Pitfalls and Retirement Traps
You can retire many times if you understand the false dichotomy of retirement, but most of us want to get it right the first time.
Here is a list of some retirement pitfalls and traps you should know about.
Retire To Something
Everyone needs to consider what they plan to do in retirement. Many doctors find more than a mere calling in medicine. Letting go of the title of “Doctor” is difficult. However, finding purpose in retirement is necessary to ensure health and sanity.
The busy clinician may never retire because they get meaning and fulfillment from work. The idea is to retire after you think you should and before your colleagues think you should. On the other hand, if you find something you are more passionate about and can pay the retirement bills, retire to something. Physicians can retire early.
Many doctors will face liquidity events.
From poor distribution options on Non-Governmental 457 plans to liquidating investments in practices, equipment, or real estate, you might have to face a taxable lump-sum early on in retirement.
A liquidity event happens when you must recognize a bolus of ordinary or capital gain income in one year. Of course, ideally, you could take a better distribution option on your 457 or spread out your payout for your share of the practice or investment over two or more tax years. Some planning is possible if you are forced to “suffer” a liquidity event. Tax planning is essential that year, perhaps to reduce your other sources of income or find a way to take a significant tax deduction in the same year.
Large Pre-Tax Accounts
This may be the largest pitfall I see in physician retirement.
Many doctors have large 401k or 403b accounts and face huge future tax burdens as Required Minimum Distributions force out this deferred income. These 401k Millionaires can do some tax planning during the Tax Planning Window, which may include partial Roth conversions. Then, after you retire and before you start social security and RMDs, you have the chance to control your income. This Tax Planning Window is the most significant opportunity to own your future tax liability and should not be squandered.
Large pre-tax accounts mean that you have a lot of tax planning to do; otherwise, you might fall into the trap of paying more for liberating the money than you did to defer it in the first place!
Other Tax Considerations
It pays to be tax efficient. After all, every dollar you save is another dollar you can send or give to heirs or charity. Aside from partial Roth conversions, there are other tax-efficient withdrawal strategies. These include:
- minimizing your taxable brokerage account (yet maintaining liquidity)
- use lower tax brackets to recognize pre-tax income
- order of withdrawal from various accounts
- capital gain harvesting in the 0% cap gains tax bracket
- avoiding Medicare Surcharges (IRMAA- a Cliff Tax on the Rich)
- maximizing charitable planning
Since the Tax Cut and Jobs Act, most have used the standard deduction and no longer get tax deductions for charitable gifts. Not that a tax deduction is the only reason to give, but if you can find a way to give tax-efficiently, you can give more! If you have charitable intent, there are many considerations. These include:
- Bunching gifts on alternative years
- Donor-Advised Funds
- QCDs after age 70 ½
- Charitable Remainder Trusts for income during your life or as a Stretch IRA alternative for your heirs
Leaving a legacy is important as many doctors will have more money than time. The loss of the Stretch IRA has engendered some new retirement planning strategies. Unfortunately, none are as good as the Stretch IRA. Read about the 10-year rule and your retirement accounts.
Cascading beneficiaries, disclaimer planning, multi-generation spray trusts, Roth conversions, Life Insurance, and Charitable Remainder Trusts are all considerations when planning your legacy.
Long-Term Care Insurance
Since we have all seen the ravages of age, Long-Term Care Insurance is a difficulty in the back of our minds. While many retired doctors can self-fund long-term care needs, there is a shortage of insurance options if you want to transfer the risk of a sizeable Long-Term Care event.
Traditional Long-Term Care Insurance suffers from issues of premium increases and future solvency. So-called hybrid LTC/Life Insurance policies are becoming more popular but have copious downsides.
If you have a lot of pre-tax money, then often you are better off NOT TO USE a hybrid policy.
This is because medical expenses are a tax deduction above an AGI floor. You can withdraw pre-tax money tax-free if you have a significant enough deductible Long-Term Care event. So, if your goal is leaving money behind for your heirs, take pre-tax money tax-free to pay for healthcare costs and let the tax-free death benefit of the policy go to your heirs. Or don’t get a hybrid policy in the first place!
Long Term Care considerations are the most intractable problem in retirement planning today. They can have truly devastating costs, but insurance is priced to cover non-devastating events. Imagine how expensive home insurance would be if we all had small or moderate fires in our houses, at least at some point in our lives! Insurance is best saved for risk pooling of catastrophic events, which is not how Long-Term Care insurance operates currently.
Social Security maximization should be something that all doctors are familiar with. If you have done well and have a reasonable life span, consider delaying social security to take advantage of delayed retirement credits. Perhaps, social security is the best longevity insurance out there, with inflation adjustment and a government-backed guarantee.
Most doctors should assume that 85% of their social security will be included with their taxable income, as the brackets for taxation of social security are absurdly low and haven’t been inflation-adjusted since Regan.
Unwinding from a Bad Financial Advice
This is another massive retirement pitfall.
Many doctors have been suckered into bad investments or products by “financial advisors.” Unwinding these takes care, consideration, and patience. If you have an insurance salesman masquerading as a financial advisor, you might own expensive annuities or unnecessary permanent life insurance products. Unwinding these might involve liquidation and some “stupid tax.” There are other important considerations, though. If you need income in retirement from annuities, you may consider annuitizing the policy or using the Income Rider you have been paying for all these years. Or, you could 1035 into an Investment Only Variable Annuity depending on the goal of the funds.
With Whole Life Insurance, you may consider a 1035 into a hybrid LTC policy if you want long-term care insurance. Understand the indication for owning a Permanent Life Insurance policy. Believe me when I tell you most people close to retirement are very happy about their whole life policy (though you will not be happy the first 10 years or so you own one).
If your financial advisor is a stock picker, then you might have individual stocks or crazy expensive mutual funds with a low basis. Unloading these will involve paying capital gains taxes. Many doctors will remain in the 18.8% capital gain tax bracket on future projections, so a decision must be made regarding the purpose of the money. I
f you plan to unwind it at some point due to the tax inefficiencies of the funds, earlier is better as it allows you to reset your basis and choose funds more in line with your goals and chosen asset allocation. These low-basis bad investments are perfect for giving away if you have a donor-advised fund or bunch deductions.
Summary- Pitfalls and Retirement Traps
Retirement Planning seems backward after being in the accumulation mindset. Instead of growing your wealth, you need to consider spending some of it down!
Additional pitfalls and retirement traps uniquely affect doctors and other high-income professionals. A forward-facing 20-30-year tax plan is often helpful to see what your tax bracket “number” will be. This will allow tax bracket arbitrage, which has been called the most important concept in retirement planning.
For instance, if you know that RMDs will expose much of your retirement income to the 25% federal tax bracket in the future, use all your tax brackets below the 24% bracket now! A percent or two doesn’t seem like it would make much difference, but if you can rescue money from a pre-tax account and convert it into a Roth, all future growth is tax-free.
The goal, of course, is not to perfectly predict how much you will be paying in taxes even five or ten years from now. Many assumptions will be wrong. The goal, instead, is to optimize the next 1-3 years so you set yourself up in the best possible position to roll with the punches as they come, all while efficiently funding retirement.
Above you can find some retirement pitfalls that are useful to understand.