In the News
Posted On: 12/6/2012
Back to News
Retirement Rules You Can Break Without Sabotaging Your Retirement
By Nancy Anderson, Contributor to Financial Finesse
Sometimes it works to break the rules and do the “wrong thing.” It’s not that rules are necessarily bad or simply meant to be broken; it’s more that they don’t apply in all situations. Financial strategies aren’t “one size fits all.” It certainly makes sense to pay yourself first and to capture the company matching funds in your 401(k), but there are some retirement rules that can be broken without sabotaging your retirement.
Here are a few:
Fund your children’s college only after funding your own retirement. Many financial planners will tell you, “there are no grants, loans, or scholarships for retirement so fund your children’s college only after you are on track for retirement.” The sad reality is that since 1985 college tuition and fees have nearly sextupled. It would be pretty tough to tell your daughter that you can’t help her anymore so she’ll need to drop out after her freshman year in college. The reality is parents end up sacrificing to help their children.
Earlier this year, student loan debt hit the $1 trillion mark and a big chunk of that debt belongs to baby boomer parents who either took out loans or co-signed them with their children. One of those people is a friend of mine in her early 50’s who co-signed with her daughter on a large portion of her $80,000 total student loan debt. Co-signing loans this close to retirement age put my friend in jeopardy because mother and daughter are now intertwined credit wise for ten years or more. This means my friend might not be able to move and buy a retirement home. She might end up having to pay the loans back anyway – with interest — if her daughter can’t make the payments.
Instead of taking the chance to ruin two people’s credit, there may be better alternatives for both parent and student. A parent might actually be better off to pay more out of pocket now and avoid loans altogether. Students shouldn’t take this for granted and need to consider working part time or taking as many classes as possible at a less expensive community college to lower the cost.
Paying off your mortgage before you retire: Paying off your mortgage seems like a great idea in retirement since your expenses are drastically reduced but the problem is so are your tax
deductions. Without the home mortgage deduction to boost up the deduction on Schedule A, many people can’t write off their charitable gifts, state and local income taxes, property taxes, etc. and have to simply go with the standard deduction. Filing the long form may be one of the only tax planning tools a retiree has.
Paying off high interest rate debt first: Paying extra on the debt with the highest interest rate is the fastest way to pay down debt – at least mathematically. When you add in human nature, it doesn’t always work that way. The strategy we call the Debt Blaster calls for paying the minimum on all of your debts while directing extra payments to the debt with the highest interest rate. Once that first debt is paid, take the payment you were making – the whole thing—and add it to the debt with the next highest rate until it is paid off and so on.
This strategy works well for many people but not for all. If the outstanding balance on the debt with the highest rate is much higher than the others, you are stuck with a handful of cards that don’t get paid down for years and frankly it can be discouraging. Watching the debt reduce is like watching grass grow or paint dry. Some people work better with some momentum, by knocking off a smaller debt first and then they can be done with it and move on to the next challenge.
For example, if you had $15,800 in total debts with a 19% rate on $15k and a 12% rate on $800, it would take you 6 years and 3 months to pay it all off if you paid an extra $100 per month over and above the minimum payment. But the smaller $800 credit card would get no attention for six long years, all that while being a temptation to the cardholder who is desperately trying to get out of debt. Why not take 8 months and pay that one off first? It’s not the most efficient way. In fact, it would take you two months longer and you would pay about $500 more over six years to get out of debt but on the other hand, you might have a better chance of sticking to your plan this way. You’d only have one card to pay and you wouldn’t be tempting fate.
Taking a loan from your retirement plan: There are definite reasons to avoid taking a loan from your retirement plan; the loan is secured by your 401(k) so if you lose your job and can’t pay it off, it’s taxable and if you are under 59 ½, you face an additional 10% federal tax penalty for early withdrawal (as well as possibly a state tax penalty). If you run into financial trouble, this is a debt where you can’t negotiate a settlement. In severe financial hardship, you can’t even write the loan off in bankruptcy court. You may get a lower interest rate now but you are essentially stuck with the loan once you have it. But there are instances when a loan on your 401(k) makes sense.
One is when you want to consolidate debt into one payment and not add to your overall loan balance. Maybe the debt was due to a divorce or other unforeseen circumstance and not due to overspending. A retirement plan loan could help you get out of debt faster though due to the lower interest rate, especially if you make the same payment. Another rule breaker would be if you want to refinance your home at these incredibly low interest rates and you are slightly under the 80% loan to value ratio. With a long-term mortgage payment reduction due to extraordinarily low rates, a short-term loan on a 401(k) may be a way to make that happen.
Replacing 80% of your gross income in retirement: If your major expenses in retirement are covered such as your mortgage (unless you are strategically keeping your mortgage for a write off)and you have long term care insurance and retiree medical from your company to cover the increased health care costs, you may not need 80% of your gross income in retirement. You may need to replace a much lower percentage of your income. The 80% rule is based on the assumption that you want to replace close to your current income in retirement. With 401(k) contributions and payroll taxes cutting into your take home pay, 80% of your gross is about what you might be taking home now. However, if your major expenses are covered and you have a plan in case health care costs rise, you may actually require much less.
Waiting as long as possible to take Social Security income: Experts will explain that once you reach your normal Social Security age, for each year you wait to receive your benefit, you receive around 8% more per year so it is better to delay your Social Security benefit (if you don’t need it of course). The argument is that if you wait to take your Social Security benefit at age 70 instead of at age 66, you’ll have a 32% higher benefit (8% higher each year) and will break even between age 80 and 81. The problem of course is that if you pass away earlier than expected, you never did break even but there is another “bird in the hand” factor that many people don’t think about. If you take the benefit at age 66, you can reinvest those funds and add a beneficiary so when you pass away they go to a loved one instead of to no one. Granted, it’s not easy to get 8% interest especially since most people tend to be more risk averse as they get older. Still, it’s not impossible to get 8% in a balanced mutual fund or a low volatility dividend focused ETF. Some people may want to take their Social Security benefit earlier than later either to enjoy now or to reinvest and enjoy later.
Some retirement planning rules aren’t meant to be broken such as contributing the maximum to your retirement account, capturing the maximum matching contribution from your employer, and investing your funds to gain the maximum return for your risk tolerance. On the other hand, if some have to be broken to help a current college student or to pay off debt in a way that might work a little bit better for you, do it in a way that minimizes any damage and move forward.
Nancy L. Anderson, CFP is the Think Tank Director and Resident Financial Planner at Financial Finesse, the leading provider of unbiased financial education for
employers nationwide, delivered by on-staff CERTIFIED FINANCIAL PLANNER™ professionals.
For additional financial tips and insights, follow Financial Finesse on Twitter and become a fan on
This article is provided courtesy of Forbes.com. For more articles like this one on personal finance and
investing, visit their web site at Forbes.com.