The IRA Mistake Almost All Retirees Make
This mistake is so common, I even see most professional investors make it.
In fact, every time I share this mistake when speaking in front of financial advisors, they all double take and can’t believe they’ve been advising their clients the wrong way for years (and I speak in front of thousands of financial advisors each year).
Yet, it’s super easy to avoid. Even easy to fix if you’re already making it.
What’s also really cool about this strategy is you don’t even have to change how you invest. No products to buy, commissions, or fees to pay.
So What is This Big IRA Mistake?
First, I should tell you it doesn’t apply to everyone. It applies specifically to investors that have both an IRA and investments in non-IRA accounts (any taxable investment account).
Second, while the mistake can be made by investors with all portfolio sizes, it is especially costly if you have a total portfolio over $500,000 or a fairly high-income tax rate. Everyone should pay attention to this strategy, but I’d say those with portfolios over $500,000 should pay special attention.
Lastly, even if this mistake doesn’t apply to you today, it very well could down the road. Once you hit age 70 1/2 and are forced to take Required Minimum Distributions, this mistake gets extra costly. So, it’s better to be prepared now even if you’re not yet to that age.
Ok, here’s the mistake:
“Blending” your investments in all of your accounts the same (or close to the same way).
Let me explain.
Many investors use some type of risk assessment to determine how much risk they are comfortable taking. A “risk score” so to speak. Based on this risk score you’re then recommended an Asset Allocation – a blend of growth and income investments.
Asset Allocation can be a smart way to help manage risk. But done incorrectly (like most people do it), can create a huge tax problem. Especially for investors that have both IRAs and non-IRA type investments.
“It’s Not What You Make, But What You Keep”
This is one of those cliche sayings that always sounds smart but is not always easy to benefit from. Except in the case of this big retirement account mistake. It’s actually the perfect saying.
Let me share a hypothetical example so you can see exactly how the math works…
Consider we have an investor named Barbara, who is age 70 and has $500,000 in her IRA and $500,000 in a taxable investment account (like an Individual Account, Jt Account, or Trust Account).
Barbara doesn’t want to take too much risk so she fills out an Asset Allocation questionnaire and it tells her to use a diversified 50/50 blend of stocks and bonds. She then implements this blend in both of her accounts.
Over the next 20 years, Barbara takes only her Required Distributions and lets the rest of her money compound.
Seems pretty normal, right?
What could possibly be wrong with this plan?
Would you believe the mistake Barbara just made could cost her over $366,000?
Sadly, it could.
A mistake almost everyone makes is almost unnoticeable, and even “professional financial advisors” often ignore… can cost investors hundreds of thousands (even millions for those with even larger accounts than this example).
So What The Heck Was The Mistake?
My writing style can sometimes be frustrating – sorry if you’re wondering when I’m going to get to the point. 😉
Here’s the mistake:
Barbara invested both her IRA and non-IRA’s the same way. She used the same 50/50 blend in each account.
The reason this is a mistake is that “growth” investments and “income” investments are taxed differently.
And, Required Minimum Distributions are based on a combination of the size of your IRA and your age. So the more you grow the IRA, the larger the Required Distribution, and the larger the tax on that distribution.
You see, income from things like IRA distributions, bonds, bond mutual funds, annuity earnings, short-term capital gains, and other types of investments are all taxed as “ordinary income”. Ordinary Income is the highest taxed income you can have.
Some investments can go up and unless you sell, have no tax at all. Others produce earnings that are taxed favorably and at a lesser rate than Ordinary Income.
There are some investments, for many people, that if managed correctly will produce no taxes for the investor during their entire lifetime and also be tax-free to the beneficiaries (and I’m not talking about life insurance).
Here’s the Math to Prove This Mistake Can Cost $366,000+
The easiest way to illustrate how this works is to show a simple example via video. So, here’s me walking through a little spreadsheet so you can see what I mean.
As you can see, just blending investments and paying taxes blindly can be pretty expensive!
Fortunately, it’s a pretty easy fix and usually doesn’t cost anything to get right. If you happen to have an advisor and they tell you otherwise – you may want to find a new advisor.
How to Fix This Mistake
If you have both an IRA and a non-IRA investment/savings account, you really should know:
- If you’re making this common IRA mistake
- How much it might be costing you
- How to fix it
If you love doing research and are really handy with Microsoft Excel, you could likely do most the math that way.
If you’re not a math geek like me (lol), then feel free to take advantage of my team of fellow math geeks as we’re happy to crunch the numbers for you at no cost or obligation. It might sound odd, but this is not a complicated thing for my team to calculate so we’re happy to do it for people so long as we have the time for it.
All you need to do is use our secure “Ask the Experts” form and we’ll usually get back to you via email within 48 hours. If we’re super busy and it will be longer than that, we’ll be sure to let you know that too so you’re not left hanging.
The key is to make sure the closer you are to age 70 (or if you’re already 70+) to make sure your more conservative investments are in your IRA and your more aggressive are in your non-IRAs.
There is more to it than just that, but in a nutshell, if you have the same or similar blend in IRAs and non-IRAs – it’s probably going to cost you quite a bit.
I would not suggest you go at diagnosing or fixing this mistake alone. Get some help from someone who really knows what they are doing. A good CPA (but not all CPAs) or a property trained financial advisor could be a good start.
If you need a referral for either, we may know someone in your area, so feel welcome to use the form on our Ask the Expert page if you’d like to find out.
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Thank you for the opportunity to share with you a little of my financial geekery.
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Jason Wenk is recognized as one of the world’s leading retirement investment professionals. He is the founder, CEO, and Chief Investment Strategist of FormulaFolio Investments where he oversees the management of over $2.3 billion. FormulaFolios was recently ranked as the #10 fastest-growing private company in the country by Inc. 500.