Retirement account paralysis
I’ve come across many articles that address what people do with their retirement accounts at retirement. A high percentage just sit there the day after retirement, as they did the day before. You might assume this is because every retiree tries to hold on to their pot of savings for as long as possible so that it lasts, but there are other reasons.
I’ll use the term “retirement account paralysis” to describe what’s happening. It’s all because of one simple reality: saving for retirement is easy to execute, while planning for retirement is entirely different and far more complex. You can easily sign up for your employer’s 401(k) plan, set up automatic payroll deductions, pick an appropriate Target Date Fund, and even be disciplined about putting more money aside in savings or an IRA on a regular basis. Everything works automatically. Even old, forgotten accounts sit there, requiring no action (though you should still pay attention and manage them). Retirement savings on autopilot is okay for a while. But in retirement, you need to understand the tax rules related to these accounts, select the appropriate investments, determine how much you can safely withdraw, and figure out how and when to pay income taxes. Then you have to consider when to claim Social Security, where you’ll live, and how to take care of your spouse when you’re gone. And honestly, none of us have experience planning for retirement, since we’ve never done it before. Even if you’re a good money manager type of person, much of it will be Greek to you.
Unless you plan the transition in the years leading up to retirement, the day will likely sneak up on you, and you’ll have to address questions and decisions one by one as they arise. Should I take money out of the 401(k) before spending down my savings? How do I get regular income from the account? Should I roll over the 401(k) to an IRA? What are RMDs? How do I pay taxes? How much can I take out without running out? And many more. In fact, one article used the term “retirement drift” to describe how many people leave multiple 401(k)s at former employers and do nothing with them for years, letting them languish and go unmanaged. Many don’t appreciate the significance of ignoring these accounts.
Beyond the shift from savings accumulation to decumulation, the retirement transition also brings new risks. If you were employed and decide to retire at your chosen time, you go from employable to unemployable (Risk #1). It’s easier for a company to keep you on board for your experience, but once you’re gone, they move on. You’re unlikely to return to that job a year later if you want to. Once employment ends, savings accumulation stops, so you’d better have figured out how much to save for retirement before you quit, because once you lose your higher career work income, you can’t easily make up that savings; that’s Risk #2. Then there are the investment adjustments you should have made. The first 5 years after retirement have the greatest long-term impact if you lose money from investments while taking money out, so the general advice is to position your retirement savings for less volatility a few years before and after retirement, then make sure they’re adjusted to produce the income you need during retirement. That’s Risk #3. Risk #4 is missing a deadline (more detail later) that has a costly consequence. Finally, Risk #5 is an unplanned event or expense (health, accident, disaster, or care for a loved one) that affects the ability to proceed with retirement as planned. In other words, something causes a large, unplanned, uninsured expense that throws your retirement plan into chaos. And because you no longer have work income, the expense has a greater impact. Five new risks that really need to be addressed.
This kind of paralysis is serious. The consequences are real: penalties, investment losses, and possibly running out of money too soon. Fortunately, the paralysis is not permanent and can be reversed. You can do it yourself or get help. This means understanding which rules apply, weighing your options, and building a plan. Getting out of paralysis may seem like a one-time thing, but it’s more like recovering from an injury first, then maintaining health to avoid a repeat injury.
While you can minimize the effort of getting out of paralysis, there are good reasons to be more complete and thorough, simply because of the passage of time. You’re only at this point once in your life, and there are key dates related to retirement that can’t be ignored. 59½ is the earliest you can withdraw from retirement accounts without a 10% penalty*, Social Security can be claimed any month from age 62 to 70, but age 67 is special because it’s known as the Full Retirement Age (FRA), and currently age 73 is when Required Minimum Distributions (RMDs) start. And age 65 is when Medicare starts. However, there’s a short period before and after 65 when you can only buy one type of Medicare supplement with pre-existing conditions. Add a spouse, and you have twice as many dates to consider. Thus, if you retire at 62, claim a Social Security benefit, and use up your bank savings, thinking you’ll wait until 73 to start taking withdrawals from your 401(k) because of the RMD, your retirement savings may run out a decade or more sooner than if you plan retirement correctly. The RMD isn’t forcing you to spend money; it’s forcing you to pay taxes. So, if you don’t plan properly, you may pay more in lifetime taxes and be less protected against future inflation. If you want to do better and lower your risk of failure, you’ll have to do some work to figure this out (or pay someone to do it for you).
My biggest worry about those who enter retirement paralyzed is that, as time passes without addressing the paralysis, they lose options and face consequences that can’t be corrected. If you mess up Medicare initially, some situations result in lifetime penalties. Another example is taxes. Ask yourself: in the first year of retirement, how much will I need to pay in federal and state taxes, and when are they due? If you can’t answer, that’s paralysis. Of course, the subject of taxes will take you down a deep rabbit hole of examining sources of income, the Social Security benefit (which may or may not be taxed), converting some or all of retirement savings from tax-deferred to tax-free (a Roth conversion), and the tax impacts of interest, dividends, and capital gains.
To be clear, without a plan that examines the tax impact of your actions, you could end up paying decades of higher taxes than necessary. When you were working, there might have been little to consider regarding taxes. But in retirement, you should understand the tax implications of your decisions. For example, as I describe in Volume 3 of “What Would Dad Do?” there is such a thing as a “Zero Tax” retirement. It’s possible by carefully positioning and withdrawing from all accounts while taking advantage of tax thresholds and limits. The example in the book shows one person paying zero federal and state taxes and another paying the equivalent of $500 a month, which can eat up over $100,000 of your retirement savings. If you don’t understand how and why this happens, you’ll never know what can be fixed to make the outcome better.
As I mentioned, there are two ways to get out of “retirement paralysis.” Do it yourself or hire someone. You can use what I provide here at abetterfinancialjourney.com or the dozens of other books available on the subject. Many 401(k) and financial service providers offer online resources, and, of course, many will turn to web searches, which, in my opinion, yield mixed results. I say this because everyone’s situation is unique. I don’t think it's that hard to do it yourself, but you have to be comfortable working with spreadsheets, understanding concepts, and spending the time to learn. If not, your challenge is to find the right help: a one-time or every-few-years consultation with a fee-only financial planner, or signing up as a client to have someone do it and manage it for you. That route is expensive, because it's an annual fee you'll pay over decades. But the paid advisor approach can work for those who need it to avoid costly mistakes. The most important thing is not to let the paralysis go unaddressed.
As Benjamin Franklin once said, “If you fail to plan, you are planning to fail.” A retirement plan is not a published book. It is a work in progress. Make the best possible plan at the start, then revise and improve it over time. Of all the mistakes people make regarding retirement, the loss of time has the most consequences. So, if you’re on the cusp of retirement and experiencing paralysis, consider how much better you’ll feel after resolving it sooner rather than later.
*There is something called the “Rule of 55,” which allows you to take withdrawals from the 401(k) of your last employer starting at age 55 (separating from service on Jan 1 or later in the year you turn 55) without penalty. Some public safety employees qualify at age 50. If you roll prior 401(k)s into your last employer’s plan before separating from service, they qualify. Funds rolled over to an IRA do not qualify. Finally, the plan sponsor is not required to honor the Rule of 55. There is also the 72(t) rule that applies to retirement accounts. This more complex rule allows you to take “substantially equal periodic payments,” i.e., equal withdrawals from a retirement account over your life expectancy, treating them as income for at least 5 years before age 59½ to be exempt from the 10% penalty.
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