professional. After all, you wouldn't see a cardiologist if you needed foot surgery. Okay, on to today's show.
Welcome to the Stay Wealthy Podcast. I'm your host, Taylor Schulte, and today I'm sharing three big retirement planning mistakes and how to avoid them. Actually, that's not true. There's actually a bonus fourth mistake that I added at the very last minute. It was just too important not to share. So be sure to stick around to the very end. For all the links and resources mentioned today, just head over to youstaywealthy.com forward slash 153.
I was backing out of the parking lot at work and next thing I knew my car was smoking and I was crawling out of the passenger window to safety. That was part of a story being told to me recently by a friend. In fact, that friend is very much connected to this show. He's actually the talented musician behind the intro music and the acoustic guitar segue that you just heard that plays directly after the intro to every episode.
Long story short, he was in a bad car accident recently, but in addition to him being okay, one of the positives of this accident was that it revealed a giant financial mistake that he's been making. And while he listens to the show fairly frequently, I wasn't all that surprised that he was making this mistake because most people I meet for the first time are making the same one, even avid listeners of this show.
So while many of you have likely already addressed this, his story just motivated me to highlight it one more time because it's just too important to ignore. And that is umbrella insurance. You see, this accident that my friend was in could have very likely been considered his fault.
It also could have resulted in the other driver being more severely injured and or just more litigious. Not only did my friend fail to max out his auto and home liability limits, but he also skipped umbrella insurance years ago when he set everything up. He owns a home, he has two kids, and both him and his wife are successful working professionals.
If this accident had been any worse and or the driver had been more litigious, it's possible that his entire life could have been turned upside down. And that's because if your auto or homeowner's liability limits are low and you don't have umbrella insurance to extend those limits, your income and or your assets can be up for grabs.
So he played out these scenarios in his head while he was sorting through everything with both insurance companies. And he shared with me that he was terrified to learn about what could have happened. He just couldn't believe that he glossed over this small and easy and wildly important financial planning task.
Oftentimes, when I bring up umbrella insurance, people tell me that they don't have inexperienced drivers, i.e. kids in their household anymore, or they aren't doing anything dangerous or putting themselves in risky situations that would require a large liability policy, that the risk is so low that it's just not worth the added cost.
Or I hear that they grabbed a $1 million policy because that just seemed like enough. However, like my friend quickly learned, the risk can be as simple as backing out of a driveway, which most of us do several times per week.
But it can also be as simple as driving to the grocery store and accidentally hitting a neurosurgeon, preventing them from working for an extended period of time or forever for that matter. Guess who they're coming after in all of those cases? Your insurance company. But if you don't have the proper insurance in place, their next stop is you and your personal assets and or income. So it can be a very accidental situation that leads to complete destruction of everything that you have worked so hard for.
Just because you don't have a pool or you don't have a trampoline in your backyard doesn't mean that you're safe from an accident resulting in large financial damages.
The great thing about umbrella insurance is that it's cheap, cheap relative to the coverage you're getting at least. And when it comes to insurance, that's exactly what we want. We want to insure against the big stuff, the catastrophic things like accidentally hitting a neurosurgeon and then skip the coverage for the little things like iPhone insurance or roadside assistance. Those are things that you can cover out of pocket, assuming that you're financially stable and you have proper savings in place.
So back to the cost for about $500 per year, you should be able to acquire around three to $4 million of umbrella insurance coverage. The average cost is around two to $300 per year for $1 million of coverage, and then about $100 per year per million dollars of coverage after that. So, you know, for about $500 per year, you should be able to get around three to $4 million of umbrella insurance coverage.
The rule of thumb is that you purchase a policy that roughly equals your total net worth. So if your net worth is, let's say $5 million, you would want to ensure that you have at least $5 million of coverage. Now you'll already have, or should have auto and or homeowner's liability coverage, usually somewhere between 250,000 and 500,000. So if you're
If we assume that your auto home liability coverage is maxed out at $500,000 and you added a $5 million umbrella and policy, then you would technically have $5.5 million of coverage, which is just slightly over your hypothetical $5 million net worth.
You see, umbrella insurance extends your existing liability coverage. Your home or auto policy will cover the first $500,000 of losses, and then your umbrella insurance will kick in and cover everything above up to that amount that you have. And as you can imagine here, in a serious accident, especially one where a high-income professional can no longer work, $500,000 is not going to go very far, hence the need for millions of dollars above that.
Lastly, while the rule of thumb is to match your liability insurance with your net worth, many clients of ours will extend it further. So instead of $5 million, they might get $10 million, especially if they feel like they're more at risk than the average person. But it's so cheap relative to the coverage that you're getting that people often just feel better about rounding up knowing that they have ample protection.
To round this all out, your action item is simply to call your auto or homeowner's insurance company and confirm that you have your liability insurance maxed out. Again, it's usually $250,000 or $500,000 that maxes it out. And then confirm that you have umbrella and coverage that extends up to your net worth on top of that at a minimum.
If you don't ask for quotes immediately and while you're at it, you might shop around and gather a few more quotes from other companies just to ensure that you're getting the best coverage at the best price. I know it feels like a stretch for something catastrophic to happen, but unlike most types of insurance, the risk far outweighs the cost here. And this is just one of those no brainer policies that everyone should have in place.
Okay, moving on to mistake number two, many of you, and I know this because I get emails all the time. Many of you are rockstar retirement savers. You're maxing out your 401k. You're maxing out your HSA. You're participating in equity comp programs. You have a healthy emergency savings account and you're making IRA contributions on top of it all.
But most of us know when you're making deductible 401k contributions through your employer, you are not also able to make deductible IRA contributions. You can still contribute to your traditional IRA, but those contributions are what we call non-deductible.
And great retirement savers like you whose income exceeds the Roth IRA limits are smart to make these non-deductible contributions to their traditional IRAs because the investments grow tax deferred. In other words, even though you don't get a tax deduction up front, it's still beneficial to get money into a traditional IRA if your income exceeds the Roth IRA limits so that you don't have to pay annual taxes on dividends, interest, and capital gains, but
which drag down your portfolio every year. The problem that leads to the mistake I'm about to highlight is that most retirement savers do end up having traditional IRA dollars that are both deductible and non-deductible. Some of the contributions went into the traditional IRA pre-tax and some went in after tax. And when you go to pull money from your IRA in retirement, you definitely don't want to pay taxes on money that's already been taxed.
For that reason, you want to make sure that you're tracking the after-tax contributions. And there's a few mistakes in here that I'm going to go through. Those after-tax contributions are the non-deductible contributions. Throughout your working career, you want to make sure you're tracking these so you don't overpay the IRS.
The technical term here is basis. After-tax contributions cause your traditional IRA to have basis, much like investments that you make in your taxable brokerage account. You only pay taxes on the growth because the amount that you contributed and invested has already been taxed.
However, unlike a taxable brokerage account where you can navigate each individual security and make tactical decisions as to what to sell and the most tax-efficient method of withdrawing money from that account, unlike those taxable brokerage accounts that have more flexibility, traditional IRAs with basis don't quite work like that.
Yes, you can buy and sell every day without tax consequences inside your IRA. But when you go to take a withdrawal from the account, the IRS looks at all of your traditional IRA dollars globally and implements what they call the pro rata rule. And this is where a lot of people get tripped up.
Because it's truly a global look at your traditional IRA dollars across all accounts and across all custodians. For example, a very basic example here. Let's say that you have one traditional IRA account with $50,000 of pre-tax contributions, i.e. you got a deduction for making those contributions. So you have one traditional IRA account with $50,000 of pre-tax contributions at Fidelity.
And you have another traditional IRA with $50,000 of after-tax contributions at, let's say, Charles Schwab. Two separate accounts at two different brokerage firms. If you go to take a withdrawal from your Schwab IRA that was funded with after-tax money, the IRS is still going to factor in your Fidelity IRA that has an equal amount of pre-tax dollars.
In its most basic form, they're going to say that 50% of your total IRA dollars across all custodians and all accounts have never been taxed. Therefore, 50% of your withdrawal, even if it's coming from a traditional IRA that was funded with non-deductible after-tax money...
is going to be taxed. 50% of that withdrawal is going to be taxed. It's a pro rata calculation based on all of your traditional IRA dollars. So the first thing to mention here is that if you're making non-deductible traditional IRA contributions, or if you've ever made them in the past, you will want to ensure that you're filing form 8606 every year with your tax return. This form tracks your after-tax contribution.
It tracks your basis in your IRA. It tells the IRS that X amount of dollars has been contributed to my traditional IRA on an after-tax basis. I've already paid the taxes on this amount, and I don't need to pay the taxes on it again when I withdraw it. A quick reminder, again, that you do pay taxes on the growth, just like any other investment that you make, but your principal contribution is not taxed again at withdrawal, if you tackle all this properly, that is.
While it's really simple to file Form 8606, even if you DIY your taxes, software like TurboTax is smart enough to know when you can and can't make deductible contributions. But it's still common for people to miss it.
If you do forget or you realize that you've made some mistakes here and there throughout your working career, you'll be pleased to know that the IRS will ignore the typical three-year statute of limitations and allow you to submit Form 8606 and correct any mistakes without also filing a Form 1040. In other words, you don't have to amend prior year tax returns to fix this, which is a huge bonus.
Also, there can be a small penalty of $50 for not filing form 8606 on a timely basis, but the penalty can be waived if you show reasonable cause for not filing. And in rare cases, especially if you don't respond to IRS inquiries asking you to explain the reason for your late filing, you do run the risk of being audited.
So step one in sidestepping this mistake is just to ensure that you or your CPA is filing form 8606. And if you think that you or your CPA has made a mistake, you want to fix this ASAP. You'll also want to ensure that you keep an eye out for IRS inquiries after you submit your late form 8606 to mitigate the risk of an audit. An audit is the last thing that you want here.
But step two is to ensure that you're tracking the basis in your own spreadsheet as well. And to keep this all on your radar as you get closer and closer to retirement. I mentioned this because we've seen TurboTax returns recently that have been filed properly with form 8606 year after year after year. But the form fails to keep a running tally of the client's traditional IRA cost basis.
This tally is typically summed up on line two of the form, but we've seen a zero on this line for people who we know have sizable basis in their traditional IRAs.
In other words, if they happen to start withdrawing money from their IRA and they don't have a running tally of their basis, they could end up paying taxes twice on those withdrawals. Or maybe they decide to hire a CPA to finally take over their taxes and they don't have a financial planner in their life who's aware of the basis in their IRA. Well, that new CPA would typically use the prior year tax return to get up to speed.
However, if line two on form 8606 has a zero, they will assume that the IRA doesn't have any basis beyond maybe the most recent contribution.
In some cases, line two might have a dollar amount and the new CPA just has to trust that it's the correct amount. There's no other record for them to review to double check its accuracy. So keeping your own tally of non-deductible IRA contributions can come in handy if you ever find yourself in this situation, or you just want to be sure that you have your own personal backup of these contributions as you get closer to withdrawing money from your traditional IRAs.
By the way, the pro rata rule, as you probably know, also comes into play when making backdoor Roth IRA contributions and doing Roth conversions. It's not restricted to just a straight IRA withdrawal here. I'm not going to go into the weeds in this episode, but just know that if you have an existing pre-tax traditional IRA, making backdoor Roth IRA contributions likely isn't going to make sense given this pro rata rule.
rule. If you want to learn more, I'll link to an article or two in the show notes to save you some time, but you can also do a quick Google search to learn more. Okay, let's move into mistake number three. As noted earlier, I know that many of you are great savers. You're super savers and you want to take advantage of every possible savings bucket while you're still working. I get it.
As I've talked a lot about recently, one of the biggest pain points in retirement is taxes and getting money out of your tax deferred retirement accounts at a fair rate before age 72. Because if you don't do anything and you're not proactive with your tax planning at age 72, the IRS is going to come knocking on your door and begin forcing you to take money out of your pre-tax accounts through what we know as required minimum distributions, those RMDs.
And for good savers like you, this can mean six figures of taxable withdrawals every year and oftentimes withdrawals that you don't really need. So in retirement, the goal is to carefully get money out of these pre-tax accounts so that you don't find yourself in a higher tax bracket at age 72 than as a working professional.
Now, the mistake that we often see is that in those final working years, let's say that the final three to five years, great savers like yourself sometimes forget about this upcoming challenge of getting money out of pre-tax accounts. And they just continue to pile money into these pre-tax retirement accounts because that's what they've been doing for 30 years. In other words, in many cases that we come across,
They're just making their upcoming challenge even more challenging. They're piling more money into their pre-tax retirement accounts when they're going to need to turn around and work carefully to try and get that money out in the very near future. Now, as discussed during my Roth conversion series, much of this decision depends on your current tax rate versus your future expected tax rate.
For example, if you're in the 35% federal tax bracket in your final working years and you expect to be in the 22% bracket when you retire and throughout your entire retirement, well, then piling more money into your pre-tax retirement accounts and getting that tax deduction while you're in that high tax bracket, that likely makes sense.
But oftentimes in those later working years ahead of retirement, people either tend to slow down and work part-time or take a lower paying role or even find themselves working in a new field that just puts them in a lower tax bracket than what they had experienced for most of their professional career.
If they're in the 22% bracket during those final working years, and they expect to be in that same tax bracket or a higher bracket throughout retirement due to those projected RMDs, then maybe piling more money into pre-tax accounts is not the most prudent thing to do. Again, in that scenario, you're just making your upcoming challenge even more challenging. You're adding more money to the very account that you're going to need to try to begin to get money out of tax efficiently.
So instead, a person in this situation, if eligible, might consider making Roth contributions or they might contribute to a plain vanilla taxable brokerage account or knowing that they'll be doing some proactive tax planning between the date they retire and age 72. Maybe they start to build up cash reserves to pay the anticipated tax bill on annual Roth conversions.
Getting a tax deduction can be a huge positive, but we have to be careful about getting trapped into looking at these deductions in a vacuum. We also have to be careful about being on autopilot all the time. Great retirement savers are often just so used to maxing out their pre-tax 401k accounts. It's on autopilot every single month. And they don't think twice about it as they make that final lap and head towards the finish line to retirement.
We have to take a longer term approach with our retirement savings and our tax decisions, just like we do with our investments. And since everyone's situation is a little different, I would just urge everyone to hit the pause button when you're three to five years out from your projected retirement or even your work optional date, three to five years out, hit the pause button and do a thorough review of your investments, your retirement plan, your tax plan, insurance, estate, everything.
Those three to five years prior to retirement and those first three to five years in retirement are the absolute most critical years of your entire life. So if you don't do anything else, just hit the pause button and go through that planning process within that three to five year time period. Okay. So I said I had three retirement mistakes to share with you today, but I actually have one more. A couple of weeks ago, a client joined us for their biannual review meeting. And like all meetings, we always start off by asking about any big updates that we should know about.
To preface all this and give you some context, so together over the last 12 months, we helped this client make the big transition into retirement after the husband finally stepped away from a very long career at a publicly traded company. And throughout his career, he and his wife followed the textbooks perfectly. Their ability to retire was not in question. They were not worried about running out of money. They had been great savers. They didn't have any debt. They had multiple income sources. Expenses were under control, etc.
The challenge for them, as some of you might be able to relate to, was what to do with their next chapter of their life, what to do with the money they worked so hard to save. Most people really struggle to make major life changes at this stage and eventually just kind of settle into this new normal, you know, enjoying time with grandkids, picking up a new hobby or two, sleeping in a little bit later, reading more books, doing some traveling, the stereotypical retirement. And that's kind of what we expected for this client based on what we knew and the discussions that we had had in previous meetings.
But when we kicked off this meeting a few weeks ago and asked them if they had any updates for us, I couldn't have had a bigger smile on my face when I heard their answer. They said, guess what? We sold our house. We sold everything in it. We sold our second car and we just signed a 12 month lease on a beautiful town home by the beach. Now, as their financial planner, you would think that they would have wanted to discuss this major life decision with us before taking action.
But most of the time, that's all people do. They discuss and discuss and discuss, and they never actually take action. This client knew through all of our planning together that their retirement was secure, that they had more money than they would be able to spend. They didn't need us or want us to tell them that over and over and over again. What they needed was to just take action, to shake it up and make a big change and enjoy the money that they worked so hard to accumulate and save.
Contrary to how I thought I might feel in this situation, you know, being left out of what most would say is a big decision that warrants a conversation with your trusted advisor. Contrary to how I thought I might feel, I was actually grateful that they woke up one day and they just did it, that they didn't call us to talk through all the what-if scenarios and run the risk of getting paralyzed by the analysis.
When I was gearing up to leave the big Wall Street firm that I was working for to go and launch my firm, a mentor of mine said, just hold your nose and jump. And sometimes that's what we need to do. Sometimes we just need to set the analysis to the side, ignore the opinions and just jump. Take action. Do something that feels scary and hard and different.
The unfortunate reality of retirement is that you likely only have a solid 10, maybe 20 years before you're forced to start to slow down. You're likely not going to be traveling overseas into your 80s and 90s. You're likely not going to be bouncing around between Airbnbs throughout the year, and you may not want to be living in a condo near the beach for the rest of your retirement.
Most really good retirement savers, rightfully so, have a difficult time transitioning into spenders. And I'm, of course, not suggesting that you go out and carelessly spend money here. In fact, sometimes these big decisions or changes have nothing to do with spending more money.
Tim Urban shares this uncomfortable statistic that for most of us graduating from high school at age 18, after graduating high school, we've already spent 90% of our life with our parents because we go from spending every waking hour with them when we're young to maybe 10 full days per year.
He elaborates by saying, being in their mid-60s, let's continue to be super optimistic and say that I'm one of the incredibly lucky people to have both parents alive into my 60s. That would give us about 30 more years of coexistence. If the 10 days per year thing holds, that's 300 days left to hang with mom and dad. That's less time than I spent with them in any one of my 18 childhood years.
Anyhow, I was inspired by this client for taking action. We just don't see this type of life-changing decision being made every day. And I told them that. So I'm sharing it with you and the chance you're inspired by it as well, because one of the biggest mistakes we can make is not taking time to enjoy the fruits of our labor or simply enjoying time, time with friends, time with family and doing the things that make us happy, like living by the beach for a few years.
I've linked to a handful of the helpful resources around each of these four retirement mistakes discussed today, including Tim Urban's eye-opening article in the episode show notes, which can be found by going to youstaywealthy.com forward slash 153.
Thank you as always for listening. And guess what? You don't have to wait very long to hear from me again. Keep your eyes peeled for a second bonus episode this week, this Thursday, two days from today on tips, AKA treasury inflation, protected securities, and why they're losing money right now.
Thank you again for listening. I'll see you back here in a couple days.
