This is a natural time to reflect on the past year. So you may be wondering if you’ve been making the right investment decisions for your eventual retirement.
In my experience as a financial adviser, I’ve noticed that many clients get caught up in what they hear or read in the media while missing some of the fundamental factors that affect their financial futures.
Here are the top six mistakes I’ve seen people make investing for retirement and why they can lead to problems:
Mistake No. 1: Going broke by staying “safe.” Investors often divide the world into what’s “risky” and what’s “safe.” That leads some who are risk averse to weight their portfolio too heavily with bank certificates of deposits and other guaranteed vehicles, like money market or savings accounts. They think that because their principal is protected, they’re ensuring a more secure future.
The reality is that they may be locking their money into a low-interest financial product that won’t keep up with taxes and inflation.
This inflation-taxation combination could have a huge negative impact, leaving them with less purchasing power in retirement. Becoming a bit more aggressive as an investor, through stocks, equity mutual funds and exchange-traded funds (also known as ETFs) that are carefully chosen and balanced with principal-protecting products, can go a long way toward ensuring income growth and adequate money in retirement while affording peace of mind that will let you sleep comfortably at night.
Mistake No. 2: Neglecting the entire tax picture of your investments. When deciding where to put your money for retirement, it’s important to understand how the four categories of investments are taxed. The tax ramifications will have a major impact on the money you’ll eventually live on. Diversifying the tax allocation of your investments can save you thousands of dollars during retirement. (Remember, too, that your Social Security benefits may be taxable.) These are the four categories:
* Taxable investments include bank accounts, money market accounts and funds, corporate bonds and dividend-paying stocks owned outside of tax-advantaged or tax-free accounts. They are usually liquid (you can sell them easily), but also come with a yearly tax burden on the interest or dividends earned.
* Tax-deductible, tax-deferred investments include employer-sponsored retirement savings plans such as 401(k)s and 403(b)s, Simplified Employee Pension (SEP) plans and traditional Individual Retirement Accounts (IRAs), if you meet the rules for deductibility. They present the risk of increased taxes in retirement, since you’ll be taxed on them when you withdraw the money.
* Non-deductible, tax-deferred investments include annuities and non-deductible IRAs. They can be useful if you’ve maxed out your retirement plan at work and want to save more for retirement or if you don’t have access to employer-sponsored retirement plans.
* Tax-free or tax-exempt investments include Roth IRAs, municipal bonds and, if used correctly, the buildup of cash inside certain life insurance policies.
Mistake No. 3: Failing to properly diversify. A self-directed investor came to me for advice on how to bring more stability to his portfolio. He had invested in a range of mutual funds, but when I looked closer, I discovered that virtually his entire portfolio tracked the performance of the Standard & Poor’s 500 index. This was why he was experiencing a roller-coaster effect, even though he thought he had diversified.
Proper allocation of your retirement portfolio requires owning a variety of asset classes to help smooth out volatility. That means domestic and international stocks; large-cap growth, value, small-cap and emerging market stocks; bonds and other fixed-income securities and cash investments, like money-market funds.
Mistake No. 4: Ignoring two of the three phases of financial planning for retirement. It’s no surprise that, when it comes to retirement investments, most people are focused on the accumulation phase: After all, if they don’t save for the future, there won’t be any assets to manage during retirement.
The problem is that by not also thinking about the distribution phase (how and how much to withdraw in retirement) and the legacy phase (passing on your investments to heirs), they may be painting themselves into a corner.
During retirement, when you are in the distribution phase, you want a reliable source of income. This may mean migrating from a growth portfolio that holds mostly stocks to one focused on growth and income from stock dividends and bond interest.
When you are in the legacy phase, preparing assets for the next generation, you’ll need to think about how those assets might be used by your heirs in the future and how they’ll be taxed.
Mistake No. 5: Short-changing heirs due to errors in your beneficiary forms. In today’s electronic age, paper forms with signatures seem a bit outdated and quaint. But time-tested beneficiary forms, which direct the distribution of everything from IRA assets to life insurance proceeds upon the owner’s death, remain extremely important.
Too often, however, beneficiary forms aren’t filled out correctly. Then the investments may inadvertently be channeled into an estate, sending the inheritance into probate, where taxes and fees can have an adverse effect on heirs.
So be sure to regularly review and update the beneficiary designations for all your financial accounts, with the right names and the percentages of your assets that you want them to inherit.
Mistake No. 6: Chasing returns rather than sticking with a plan. Investors tend to buy and sell on emotion rather than logic. Here’s an example:
You hear about a stock and start talking about it to friends. But you don’t buy the stock until it starts to go up, at which point, the emotion of hope sets in. The stock has a nice run-up, so you put more money in. Then, the emotion of greed sets in. When the stock starts to fall, the strongest investment emotion – fear – sets in. So you then sell, just as the stock hits bottom.
By creating a written financial plan, sticking to it and keeping emotions in check, investors can avoid chasing often-elusive returns. That’s why I recommend outlining your investment goals with a financial adviser, so the two of you can work together as a team.
Securities and Investment Advisory Services offered through ING Financial Partners Inc. Member SIPC. Rosenthal Wealth Management Group is not a subsidiary of, nor controlled by ING Financial Partners. These views are the sole opinion of Larry Rosenthal.