Penalty Costs for the Investor Essay

For years, it’s been repeated for countless times that retirees can no longer rely on outdated rules for generating sufficient retirement income – such as the 4% withdrawal rule. Since they are living longer, it also means that finding a sustainable source of retirement income is now more crucial than ever. What’s worse is that financial advisers are can manipulate retirees into making financial moves that, in a matter of years, can deplete what took decades to build.

One of the most common careless mistakes retirees make is neglecting to thoroughly read and vet financial products to ensure they will not lose significant amounts in hidden fees. Financial advisers lure in their victims with promises of higher or guaranteed returns – or bonuses – which typically take years to obtain (a detail they may forget to highlight), and in return, retirees roll their money into costly investments. (Learn more by reading “What to Know Before Purchasing an Annuity Income Rider”)

For example, financial advisers like to suggest variable annuities for IRA rollover dollars or pension funds (which they will probably suggest you take out in a lump sum before investing). These insurance products let the investor pay into mutual fund sub-accounts, letting returns grow tax-deferred until withdrawal. However, they don’t emphasize the high fees associated with variable annuities, which are normally 2-3% or more of your assets to cover the costs of investment management or offer unnecessary guarantees.

What’s more, financial advisers might suggest cashing in one annuity and buying into another. While these turnovers can bring advisors 5% or more in commissions (with fixed indexed annuities it can be as high as 9%), that may mean penalty costs for the investor. These penalty costs come from the surrender charges associated with cashing out an annuity within the contract period – as low as 3 years but as high as 15 years. These penalties and fees can significantly erode a retiree’s retirement savings.

Many people are familiar with the “4% Rule” – the supposed “safe” withdrawal rate retirees were told to use and never run out of money. The problem with the rule is it was developed during the mid-1990s when bond interest rates were much higher and the stock market was historically higher. Since then, bond interest rates have been much lower and there have been some major fluctuations in the market since the turn of the century.

Depending on a retiree’s sequence of returns risk – a term used to analyze investment returns when paired with risk and periodic withdrawals – a retiree could end up more than 57% likely to run out of money utilizing the 4% rule. The first 5 years of retirement are the riskiest, which means that poor investment returns can put your retirement plan in danger. This rule could work if a retiree were wealthy or young enough to withstand the volatility of market fluctuations. But for the average retiree (who is now also living longer historically than previous retirees), time may not be on your side.

Certain annuities – such as fixed and fixed-indexed annuities – can be a way for individuals to protect a portion of their retirement savings without having your investment accounts exposed to complete risk. They are an alternate solution to other safe investments, such as CDs, money markets, savings accounts and even Treasury bills. However, if you are concerned about protecting retirement savings, make sure to stay away from variable annuities as they will expose you to risk. Fixed and fixed-indexed annuities are risk-adverse, variable annuities are risk-seeking. (Learn more by reading “Are Annuities a Solution for Baby Boomers in Retirement?”)

Retirees should be aware of how taxes can impact and drastically reduce their retirement savings. For example, a retiree couple that receives Social Security and a small pension is in a low enough income tax bracket that they potentially might be able to withdraw a portion of their IRA earnings or taxable accounts and possibly have no (or very minimal) overall taxation. Most of this is due to how Social Security income is taxed.

In 2019, if you’re single and your combined income was $25,000-$34,000, you’ll pay taxes on up to 50% of your Social Security benefit. If your combined income was more than $34,000, you’ll pay taxes on up to 85% of your Social Security benefit.

If you’re married filing jointly and your combined income was $32,000-$44,000, you’ll pay taxes on up to 50% of your Social Security benefits. If your combined income was more than $44,000, you’ll pay taxes on up to 85% of your Social Security benefits.

Now might be the time to act if you’ve been looking for a chance to convert your fully taxed IRA to a Roth potentially tax-free! Taxes are on sale, and the consequences might be minimal versus years ago, but probably more favorable than in the future, especially if tax rates increase. Keep in mind that Roth conversions can no longer be recharacterized – or undone – so make sure it’s the correct move.

The biggest mistake retirees can make when it comes to their IRAs is cashing them out completely. Based on advice from their financial advisers, retirees may choose this but it is not recommended. Not only can this generate severe penalties – such as an early distribution penalty of 10% if you’re under the age of 59 ½ – but you’ll also need to pay income taxes, and depending on your tax bracket, it can be a hefty sum. Instead, with careful preparation, there is a process to rollover the funds tax-free.

The ‘once-per-year’ (or once every 365 days) rollover that retirees can use means they can take possession of the funds in their personal account and make sure it’s redeposited in an IRA within sixty days. If you do not complete the move within 60-days, you’ll be subject to the same penalties as if it was cashed out (e.g. 10% penalty and income taxes).

Instead, use a direct transfer where the funds are sent directly to the new custodian (also known as a “direct trustee-to-trustee transfer”). It’s important to note that you can use the direct trustee-to-trustee transfer an unlimited amount of times in comparison to the 60-day rollover. Retirement can be filled with different traps and landmines, but you don’t have to end up in a disastrous situation as long as you’re aware of what’s ahead.