By Erik Carter
In our latest research report, retirement was the number one financial priority of employees that took our online financial wellness assessment. It’s also a growing area of interest as the percentage of questions we’ve received about retirement planning went from 14% in 2009 to 32% the same time this year. However, I find that when I’m leading a retirement workshop or answering questions on our financial helpline, there are still quite a few recurring myths out there that could be hurting people’s ability to plan properly for their retirement. Here are 10 of the ones I hear most often:
1. It’s too early to start saving for retirement. We see this most commonly with young people. For example, those under 30 were the only age group not to list retirement as their top priority and had the lowest participation rates in their employer’s retirement plan of any age group. This is particularly unfortunate for several reasons. First, with the disappearance of traditional pension plans and the impending insolvency of government programs like Social Security and Medicare, young people will likely need to save even more than previous generations. Second, they have the most to gain from being able to invest more aggressively and benefit longer from the magic of compounding. Finally, the financial habits that young people develop early in their careers can stick with them throughout the rest of their lives.
If you’re just starting your career, try to contribute at least enough to get your employer’s match so you don’t leave that free money on the table, even if it means having to share living expenses with a roommate for a bit longer. You can then begin to slowly increase your contributions over time as their income grows. Your retirement plan may even have a contribution rate escalator that will do that for you automatically.
2. I’ll need about 80% of my current income in retirement. For many people this may be true, but retirement needs can vary dramatically based on your particular circumstances. You may need less than this if you’re saving a lot for retirement, will have your mortgage paid off, or are planning to downsize or move to a lower cost area. On the other hand, you may need more than 80% if you want to spend more time traveling or engaging in other expensive activities.
One expense that people often underestimate or neglect to factor in at all is the cost of health care. This is especially true if you’re planning to retire before you are eligible for Medicare at age 65 and would not be covered under your spouse’s plan since you would then probably need to purchase insurance on your own, which can be very expensive. Even once you reach age 65, a recent study estimated that a typical 65-yr old couple without any other health insurance would need about $240k to cover medical costs over their lifetime, not factoring in long term care or any reductions the government may make to keep Medicare solvent.
3. I won’t see a dime from Social Security. This myth comes from the fact that the Social Security trust fund has been projected to run out in 2033. The good news is that doesn’t mean there won’t be any money at all in the program. After all, millions of people will still be paying taxes into the system. However, it’s projected that there will only be enough money to pay about 75% of the promised benefits. That means you may want to take your estimated benefit and reduce it by 25%. While it seems safer to assume you’ll get nothing at all, the amount you’d have to save in that unlikely scenario can be discouraging.
4. If I contribute to a retirement plan, my money will be all tied up. This myth is often tied to the first one since young people are typically also saving for emergencies, a home purchase, and possibly going back to school. One of the best solutions for someone in this situation is a Roth IRA since the sum of the contributions can be withdrawn at any time and for any reason without tax or penalty. Whatever you don’t need to withdraw will then grow and become tax-free after age 59 1/2 (as long as the account has been open for at least 5 years).
If you already have a sizeable balance in your employer’s retirement plan, you may still be able to access this money tax and penalty free by taking a loan. Unlike credit cards and home equity loans, there is no credit check and the interest goes back into your own account. As a last resort, you may also be able to request a hardship withdrawal. Just be aware that these are limited to certain circumstances, are subject to taxes and early withdrawal penalties, and cannot be paid back. While it’s best not to touch your retirement money at all, knowing these options are available can help make you feel more comfortable about contributing to these accounts.
5. I should automatically roll my retirement plans into an IRA when I leave a company. Many financial advisors like to give this impression since most of them make money managing IRAs or selling the investments in them, but there are several reasons why it isn’t always a good idea. First, if you retire during or after the year you turn 55, you would be able to make penalty-free withdrawals from that employer’s retirement plan immediately, while you’d have to wait until age 59 1/2 with an IRA. Second, if you have company stock in your retirement plan, you may get favorable tax treatment transferring the stock to a brokerage account rather than rolling it into an IRA. Finally, you may have access to lower cost investments and advice services than with an IRA.
6. I can’t contribute to an IRA because I have a retirement plan at work. This myth comes from the fact that if you’re covered by a retirement plan at work, there are income limits in being able to deduct traditional IRA contributions. However, even if you don’t qualify for the deduction, you can still make nondeductible (but still tax-deferred) and possibly Roth IRA contributions.
7. My income is too high to put money in a Roth IRA. You may earn too much to contribute to a Roth IRA but there is a way to get money into a Roth IRA through the backdoor. Since there’s no income limit on Roth IRA conversions you can contribute to a nondeductible IRA and then convert it into a Roth. The only catch is that if you have other pre-tax IRAs, you’ll have to pay a tax on the converted IRA on a pro-rata basis. However, you can avoid this by rolling the pre-tax IRAs into your employer’s retirement account.
8. My tax rate will be the same in retirement so I don’t get any benefit from tax-deferral. While it’s true that many people will be in the same tax bracket in retirement, that doesn’t mean you won’t benefit from tax-deferral. First, you may be in the same bracket but pay a lower effective rate in retirement. For example, let’s say that you’re in the 25% bracket both now and after you retire. When you contribute to a pre-tax 401(k), you’re contributing money that would otherwise be taxed at 25%. But when you withdraw that money in retirement, some of that money is likely to get taxed at the lower brackets, providing for a lower average rate. Second, even if you pay the same rate when you retire, you’ll still benefit from all the extra earnings on the money that would have gone to taxes each year.
9. I can be well-diversified by just spreading money around all the options in my retirement plan. Depending on how that money is spread out, you may not be as diversified as you think. For example, let’s say your plan has 5 options: a company stock fund, 3 other stock funds, and a bond fund. If you spread your money equally, you’d have 20% in bonds and 80% in stocks, with 20% in company stock. That’s a pretty aggressive mix and it’s generally a good idea not to have more than 10-15% in any one stock, especially if it’s your employer’s since your job is already tied to your company’s fortunes.
You can actually be well-diversified with as little as one fund by picking a one-stop shop asset-allocation fund like a target date retirement fund. These funds divide your money into lots of different investments based on how long you have until retirement. You can also build a customized portfolio based on your particular risk tolerance and time frame using a worksheet like this.
10. I should invest my retirement account in the top-performing funds. Picking the top performing funds may seem intuitive but it turns out that not only is past performance a poor indicator of future performance, it may actually be an indicator of poor future performance. Standard and Poor’s does an ongoing study in which they look at the top 25% of mutual funds in various categories and see how they did 5 years later. Their latest report shows that these top performers are actually less likely than average to continue being a top performer.
Instead of looking at past performance, look at costs when comparing similar type funds. Numerous studies have shown a pretty good correlation between low costs and superior investment results. In fact, Morningstar even had to admit that low fees and expenses are a better indicator of performance than their own star ratings.