Morningstar.com
Top 10 Wealth-Management Pitfalls
Thursday January 25, 6:00 am ET
By Sue Stevens, CFA, CFP, CPA

You're smart. You're well-educated. You're doing well in life. Then why are you so worried about losing it all? Or worse yet, maybe you aren't worried and you should be.

Let's take a look at some of the biggest pitfalls on the road to wealth. If you're truly going to be successful, you'll need to navigate carefully through the many hazards along the way.

1. Leaving Assets Unprotected
It's not going to do you much good to build up your wealth if you let it slip through your fingers. Any number of catastrophes can occur along the way. Have you really protected yourself and your family?

Do you have adequate life insurance? If you died tomorrow, would your spouse or loved ones have money to pay some of their biggest expenses like college or paying off the mortgage balance? Would they be able to stay in your house and still be able to pay the bills? Life insurance can help protect the assets you've built up by sheltering them from estate tax and providing income replacement for your family. This is especially important when you have young children, a nonworking spouse, or a big mortgage. You'll want to consider these needs as you weigh the cost of life insurance.

Another potential wealth destroyer is the dizzying cost of medical care in your later years. Have you considered long-term care insurance? According to a study by the New England Journal of Medicine, 43% of people age 65 are expected to enter a nursing home at least once before they die. Many people are in denial about long-term care. If you don't have a relative or family friend who has gone through this process, you may not have given it much thought at all. For those of you who have experienced it first-hand, you know the physical, mental, and financial strain that aging relatives can bring to the whole family. Does everyone need long-term care? No. The very rich can self-insure, and the very poor won't be able to afford it. For everyone else, it's worth taking a look at these policies.

Finally, consider how you are protecting your personal property. Is your home protected from fire, weather disasters, and theft? How about acts of terrorism? Take a look at your homeowners insurance to be sure. You should also have adequate coverage on your auto insurance. If you or someone in your family had an accident, would your insurance company pay for the damage? What about lawsuits that could arise from an accident? Check to see what the underlying liability coverage is for both homeowners and auto insurance. Protect yourself from property lawsuits by purchasing an "umbrella" policy. These policies build on the underlying liability levels in your homeowners and auto policies and take your coverage up to the $1 million range. The more wealth you've accumulated, the more umbrella coverage you should carry.

2. Mismanaging Cash Flow
The most successful wealth managers know that they must be disciplined in their spending. It's so easy to let expenses creep up as you make more and more money. If you're not careful, those expenses can kill your chances of capitalizing on that wealth. The first rule of any good financial plan is to pay yourself first. Make sure you are putting away a healthy portion of your income and investing it. Don't trip over the pitfall of living beyond your means.

Another aspect of managing cash flow is minimizing taxes. As your return gets more and more complex, you need to find professional help to take advantage of every deduction you're entitled to. Your accountant can also help identify other opportunities like additional retirement funding vehicles, mortgage refinancing strategies, and/or estate planning techniques. At the very least, you should be discussing ways to use capital loss carryforwards (many of you will have these) to your advantage.

During your working years, it is critical that you carry disability insurance. Many of you can purchase this coverage through your employer. Take advantage of the opportunity to protect your income should something prevent you from working. It's far more probable that you'll have a disability claim than a life insurance claim, and yet many people ignore this important coverage.

3. Mismanaging Debt
A well-run company knows how to manage its debt. You need to think about debt management in your personal life, too. How much debt is too much? Look at your shorter-term debts first--things like credit card debt, car loans, bank loans (other than mortgages), and student loans. If your short-term loans add up to more than your liquid assets are worth, you probably have too much short-term debt. (Liquid assets include cash accounts, brokerage accounts, and cash surrender value of life insurance policies.) If you find yourself in this situation, you should (at the very least) examine the interest rates you are paying on each loan and try to consolidate your debt at a lower interest rate. Home equity lines of credit work well in many situations because not only are interest rates low, but the interest is tax deductible.

Mortgages can be a good way of managing debt because you get a tax break on the mortgage interest. But even with your mortgage you should exercise some caution. Taking on more debt makes it harder to adjust should you find your circumstances change (for instance, you lose your job). If at all possible, I'd try to keep mortgage debt below 75% of the value of the property. Just paying your mortgage every two weeks throughout the year helps to cut overall interest payments over the life of the loan.

4. Neglecting Your Finances
One of the biggest pitfalls I see in wealth management is just lack of attention. People are very busy. Sometimes personal finance takes a backseat to other more pressing matters. But if you take that approach, you may wind up feeling that the years have flown by and you haven't made much progress. Successful wealth creation takes a commitment of time.

5. Choosing the Wrong Investment Strategy
I've written entire articles about the pitfalls of investing. Even if you're able to generate a considerable amount of income, you have to know how to protect and preserve that capital.

One pitfall a lot of people have experienced in the past several years is misjudging your risk tolerance. When the market just keeps going up, it's easy to think you can handle the risk. But after seeing what happened in 2000-2002, many investors rethought how much risk (or loss) is acceptable to them. Even as the market sets new highs now, it's important not to forget the risk involved.

Another common mistake is not rebalancing periodically. Many people refuse to sell if they've lost money on an investment. If your mix of stocks, bonds, and cash (your asset allocation) makes you very uncomfortable, you need to think about taking some losses and moving to an asset allocation that is in line with your ability to handle risk.

If you do realize losses, you can try to make the best of it by being tax-savvy. No one likes to lose money, but those losses can be a benefit at tax time. You can use $3,000 a year to offset ordinary income. You can net out an unlimited amount of capital gains and losses against each other. Any losses you can't use right away can be carried forward indefinitely. This is just one of many techniques you can use to create a tax-efficient portfolio.

6. Mismanaging Windfalls
Sometimes life hands you a little something extra. Maybe it's stock options or an inheritance or some other once-in-a-lifetime event. Now that you've got that money, what do you intend to do with it?

Many of you will benefit from professional advice in these types of situations. There are almost always tricky tax implications. For stock options, you have to understand what type of tax you may trigger upon exercise or sale of your shares: ordinary income tax, capital gains tax, alternative minimum tax, or all of the above. Careful planning can help you keep more of your windfall.

Over the next 10 years, $10 trillion will pass from generation to generation. Most heirs have no idea how to integrate that wealth into their own portfolios. For more on that topic, read "Six Steps for Investing an Inheritance."

7. Failing to Maximize Retirement Plan Benefits
Sadly, the majority of participants in company retirement plans don't put away anything close to the maximum contribution. For 2007, you can contribute $15,500 ($20,500 if you are over age 50 and your plan allows it) to 401(k) plans, 403(b) plans, and 457 plans. If you have a Profit Sharing or SEP plan, you may be able to sock away as much as $44,000 a year.

If you are at the executive level of your business, in addition to the "qualified" types of plans discussed above, you may be able to take advantage of "nonqualified" plans. These plans allow you to put away money and defer paying tax on the income until a future date when you take withdrawals. These plans have fewer restrictions on how much and who can contribute than qualified plans do. The downside is that you cannot roll over these plans (in general) to an IRA. When you take distributions, they are immediately taxable. In addition, if your company goes bankrupt, your nonqualified assets are not protected. You'll stand in line with other creditors. Good planning can help you make the most of these opportunities.

Another potential retirement pitfall is making a mistake when rolling over your company retirement plan to a traditional IRA. It's important to understand the tax issues, cash flow considerations, and potential penalties. For more, read "Tips for Managing Rollover and Inherited IRAs." To better understand the "dos" and "don'ts" of pension planning, read "Set for Life Through Your Pension Plan?"

8. Drawing Down Assets in Retirement
One of the biggest fears retirees have right now is running out of money too soon. You need to spend time thinking carefully about what you'll have coming in during your retirement years as well as how much you expect to spend. You should probably seek professional help to quantify the probability of whether your assets will provide the type of retirement you've envisioned. For more ideas on drawing down assets in retirement, read "How to Tap Your Assets in Retirement."

Even with careful retirement planning, there's always going to be change. You'll need to revise your plan as time goes by. A healthy dose of common sense also goes a long way. In times when the economy is sluggish and the stock market is gloomy, you can at least control your own expenses. This can mean voluntarily tightening your belt by spending less as well as by choosing investments with low costs.

Once you reach age 70 1/2, you'll have to start taking withdrawals from traditional IRAs and most company plans. For more on how to calculate what to withdraw, read "How to Manage Retirement Portfolio Distributions." If you need a little help on structuring a portfolio in retirement, read "Model Portfolios for Retirees."

9. Failing to Plan Your Estate
The estate-planning arena is loaded with wealth-management pitfalls. Many of you may not have any plan in place at all. That's your biggest pitfall. The best way to care for your family if something happens to you is to put an estate plan in place. To find out more about what a surviving spouse will need to do, read "Prepare Your Spouse for Financial Independence" and "Financial Steps to Take When Someone Dies."

Other potential pitfalls include setting up a plan but forgetting to fund your trusts, and forgetting to change your beneficiary designations on life insurance, company benefits, IRAs, and other accounts. Another important part of your planning should include considerations for disability as well as death. Powers of attorney for health care and property can help if you are disabled. So can living trusts. For more on estate- and gift-tax issues, read "Top 10 Estate-Planning Mistakes."

10. Leaving Heirs Unprepared
One of the biggest concerns for families with significant wealth is how to teach their heirs how to responsibly manage the money they'll eventually inherit. You can set up children's trusts within your estate documents that stagger the ages for access to the money over time. For example, instead of giving the children all of their inheritance at age 25, when they may not be emotionally ready for it, you can give them part of it at age 25, another portion when they are 35, etc. If they "blow" the first installment, there is still a chance they can make the most of the remainder of the estate.

Having family meetings during your lifetime can also go a long way toward educating your loved ones on how to manage that wealth. It can also head off potential family squabbles over what your intentions are with respect to your assets.

A version of this article last appeared May 13, 2004.