Do you want to make work optional before age 65 and not have to worry about running out of money or being forced to sacrifice your lifestyle later on? Read this comprehensive guide to avoiding the top mistakes young professionals make.
Mistake 1: Saving The Wrong Amounts In The Wrong Types Of Accounts
If you have access to contribute to an employer-sponsored retirement plan, you should always contribute enough to that account in order to receive the full company match. That's a no-brainer. But if you want to retire early, you need to be strategic in allocating the rest of your savings.
Too many people don't fully understand the eligibility rules and contribution limits for 401(k)s, 403(b)s, 457(b)s, Traditional IRAs, Roth IRAs, HSAs, and if you have self-employment income, SEP IRAs, Solo 401ks, and Cash Balance Pension Plans. Not getting this right could mean you are missing out on contributing to an account that could play a vital role in your retirement. Choosing the wrong strategy could cost you tens of thousands, if not hundreds of thousands of dollars in lifetime taxes. Or it could mean you are making ineligble contributions to an account which could lead to you paying the IRS penalties.
Not enough people are aware that even if their income is too high to make direct contributions to a Roth IRA, they have other options for funding a Roth bucket of money for retirement via a Backdoor Roth IRA, or if your 40(1)k or 403(b) allows, the Mega Backdoor Roth. This Roth money can be especially helpful for early retirees as the contributions (not the earnings) can be accessed at any age without taxes or penalties. Plus, when RMD's (required minimum distributions) kick in later in life, you will be glad to know those don't apply to Roth IRAs for the orginal account owner. However, you must be aware of the Pro-Rata Rule.
Brokerage accounts should also not be ignored. This is because of they way they are taxed. Unlike a pre-tax 401(k) or IRA, when you take money out of a brokerage account, you pay capital gains taxes which are normally less than ordinary income tax rates, and you can tap into them at any age.
Mistake 2: Making The Wrong Decisions With Inactive 401(k)s and 403(b)s
You can read a much more in depth article about this here, but the following is a brief summary. Too many people just assume that when they leave an employer, they should just roll it over to a personal IRA. Or worse, they get sold on this idea by a financial advisor who may not have their best interests at heart. It's important to be aware that unlike HCP Wealth Planning, most financial planners get compensated based on how much money you invest with them. This usually menas that if you keep it in your 401(k), they don't get paid. So they have a very real financial motivation to convince you to rollover your account to an IRA through them.
But in many cases it makes sense to leave your investments in your old employer plan, or roll it to your new employer plan. You need to compare the overall costs, investment choices, and resources available in your employer plans and IRAs when deciding what to do. I have literally seen over a thousand 401(k)s and 403(b)s in my career. Some are fantastic and have funds with very low fees, lower than if you held those same funds in an IRA. Others are limited and expensive.Taking the time to understand which category your 401(k) falls under could save you literally thousands or tens of thousands of dollars in fees over your lifetime.
Keep in mind that your 401(k) or 403(b) may provide better protection against lawsuits. There are some other factors you may need to consider as well when deciding if you should rollover such as the Age 55 rule, NUA opportunities, having access to stable value funds, etc.
If your new 401)k) plan has lower costs, and a lot of tools and resources to help you manage the portfolio, it may make sense to roll your old plan into that. If the opposite is true, there shouldn't be any reason why you can't keep your investments in your old plan, while at the same time start contributing to your new plan (you can't keep making contributions to an employer's plan once you stop working for them).
If you really are self directed and prefer having access to the universe of investments instead of being limited to your employer's menu, then that could be a reason to rollover to a personal IRA.
Mistake 3: Not Aligning Your Savings and Investments With Your True Priorities
Before you can ask what you should do with your money, you should be asking yourself what you ultimately want your money to do for you. Unfortunately, most of us don't have unlimited financial resources, which means tradeoffs must be made. If you don't have enough in your retirement accounts by the time you want to stop working, that's a problem. On the flip side, if you are blindly throwing every dollar you have into saving for retirement, and ignoring other priorities such as travel, home updates, buying a new house, funding your children's college expenses, etc, you may not feel fulfilled in the present.
Real financial life planning is about figuring out how to allocate your financial resources so that you are fullfilled in the present, without risking your ability to retire early and stay retired in the future. It's extremley difficult to to do this without literally sitting down, and writing out a list of any goals you have that require money, and then ranking them. If you plan with a significant other, this can be an especially helpful exercise. You may find that you may have some differences of opinon , and thats quite alright. The idea is to come up with a plan that balances both of your priorities. Once you know which goals are most important to you, and understand the tradeoffs, you can then determine where to prioritize your savings.
Mistake 4: Not Properly Taking Advantage of an HSA
One of the best ways to help prepare for healthcare costs in retirement is to take advantage of an HSA. They come with a triple tax advantage meaning you get a tax deduction when you contribute to them, the money grows tax deferred, and when you withdraw from them for qualified medical expenses, those withdrawals are tax free. Oh yeah, and unlike an FSA, they aren't a "use it or lose it" account. You can continue to rollover the account balance year after year. Since you can actually invest in the stock market with them, the earlier you start, the better, so that you can let the power of compounding do it's thing. This makes them one of the most powerful financial planning tools for younger professionals.
One of the biggest mistakes people make with HSAs, is they don't actually invest their contributions. They let the money sit in a cash position not really working for them. But to get the biggest benefit out of them, you need to invest them in the stock market for the long term. The second mistake I often see is people spending their HSA money while they are still working. To truly take advantage of the triple tax benefit, you should treat them like a 401k or IRA and assume you won't touch them until retirement.
Mistake 5: Making Investing More Complex and Expensive Than It Needs To Be:
There are a lot of advisors out there who will attempt to convince you that investing is extremely complex. They will show you a model of a portfolio that contains way too many funds, many of which needlessly overlap various sectors of the market. They may also use funds with extremely high expense ratios that are charged in addition to their portfolio management fees. Their thought process is that they can convince you that they can "beat" the market" by utilizing a complex strategy that would be way to difficult for you to implement on your own. The problem is that it is extremely likely that they will not "beat the market" over the long run, no matter what type of investment strategy they use. But they will be happy to charge you that 1% of your portfolio balance year after year, regardless of the performance of your investments.
When it comes to investing, its important to keep things simple by focusing on what you can control. The first is the amount of risk you are taking (and therefore how much return to expect). Your investments should be set at a level of risk that aligns with how and when you intend to use that money. If they aren't, they may not grow enough to fund your goals for the money, or they may lose too much value just before you need to use the money.
Once you determine the appropriate amount of risk for each bucket of money used to fund a goal, you should invest at that risk level by using the appropriate mix of low cost, index-based investments. These types of investments won't "beat the market". But they are designed to replicate market returns. And if you have a sound financial and investment strategy in place, that should be all you need.
Mistake 6: Not Knowing exactly What Your Current and Future Cash Flow Looks Like:
Many familes whom I partner with for financial planning have a fairly poor grasp of where all of their hard-earned dollars are actually going. This can lead to one of two negative outcomes. One is that they end up spending frivolously on things that don't really add to their happiness and fullfillment in life. The other is that they actually end up saving too much money in a bank account earning next to nothing. This is why it's important to create a detailed financial plan using cash flow analysis. By visualizing exactly how much of your cash inflows are being allocated towards your cash outflows (including monthly living expenses, taxes, investments, savings, debt, insurance, goals, and hobbies), you can be confident that every dollar has a specific purpose and is not being wasted.
Mistake 7: Not Planning For Healthcare Expenses In Retirement:
If you are trying to determine if you will have enough money to make work optional at a specific age, its extremely important to accurately project how much healthcare is going to cost you over different stages of your life. Most people benefit from reduced group health insurance premiums while they are working. Or if they are self-employed they can at least deduct their premus. Once they are 65, they can rely on Medicare. But Medicare premiums can vary widely depending on your income. You need to factor in how much those premiums and out of out of pocket expenses may cost you in retirement.
And what if you retire five, ten, fifteen years before you turn 65 and are eligible for Medicare. If you don't properly evaluate how much healthcare will cost during those years, you may think you have enough money to retire when you don't, since you may be forced to draw down from your assets to cover those expenses sooner than you thought. This is on top of planning for the very real possibility that you may need long term care at some point towards the end of your life. You have to decide if its worth it to pay the expensive premiums for long term care insurance, versus planning to pay for these expenses out of your assets. If its the latter, how much of your assets would have to be used to pay for various types of care (in-home care, assisted living, or a nursing home). And don't forget inflation. Healthcare costs typically rise at a faster pace than normal costs of goods.
Mistake 8: Buying The Wrong Types Of Insurance With The Wrong Amounts of Coverage.
When it comes to life insurance, and property and casualty insurance (i.e. home and auto), there are plenty of insurance agents out there who will sell you products you don't need, or will sell you too much coverage. When it comes to life insurance for example, they may try to sell you whole life policies when all you need is term life. When you buy term life, they may talk you into buying more than you need. That could result in a needless increase in premiums that could literally cost you thousands of dollars. On the flip side, if you don't buy enough coverage, your family's financial needs may not be taken care of the way you hoped. The only way to know for sure that you have the right amount of life insurance coverage is to project your family's future cash flow needs and make sure your death benefit will be enough to cover them. You can do this on your own, or get some advice from a professional who has no financial incentive to steer you in any one direction when it comes to determing the proper amount of coverage.
The same goes for home and auto coverage. It's important to understand how much coverage you actually need, and only purchase that amount. Then shop around for new quotes for that coverage every year or two. For some people, umbrella coverage may be neccesary. But to avoid purchasing too much coverage, you need to understand which particular assets in your state are already proteted against creditors.
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