The Biggest Mistakes Seniors Make With Their Money Can Be Avoided

Even the smartest people can run into trouble managing their money. Serious mistakes can be hazardous to your wealth…

Mistake: Becoming too conservative. Seniors may feel that they must quickly shift their investment portfolio from stocks to bonds and other income-oriented instruments.

Reality: At age 60 or 65, your investment portfolio might have to last for 30 or 40 years, or even longer. Married couples, in particular, face the probability that at least one spouse will live for many years.

Over long periods, stocks have outperformed bonds, and that probably will be true in the future. Giving up on stocks can mean crimping your future lifestyle.

Strategy: Early in retirement, the best portfolio is a blended one that includes a large portion of stocks or stock funds.

With an average risk tolerance, a 60-40 split, stocks to bonds, may be appropriate. As you grow older, gradually tilt your portfolio toward bonds and other fixed-income investments to reduce the risk of incurring heavy stock market losses that you won’t be able to make up. A retiree with a 60% allocation to stocks at age 65 might drop that to 55% by age 70… 50% at 75, etc.

Mistake: Tapping retirement accounts too soon. Many people start to withdraw funds from their IRAs and other retirement plans as soon as they retire.

Trap: Such withdrawals reduce the tax-deferred growth enjoyed inside a retirement plan. Also, withdrawals before age 59½ may be subject to a 10% penalty tax.

Strategy: Assuming that you have enough other assets to leave your retirement account in place, tap taxable accounts for spending money during the year. In November or December, once you can project your taxable income (and tax bracket) for the year, take low-taxed withdrawals, if possible.

Example: At year-end, your tax pro tells you that you can withdraw $10,000 from your IRA this year and remain in the 15% federal tax bracket. You should take the money out at the 15% rate, because future withdrawals may be taxed at higher rates, depending on your personal circumstances and changes in tax law.

This strategy can be repeated each year (after you turn 59½ and the 10% penalty no longer applies). After you pass age 70½, though, you’ll have to take minimum withdrawals from most retirement accounts to avoid a 50% penalty.

Mistake: Ignoring Roth IRA conversion opportunities. In any year that your adjusted gross income (AGI) is no more than $100,000 on a single or joint return, you can convert all or part of a traditional IRA to a Roth IRA.

Advantages: After five years, all withdrawals will be tax free, assuming that you’re at least 59½ years old. (Contributions can be withdrawn tax free at any time.) Also, there are no minimum required withdrawals from Roth IRAs.

Trap: Some seniors fear Roth IRA conversions because they think a total conversion is necessary, which will require a large tax payment to gain eventual tax-free distributions and/or relief from required distributions. In fact, partial conversions are allowed.

Example: Len Johnson has $200,000 in a traditional IRA. His AGI (before any conversion) is less than $100,000, so he’s eligible for a Roth IRA conversion.

However, converting the entire IRA would generate $200,000 in additional taxable income and cost Len around $66,000 in tax, assuming a 33% effective rate. Len does not have $66,000 in cash, so he chooses not to convert.

Strategy: Len can do partial conversions, year after year, as long as his AGI doesn’t exceed $100,000.

Example: Len converts $40,000 of his traditional IRA to a Roth IRA each year. Even if he still owes tax at 28%, that would be an annual tax obligation of only $11,200. After five years of such conversions, Len’s entire IRA will be a Roth IRA.

The five-year period for tax-free Roth IRA withdrawals starts on January 1 of the year of the first partial conversion. The five-year test, which applies to each separate conversion, is met five years from January 1 of the year of the first partial conversion. Assuming that the Roth IRA owner is beyond age 59½, the account can be tapped at will, tax free.

Mistake: Overspending. You may be tempted to spend as much after retirement as you did while you were working. However, chances are that your retirement income is substantially less than when paychecks were coming in.

Best: Be realistic. You might, for example, spend what you receive from pensions, Social Security, part-time earnings, etc., after paying income tax.

It also makes sense to withdraw no more than 4% of your total investment portfolio for spending in Year One of retirement, then increase that withdrawal amount annually to keep pace with inflation. Academic studies have shown that such a drawdown rate, accompanied by a well-balanced investment plan, is likely to keep a portfolio viable for 30 years or more.

If you already have been retired for some time and your age is around 65, you can start this year to take 4% from your portfolio. Next year, adjust what you take to keep up with inflation.

If you’re around 70, you can start with a 5% withdrawal, then increase for inflation. Older retirees might start with 6% or even 7%.

Mistake: Halting retirement plan contributions. Many “retirees” actually have earned income from part-time employment, self-employment, director’s fees, etc.

This allows you to contribute to any of a number of retirement plans — defined-benefit, simplified employee pension, profit-sharing and 401(k) plans, for example.

Advantages: Contributions reduce the tax that you’ll owe today and the retirement fund will provide an additional income stream for your later retirement years.

Mistake: Canceling life insurance prematurely. Once your children are living independently and you have enough assets to provide for yourself and your spouse, you may wish to stop paying insurance premiums.

However, you might want cash from your life insurance at your death to pay taxes, your funeral costs, unpaid medical bills, etc. In addition, if you are going to leave one asset (such as your house) to one of your children, cash to other heirs can make for a fairer division. Life insurance can play other valuable roles, such as benefiting your favorite charities.

Best: Talk with a financial adviser and proceed cautiously before letting your coverage lapse.

Rule of thumb: If you can enjoy your desired lifestyle while still paying insurance premiums, you might as well keep paying.

Mistake: Giving away too much, too soon. Affluent retirees may give assets to children or grandchildren to help them and to reduce their own taxable estate.

There may even be pressure from family members to start doing this. However, such gifts should not begin too early, from a personal comfort standpoint. You may be concerned that you or your spouse will need those assets someday.

Strategy: Make formal loans instead, as needed, to your children. As they prosper, they may be able to repay the loans, providing you with additional retirement assets.

A formal loan is one that’s written down and signed by all the parties involved in the transaction. Terms (interest rate, repayment obligations) should be similar to loans from an unrelated lender.

Bonus: If you determine one day that you really don’t need the loan money back, you can forgive the loans and elect to treat the transactions as gifts.