Half of Americans aren’t saving a dime.

Why? There are a lot of reasons, but one big one, according to the study’s findings, is that people don’t know how retirement plans work. Another is the perception is that people can’t afford retirement savings. Still others include some of the statements I see in reader emails, often repeated.

Here are five simple facts about retirement savings. Each one of these hammers down on a myth I often hear about retirement savings.

Retirement savings plans are not scams.
A retirement plan is just an investment account with a few extra rules attached to it, most of which benefit a person who is saving for retirement. That’s it.

An investment account is like a bank account, except that instead of having an account at your local bank, you have it with an investment firm. Just like a bank account, you deposit money. Just like a bank account, you can withdraw money from it. The only difference is rather than a bank just holding onto your money, an investment house will use it to buy investments at your discretion – stocks, bonds, and so forth.

It’s not a scam. It’s not something to be afraid of.

You will survive just fine with a slightly smaller paycheck.
Many people are absolutely afraid of the idea of seeing their check get any smaller. They’re barely making ends meet as it is – how can they possibly live with a smaller check?

Here’s the truth: most of us spend just a little more freely if we have ample cash in our checking account. It’s a lot easier to buy a bottle of soda at the gas station if you have plenty in checking. It’s a lot easier just to roll through Starbucks when it’s not going to grind you down to nothing.

Yet, when we look at our account and see it’s about empty, we’ll skip those treats with no hard feelings. They’ll come around again.

For an awful lot of people, all retirement savings does is spread out those treats a little bit. If you put, say, 10% of your income into your 401(k), you’re usually only dropping your paycheck by 7% or so. Even if you just save 5%, you’re only actually cutting your paycheck by 3%. That’s $3 out of every $100. For most paychecks, that’s a stop at the coffee shop – and that’s about it.

You won’t even miss it. It seems like a big deal, but when it comes down to the reality of your paycheck, it really fades into the woodwork quite seamlessly.

Virtually any investment option is better than not investing at all for retirement.
Some people get locked down because of the investment choices. They’re worried about not picking the right one and get so tied up in that choice that they simply avoid ever signing up.

Here’s the truth: you’re better off closing your eyes and pointing at one at random on the page than you are skipping even a week or two of retirement savings.

Yes, you might not pick the “best” one. Guess what? If you simply take the recommended option, you’re probably going to get pretty close to the best results.

What if I change my mind later? The money is in a retirement account. You can change your investments around without worry or taxes.

The sign-up process is very simple and someone will walk you through every step.
If you’re intimidated by the applications, don’t be. Just ask for some help at the human resources office.

Most businesses have someone on hand who can help you go through the paperwork. Most of the paperwork amounts to personal information. Beyond that, you mostly just have to say how much you’re wanting to save each month and, beyond that, you just choose what you want to invest it in.

The information you need to give is really straightforward. If you are unsure about the investment choices, as suggested above, just pick the default one. You can change it later if you decide something else will work better.

Not saving for retirement has some seriously negative downsides.
If you choose to save nothing for retirement, the only income you’ll have when you reach your late sixties and seventies is Social Security. Unless you live extremely lean, Social Security won’t cut it for an enjoyable lifestyle. Another aspect of reaching retirement age is the increased expense of medical bills. Retirees without any savings generally rely on basic Medicare for medical expenses, but what about the costs of long-term care?

By not signing up, you’re choosing to add a lot of misery to your later years just so you can have a few minor creature comforts now. It’s a pretty poor long-term tradeoff.

In the end, there’s no excuse not to be saving for retirement. You can afford it and you don’t need to have a lot of knowledge to get started. The downsides to not doing it are tremendous.

If you haven’t signed up for a retirement plan at work, you owe it to yourself to do it right now. If your work doesn’t offer one, ask your friends for a recommendation about starting a Roth IRA – and do it right now. You won’t regret it.

The post Five Very Simple Truths About Saving for Retirement appeared first on The Simple Dollar.

“The economy, as measured by gross domestic product, can be expected to grow at an annual rate of about 3 percent over the long term, and inflation of 2 percent would push nominal GDP growth to 5 percent, Buffett said. Stocks will probably rise at about that rate and dividend payments will boost total returns to 6 percent to 7 percent, he said.”

Let’s assume that Buffett is exactly right with his predictions. What does that mean for retirement savings?

First, we have to make a few assumptions. Let’s assume that you’re going to want to be able to withdraw 60% of your salary each year for 25 years out of your retirement savings when you retire, so we’ll use that as a target amount.

We’ll also assume, for convenience, that you’re going to be invested entirely in a broad-based index fund until the day you retire and then you’ll switch everything to more secure investments that will just match inflation.

We’re also going to assume that the return Buffett describes is steady. The stock market is volatile year over year, but over a very long term, it’s not that terrible. I’m also going to assume that you get half of the return during the year you invest it because it’s so steady (since most people contribute throughout the year, not in one lump sum at the end).

We’ll also rip inflation out of the question. Buffett states that a stock market investment will earn about 3% per year outside of inflation plus an additional 1.5% in dividends, so let’s use that. We’ll ignore inflation and assume that the stock market will rise faster if inflation goes up to match it, as Buffett predicts.

So, what we’re left with is that every dollar we put into retirement is going to earn a 4.5% annual return beyond inflation in the stock market – the 3% growth plus 1.5% dividends that Buffett predicts. However, we don’t have to worry about inflation at all – we’re just going to try to match our current salary in retirement.

Let’s say Bob is making $50,000 a year. In order to be able to pull out 60% of that per year for 25 years, Bob will need to have $750,000 in retirement savings. What will Bob have to save each year to make his dream of retiring at age 65 with long-term security come true?

What if Bob is 50? That means he has fifteen years to reach that $750,000 target. To reach that target in that timeframe, Bob would have to sock away $33,000 per year. This would give him $766,607.22 over the course of those fifteen years. Bob would have to put away almost all of his take-home pay into retirement to make that goal, so that’s probably unrealistic.

Let’s back off a bit and say that Bob is 40. That means he has twenty five years to reach that $750,000 target. To reach his target in that timeframe, Bob needs to save $15,500 per year, or about 30% of his annual salary, to make that target. This would give him $753,935.25 after those twenty five years.

What if Bob is 35? To reach that target, Bob needs to save $11,300 per year, giving him $748,165.28 after those thirty years.

What if Bob is 30? To reach the big $750,000 target, Bob merely needs to save $8,500 per year, giving him $748,872.57 at retirement.

Even at age 25, the savings are intense. To reach that target at retirement, Bob needs to sock away $6,500 per year, giving him $750,007.30 at retirement. That’s still 13% of Bob’s salary.

In other words, if you believe in Buffett’s numbers instead some of the more rosy projections, you should be saving as much as possible for retirement.

Why such a different picture than the 10% or 15% suggestions that investment managers often give? Those managers are using overoptimistic approaches, as noted in that article:

“The Standard & Poor’s 500 Index, a benchmark for U.S. stocks, surged 18 percent a year on average from 1982 to 1999. The bull market tainted investor expectations, Buffett said. Polls in the late 1990s showed some investors expected stocks to gain 14 percent to 15 percent a year, he said.

“‘Thinking that in a low-inflation environment is dreaming,’ he said.”

Retirement advice that indicates that you’ll be fine by just saving 10% of your income starting at age 40 is using unrealistic assumptions, at least from Buffett’s perspective.

Save plenty for retirement, and start saving now.

The post Applying Warren Buffett’s 7% Figure to Your Retirement appeared first on The Simple Dollar.

Everything you need to know about financial planning

Make a will.
Pay off your credit cards.
Get term life insurance if you have a family to support.
Fund your 401(k) to the maximum.
Fund your IRA to the maximum.
Buy a house if you want to live in a house and you can afford it.
Put six months’ expenses in a money market fund.
Take whatever money is left over and invest 70% in a stock index fund and 30% in a bond fund through any discount broker and never touch it until retirement.

If any of this confuses you, or you have something special going on (retirement, college planning, tax issues) hire a fee-based financial planner, not one who charges a percentage of your portfolio.

I largely agree with the ideas presented here and I think that, if your primary goal is to save for early retirement above all else, this is a great plan.

I have just a few small problems with this plan.

First of all, there’s no encouragement to cut out unnecessary expenses. The broad stroke of “take whatever money is left over and invest it” doesn’t point people toward one of the most powerful tools there is for improving their financial state – taking a serious look at their life and cutting back where it makes sense.

It is very easy for anyone to slip into a routine of spending money without any real benefit. We’ll start a Netflix subscription, for example, and keep paying for it even though we rarely use it. Taking a regular hard look at one’s expenses can provide quite a lot of money for investment.

Second, the money market fund idea isn’t a good idea for most people right now. At this point in time, having money in a money market fund is like having money in a savings account that returns only a tiny fraction of a percent and isn’t FDIC insured. There are times when a money market fund is a decent place to store your cash. Right now isn’t one of those times. Use a savings account.

Finally, it doesn’t look at non-retirement goals. Like I said earlier, this is a great plan if you’re saving for early retirement. If you’re not saving for early retirement, you’re going to want to take a different approach to the “money left over” investment and you might not necessarily want to be maxing both your 401(k) and your Roth IRA.

If you have non-retirement goals, I’d say it’s a good goal to be saving 10% of your income for retirement and throw everything else you can toward that non-retirement goal. If that goal is farther off than eight or ten years, then you might want to follow the investment advice above. Otherwise, you’ll probably want to be more conservative than that because stock market volatility makes stock investments much less of a sure thing over a term shorter than eight years. The stock market has leaped and fallen and leaped again like a hyperactive gymnast over the last eight years and over some shorter periods it has seen some devastating losses.

Aside from those quibbles, if you’re looking for a very straightforward plan for financial success, this is a pretty sensible one.

The post Is This Everything You Need To Know About Financial Planning? appeared first on The Simple Dollar.

The only way this even looks like a good idea at all is if you’re looking only at the very, very short term. If you look beyond that, making this move is pretty clearly worse than using a high-interest credit card to pay your bills. In fact, if we’re comparing disastrously bad financial moves, I’d actually prefer to use a credit card cash advance to pay a bill than pull money out of my 401(k) early.

Why is it so bad to tap into your 401(k) early? Let’s use this 401(k) early withdrawal calculator to see how big the disaster is.

Let’s make a few reasonable assumptions first.

First of all, let’s say we want to take $20,000 out of our 401(k). We’re in the 33% federal income tax bracket, and we pay 5% in state income taxes. We’re 45 years old and don’t plan on retiring for 20 years at least. If we left our money in there, we’d get an average of a 7% return each year until retirement – the long term return that Warren Buffett suggests people will get from the broad stock market.

On that $20,000, you’ll have to pay a $2,000 early withdrawal penalty, $6,600 in federal taxes, and an additional $1,000 in state taxes. Thus, out of the $20,000, you’ll only keep $10,400 of it. Between federal and state taxes, you’re going to lose just about half of your money instantly. Poof.

Let’s say that instead you left it there where it earns a 7% annual return. In twenty years, your investment will be worth $77,394. That’s the start of a pretty nice nest egg, one that will probably give you $3,000 or so a year take-home all throughout retirement.

So, just to get $10,400 now, you’re sacrificing $3,000 a year for years and years and years when you retire. That is an incredibly bad trade.

Then there’s the flip side of that coin.

Let’s assume the average person pulling money out of their 401(k) is making $50,000 a year. That’s a little higher than the average American salary, but many of the low-end salaries don’t have a 401(k) involved, so we’ll assume a bit higher average income.

If that person can find a way to come up with just 20% of their annual income to fix their financial situation, they don’t have to pillage their retirement.

Clean out your closet and sell the junk you don’t use. Write a grocery list when you go to the grocery store and stick to it. Even better, don’t go to the grocery store on an empty stomach. Have some friends over to your house instead of going out. Stop using your credit card for purchases and live off of cash so that you’re paying less credit card interest every month. Call up your creditors and negotiate a lower interest rate or a payment plan.

If you’ve been reading The Simple Dollar for long at all, you get the idea. Here’s a hundred more.

Fixing a short term problem by pillaging your long term savings is never a good idea. If you’re eyeing your retirement savings in order to keep your head above water or to enjoy some life “treat,” turn your eyes instead to the multitude of tools you already have in your life for coming up with some quick cash or trimming back your spending for a while.

The post More Than 25 Percent of Americans Are Making a Huge Financial Mistake appeared first on The Simple Dollar.

My problem is that I can’t stop looking at my retirement accounts. Whenever I see an investment option that’s doing a little bit better than whatever I’m doing, I start to feel sick to my stomach and I panic and I have to switch my investments over. Then a week later I see something else that’s doing a little bit better.

There’s no tax implications for this because it’s all inside my retirement account. Still, I feel like I’m obsessing and not really gaining anything.

Your suspicion is right. With all of this switching around, you’re probably not gaining much at all and you’re likely losing compared to just sticking with a small portfolio of investments.

Here’s what I would suggest doing. Go back and see how much you earned in returns in 2012. Ideally, your investment house will help you with this kind of calculation. Then, compare that percentage return to what you would have earned just sitting in some of the investment options.

What you’ll probably find is that your annual return is pretty close to the returns on a lot of those investments. In fact, I’d bet that your returns are actually lower than most of them.

Why do I think that? The biggest reason is that when you jump from investment to investment chasing the latest bump, you’re likely “buying high,” which means that the investment isn’t going to see the same short-term returns that the investment saw over the earlier period. Also, there might be delays as well as fees in the transactions, which means that there are periods where your money’s not invested at all between the transactions and that some of the money might be swallowed up in the transaction. Many funds require you to hold your purchases for a short period or face fees.

My best advice to you is to stop looking at your retirement accounts. Delete the bookmark from your web browser and clear out your browser’s history. Limit yourself to one peek per quarter and only one change per year.

If you’re ever tempted to look, show yourself those numbers. They’re proof that obsessing over your retirement accounts is directly costing you money.

Before you do that, though, think about and settle on some sort of long-term portfolio. One good suggestion is this “bucket” portfolio that divides up one’s retirement savings into a variety of investments, each with a different risk level. This diversifies the retirement portfolio while spreading out the risk.

Once you’ve figured out the exact portfolio you want – a set of investments that’s diversified, in other words – go into your retirement account and transfer all of your holdings to match that portfolio.

Let’s say you have $200,000 in retirement and you’ve decided to put 15% in investment A, 20@ in investment B, 30% in investment C, and 35% in investment D. You’d fire up your retirement account, put $30,000 in investment A, $40,000 in investment B, $60,000 in investment C, and $70,000 in investment D.

After you do that, close your browser window and don’t look at it for a while. If you’re tempted, look at your 2012 returns and remember that tinkering costs you money, and looking makes it tempting to tinker.

Your contributions should be split up among the investments to match the various percentages you have.

Now, check it at the one year mark and rebalance it. Move the amounts around in such a way that the money is back at the percentages you want. That’s because some investments will gain more than others – but you can’t predict which ones will be the ones that gained the most.

That’s really all you need to do with your retirement accounts, and you’ll likely experience more stable returns this way. Just do this, delete your bookmark and retirement history, and keep the evidence that your activity was costing you nearby. You’ll be glad you did.

The post Retirement Investment Obsession appeared first on The Simple Dollar.

I’ve been contributing 10% to my 401(k) since the day I started my job fourteen years ago, and my employer kicks in 6%. I’m now 36 and I have about $200,000 in there.

I should be happy about that. I’m not. Whenever I look at that money, I just see tons of opportunity lost. I’m still struggling with my student loans and I live in a crummy apartment. $200,000 changes all that.

I can understand that feeling, but I think you’re misrepresenting what’s actually in your retirement account. So, let’s start off by breaking it down and looking what you would actually have in your pocket if you hadn’t contributed all the way along.

First of all, 37.5% of the contributions to the account were bonuses from your employer. So, right there, we can whack away $75,000 of the total. $125,000 of that amount was due to your contributions.

Also, that amount has been growing steadily over the last twelve years. Assuming you contributed the same amount each year and the amount has grown an average of 7% a year, that means your actual contributions were about $5,200 per year. My guess is you’re contributing $100 a week based on the numbers you gave me.

Okay, let’s also assume that you would be paying 30% income taxes on that money. Your $100 extra in take-home each week falls to $70.

Do you want to know how much that $200,000 in retirement savings actually cost you in take-home pay? Only $50,960. You would have brought that amount home at a rate of roughly $70 a week.

Now, let’s say you were bringing home an extra $70 a week all that time. It would be easy to say that you would have used it to pay down debts, but is that the honest truth? If your paycheck were bumped $70 a week, would you live the exact same lifestyle you have right now and always use all of that $70 to pay down debts and save for a down payment?

Very few people would honestly be able to say that.

To put it simply, your overall financial life might have been a bit better had you not invested in retirement, but it wouldn’t have been significantly better. You’d likely still have that apartment and you’d likely still have some student loan debt.

Now, look at it this way: instead of whatever you would have spent that $70 each week on, you now have $200,000 in the bank for retirement at age 36. Assuming that it continues a steady rate of 7% growth, even if you never contribute another dime to that account, it will have a value of more than a million dollars on your 60th birthday.

If you were to give me a choice of a slightly better day-to-day financial situation with $0 in retirement versus a slightly worse day-to-day situation with a retirement account that’s going to be worth $1 million at age 60, guess which one I would choose?

Because of the choice you made to save for retirement, Charlene, you’re most likely going to be able to just retire without a bit of worry when you hit your sixties. Your exact retirement date depends on how large you want to live in retirement.

If you hadn’t done that, you would have been working until you were pushed out, then you would have lived hand-to-mouth waiting for the next Social Security check.

Giving up $70 a week now has basically transformed the last years of your life from a challenging and potentially miserable experience into a wonderful one.

Here’s the reality. The money you put away for retirement is money you’ll barely miss. It’s money that, for the most part, you would have spent on things you didn’t really need anyway. By putting it into a 401(k), you’re not paying taxes on it, you’re getting free money from your employer that you would not have otherwise received, and it’s going to grow by leaps and bounds toward retirement.

You might wistfully think about some of the things you might have done with that retirement money if you hadn’t saved it, but in the long run, you will never regret a dime that you put in there. It’s peace of mind right now and it’s a much better life later on.

The post The Retirement Blues appeared first on The Simple Dollar.

I’m a 28 year old single mom. I just got a great job as an administrative assistant, one that I was extremely lucky to get. During orientation we were asked to sign up for the 401(k) plan. I don’t know anything at all about 401(k) plans, but I have enjoyed your site for a long time and I love the way you make money issues seem easy. Could you explain what I need to know about 401(k) plans in the simplest terms possible?

I’ll do my best.

What is a 401(k) plan? A 401(k) plan is just a very simple way for people to save for their retirement. Almost all of the time, a 401(k) plan is offered by a company to their employees, which is why you were encouraged to sign up for it during your employee orientation.

After you sign up, you’ll agree to put aside some percentage of your paycheck for this plan. Think of it as being a special kind of savings account, and the money you set aside goes into that account.

So, let’s say you’re going to make $26,000 a year, and you get paid every two weeks. That means your gross pay – the amount you’re going to make before taxes are taken out – would be $1,000 per paycheck.

The percentage that you agree to take out of your check comes out of that gross amount. So, if you’re going to put 5% into your 401(k), $50 from each check will be put into your 401(k) account.

Then, your taxes will be figured based on $950 per paycheck, not $1,000 per paycheck. That means you’ll actually be paying less income tax than you would if you were contributing nothing to your 401(k). You’ll be contributing $50 per month, but your paycheck would actually go down by less than $50.

You do end up paying taxes on the money, but you don’t do it until money comes out of the 401(k), usually at retirement age.

How much should you be contributing? I would suggest a minimum of 10%, regardless of age. If you’re over 35, make it 15%. If you’re over 50, make it 20%.

What about employer matching? Some employers offer matching contributions to their employee’s 401(k) accounts. Essentially, these contributions act as free money in your 401(k).

Let’s say your employer matches half of your contributions up to 10%. In the above example, you’d be contributing $50 per paycheck to your 401(k) and your employer will put in $25 on top of that. This makes your 401(k) contributions even more valuable.

What about all the investment options? When you put money into your 401(k) account, that money will need to be channeled into one of the investment options offered by your employer’s 401(k) program. The options vary greatly from company to company, too, which can add to the challenge.

Let’s make this clear right off the bat: don’t worry about picking the “best” investment. Making contributions and putting them in any investment option is going to be better than not making any contributions at all.

If you’re not sure which one to pick, there are a few simple guidelines I suggest.

First, choose a “target retirement” plan if they’re available. You’ll be able to choose among several target retirement plans. These plans are usually distinguished by different years – Target Retirement 2045 and so on – so choose the one that comes closest to the year that you’ll turn 67.

If that’s not available, subtract your age from 70, then double that number. So, in Debbie’s case, she’d take 70 minus 28, which is 42, and then she’d double it, to get 84. Contribute that percentage to stocks. If there are different stock options available, ask the person in charge of your plan for the option with the most diversification. Then, contribute the rest to bonds – again, if there are different bond options, ask for the one with the most diversification. You’ll want to readjust your plan every year or two, because the closer you get to retirement, the more you’re going to want in bonds and the less you’re going to want in stocks.

This should cover the basics. A 401(k) plan is simply a way to make sure you have money set aside for you in retirement. In some places, your employer will contribute extra. If you’re not sure which investment option to take, choose a target retirement fund – and if that’s not available, follow a really simple formula. Do those things and you’ll be set up for retirement.

The post 401(k) From Scratch appeared first on The Simple Dollar.

The last time I saw her, I was struck by her frailness. My grandmother had worked at a maximum security prison for many years. She was a tough woman, the type of person who wouldn’t take any nonsense from anyone. She was stubborn as a mule when it came to taking care of herself.

To see that strength slipping away from her slowly over the final years of her life was a bit painful. I would visit her and see her putter around her kitchen slowly, preparing herself very simple meals. That spark of stubborn independence was still there, but it was softened.

When I think of my grandmother, I recall this period in her life, but it stands in stark contrast to the vibrant woman I knew throughout my childhood.

One thing I will remember about my grandmother’s final years, though, is how my mother stepped up to the plate to take care of her. She called her multiple times a day as she got weaker and stopped in daily to visit her. My uncle even moved in with my grandmother near the end of her life.

My mother and grandmother together showed me that the most valuable thing to have in the final years of your life is people who care about you.

This, of course, brings me around to my own parents.

I’ve seen them quite a lot lately, and the little signs of their decline have been difficult to ignore. They’re getting older. They’re nowhere near as fast as they once were and simple things that used to be normal to them wear them out.

My father used to have boundless energy for his various hobbies and side businesses. Over the past several years, his garden has become smaller and smaller and his commercial fishing exploits have come to rely on people he’s hired to assist him with it.

My mother is hobbled a bit with a knee that needs some surgical repair. She does an amazing job keeping up with her grandchildren, but it doesn’t take much observation to see a wince of pain here and there from her.

During my early adulthood, I was fully confident that my parents were fine. They had always been like rocks to me, completely able to take care of themselves.

Now, I’m beginning to see that changing, and I’m now realizing that my parents are going to need me in new and different ways in the coming years.

The thing is, it’s not money they really need. It’s time and attention and love.

They need someone who will call them up regularly and visit them.

They need someone who will help them connect with their grandchildren.

They need someone who will help them get their affairs in order.

More than anything, though, they need someone they can talk to who is actually listening to what they are saying and cares about it and takes action based on it instead of brushing them off as another duty to fulfill.

When I was a young child, my grandfather lived with us for a while near the end of his life. One evening after my grandfather had fallen asleep and I was working on a jigsaw puzzle with my father, he told me that when you’re young, the parent takes care of the child, but when you’re old, the child takes care of the parent.

That transition has been happening over the last several years. It’s been a slow one, but with every passing year, it becomes more and more real.

In a very real way, I am a part of my parents’ retirement plan. They invested so much in raising me, and now I can do a lot of things to help them in return.

If you know someone who is in the September or November of their years, give that person a visit or a call. Ask them if they need any help with anything. Drop by with a bag of groceries and make them a meal. You’ll be surprised at how much something relatively simple for you can mean a great deal to someone else.

If you’re worried about someone you know who is getting older, there is no better way to help them than with a little bit of time and attention and effort. You don’t have to give money to make an enormous difference.

The post Loved Ones in Decline appeared first on The Simple Dollar.

The theory was simple: If you spent a maximum of 4% per year of your retirement funds, the decline in principle will be slow enough that your money would last as long as you did. Though the percentage seems modest and the reasoning sound, this 4% rule ignores two factors that have become increasingly, glaringly relevant: first, market volatility, which has battered retirement savings over the last decade, and second, inflation, the silent force that erodes purchasing power year after year.

What does that mean?

The other issue with basing your retirement plan on simple rules is that it can lead to complacency. But the idea that you can “set it and forget it” and everything will be fine is a trap.

“There are so many ‘experts’ telling people different things, that they’re not going to have to worry,” D’Arruda said. “A rule means something in writing, something enforceable. But in retirement planning, there’s a fluctuating source. You can’t take a guarantee.”

Let’s look at an example case from a reader that I’ll call Marvin.

Marvin has $800,000 put away for retirement, mostly in really conservative stuff like bonds and cash. Overall, he’s earning about 2% a year on his money. He was bitten by the stock market collapse in 2008 and doesn’t want his money in stocks. Marvin wants to retire in ten years, so he wanted to know how much money he should be putting away.

I asked him a few questions. How much does he anticipate spending (in current dollars) per year in retirement? He told me about $50,000. What will his Social Security benefits look like? He estimated around $1,500 a month (adding up to about $18,000 a year).

I told him that if he wants to retire in ten years, he should be putting away every single dime he can starting right now and that he should anticipate trying to earn at least some income during his retirement.

I don’t think Marvin liked that answer.

Why did I tell him that, though? The big reason is that his plans for retirement are riddled with uncertainty.

First of all, there’s inflation. Let’s say inflation grows at 3% a year for the next thirty years. If he’s estimating spending $50,000 in today’s money, during his first year in retirement, he’s going to be spending just shy of $70,000. During his eleventh year? $93,000. That’s more than 10% of his total retirement balance. His Social Security might go up a little, but it’s not going to go up that much.

There’s also the issue of fluctuation in investment returns. Right now, Marvin is very conservative and only earning a 2% return on his money. That’s not enough of a return to build substantial wealth. With that level of return, unless he contributes more, he’s not going to even crack $1 million for his retirement plans.

If he moves into stocks, he will likely get a higher long-term average annual return, but it will be highly volatile. He might average out to 5%, but one year might see a 20% loss while two other years might see 15% gains. Volatility at the wrong moment in retirement can eliminate years of living expenses and you won’t have time to see the market rebound save you.

There’s also the issue of uncertain lifespans. If Marvin retires at 65 and lives until 75, he’ll be fine. If Marvin retires at 65 and lives until 95, he’s going to be in big trouble. None of us know for certain how long we’ll live.

The article seems to imply that individuals shouldn’t be involved in planning for this and that financial advisors know better. I don’t really agree with that. All of these factors rely on knowing unknowable facts about the future. No financial advisor in the world can tell you how long you’ll live, how volatile the stock market or other investments will be in the next ten years, or what inflation will do in the future.

However, there’s one thing that almost no one can argue with. The more money you save for retirement, the more money you’ll have when it comes time to retire. The more you put in now, the more you get out later.

The solution is simple. You can either save as much as possible for retirement now so you don’t really have to worry about this too much. On the other hand, you can save less and accept that your final years will likely involve leaner living.

I am almost always of the belief that if I can make a minor sacrifice now, that’s far better than having to make a major sacrifice later. If I can squeeze out another $1,000 a year right now, that might add up to another $1,500 a year in retirement.

It might make the difference between never going out to eat with my wife or having a nice dinner out with her once a month.

What do I have to sacrifice today to get there? If it’s something small that I can give up and apply that savings to additional retirement savings, then it’s well worth it.

That’s how I look at retirement savings. I’m making little sacrifices now so that I can enjoy life more later on. If I can resist that new gadget that I don’t really need and probably won’t use very much today, I can have some breathing room and a little less stress and a little more fun later on.

It is never a bad move to save more for retirement.

The post Now and Later: The Great Retirement Question appeared first on The Simple Dollar.

My parents are both retired in the traditional sense. They have a limited fixed income made up of Social Security and some pension money. Their house and vehicles are long since paid for, and since their house is relatively small and older, insurance and property taxes are low.

Sarah’s parents are a completely different story. Her father will probably work until he can’t, partially for income reasons and partially because I think he deeply enjoys his work on many levels. Her mother had a “pseudo-retirement” but couldn’t stand it, so she returned to work. Thus, their income level is significantly higher, but their expenses are higher, too. They have nicer cars and travel regularly.

My own “retirement” plans involve a mixture of working on my own side projects and doing volunteer work. Much like my in-laws, I don’t feel happy unless I’m working on large projects. When I find myself without such large projects, I tend to drift and feel depressed.

As for Sarah, I expect her to very oriented toward volunteerism and any grandchildren we might have to take care of.

It’s pretty clear from just a simple survey of my own life that everyone has a different life plan for their 60s and 70s. Some people intend to enjoy leisure and volunteer work. Other people are wired to be productive in various ways.

Think about it for a minute. What do you plan to be doing in your 60s and 70s? Is it the same thing that you expect all the people around you to be doing?

Given how varied the plans people have for their later life are, why is it reasonable to think that everyone should plan for retirement in the exact same way?

For example, let’s say my dream is to switch to a career path as a novel writer as soon as I possibly can, living off of my investment income starting at the youngest possible age. This means that I’d be choosing to live very lean in my 40s and 50s while I get some novels published, then enjoy more income from the combination of investments and book income in my 60s and 70s.

In that scenario, traditional retirement savings would serve a relatively small role. I might want to fund a Roth IRA or something to guarantee a bit more late-in-life income if needed, but most of my saving for the future wouldn’t be in retirement investments. I would focus instead on investing outside of retirement accounts to fund my dream.

On the other hand, a person like my father-in-law, who fully intends to work until he’s unable to do so, won’t need to live for twenty five years off of his retirement accounts. Much like my earlier scenario, the “traditional” use of a retirement plan doesn’t really fit his plans. It’s worthwhile for him to have some money in his retirement savings, but does he need to save for twenty five years of retirement?

I don’t have the ultimate answer as to how the people in the two above scenarios should be saving for retirement. However, it’s pretty clear that these scenarios don’t simply follow the “save 15% for retirement each year” plans that are often simply prescribed for people.

So, what does this mean for you?

First of all, thinking about your plan for your whole life pays off. We don’t always know exactly where our life is going to lead, but I’ll say that the general idea I had for my life when I was in my early twenties is more or less coming to pass. I envisioned having children and having a career that I had creative control over.

Naturally, big unexpected things can always derail those plans. I could get sick. Something else unforeseen could happen. In the vast majority of those scenarios, though, I’m not helped by having a lot of retirement savings, though I am helped by having assets on hand.

Second, understanding how to translate those plans into a financial plan is key. This might involve the aid of a financial planner, but at the very least, it involves some significant time studying investing options and knowing in what situations they’re most useful.

Finally, and this is key, just because you’re not saving for retirement doesn’t mean you’re not saving. If you have a future, it’s valuable to spend less than you earn and save for that future. No matter what your future self will be doing, he or she will be better off if he or she has money in the bank.

Retirement savings, in the form of a 401(k) or a Roth IRA, has certain advantages. However, those advantages only really matter if the direction of your life allows you to take advantage of them. Your life is not dictated by your retirement investment plans. Your retirement investment plans, if they’re needed at all, are dictated by how you live your life.

Spend less than you earn. Use retirement plans to help you for whatever you’ve got planned for your 60s, 70s, and later. Don’t assume that’s enough, particularly if you have a plan for your future.

The post The Different Meanings of Saving for Retirement appeared first on The Simple Dollar.

At the same time, I also get emails from people in their twenties who are already saving diligently for retirement. What they want to know is how much they actually need to save so that they, too, can retire at age 65.

The people in the first group obviously spent a big chunk of their adult life not having to save for retirement. This gave them more flexibility with their money in their twenties and thirties than people who were already saving for retirement.

On the other hand, people who start saving early don’t have to save as much overall as people who start later on.

So, which approach is better? Let’s look at the two cases.

Let’s say you’re 20 years old right now. You want to have $2 million set aside for retirement at age 65 and, magically, there’s an index fund out there that will return 7% a year (I’m using this index fund as a convenience, basing the 7% on what Warren Buffett suggests is a good number to use for average stock market returns going forward).

If you start investing at age 20, you’ll need to put aside about $510 a month to reach this goal.

If you start at age 25, you’ll need to set aside about $725 a month to reach this goal, but you don’t have to save anything from ages 20 to 25.

If you start at age 30, you’ll need to set aside about $1,050 a month to reach this goal, but you don’t have to save anything from ages 20 to 30.

If you start at age 35, you’ll need to set aside about $1,530 a month to reach this goal, but you don’t have to save anything from ages 20 to 35.

If you start at age 40, you’ll need to set aside about $2,270 a month to reach this goal, but you don’t have to save anything from ages 20 to 40.

If you start at age 45, you’ll need to set aside about $3,480 a month to reach this goal, but you don’t have to save anything from ages 20 to 45.

If you start at age 50, you’ll need to set aside about $5,600 a month to reach this goal, but you don’t have to save anything from ages 20 to 50.

As you read through those previous sentences, you probably thought that the amounts early on were quite manageable, but when you got to age 50, you’re likely thinking that it’s bordering on impossible.

That’s the lesson here. You can forego the early retirement savings, but catching up later on can be incredibly punishing and the longer you wait, the more punishing it gets.

Thus, my advice is to start saving for retirement right now, no matter what age you are. Even if you can’t save very much, start by saving something. If you’re not saving, you need to be doing something else that’s financially urgent with your money.

For example, if you just save $100 per month starting at age 20 in the above retirement account, increase it to $200 a month at age 30, $300 a month at age 40, $400 a month at age 50, and $500 a month at age 60, you’ll have $720,000 saved for retirement. Double each of those numbers and you’re getting close to where you need to be.

Start saving now, even if it’s just a little bit. Don’t burden your future self with crippling amounts of retirement savings or employment until the very end of your life.

The post How Important Is It to Start Early? appeared first on The Simple Dollar.

Roth, IRA, 401(k), 403(b), FERS, TSP – what on earth does it all mean? I know they all have to do with retirement savings, but it’s all just a word salad to me.

This is going to be something of a “dictionary” post where I spell out, as simply as I can, what these terms mean and what it means for you. I’m not going to get into every single detail of each term, but instead I want to give you enough information that you can sensibly navigate other articles you might read about retirement planning.

A 401(k) is a retirement plan, meaning it’s a special way for you to put aside money for when you’re of retirement age. What makes a 401(k) better than a normal retirement account? For one, you can put aside money directly from your pay before taxes are taken out of it. This reduces the income tax you have to pay right now.

For most people, it means that you sign up to have a certain amount of money withdrawn from your paycheck each pay period. This money will come out before taxes, as mentioned above. This means your paycheck will be a bit smaller than it otherwise would, but it won’t go down quite as much as the amount you withdraw (because your taxes will be smaller, too). So, if you sign up to have 10% of your check taken out, your gross income might go from $2,000 to $1,800, but your take-home might only drop from $1,700 to $1,530.

When you’re retired and go to take money from a 401(k) account, that’s when you’ll pay income tax on your withdrawals. In a way, you’ll be able to think of it as a normal paycheck coming out of your 401(k) account, as it’ll have taxes taken out of it.

Sometimes, employers will match what you have withdrawn from your check. If this is available to you, get every dime you can. This is free money. Yes, you don’t have access to it right now, but there’s no easier way to cause your retirement savings to skyrocket than to get every dime of matching you can.

Typically, a 401(k) plan offers a lot of different options for how to invest your money. This can seem overwhelming. Thankfully, there’s a pretty easy solution that works for most people. Just ask your investment advisor for a “target retirement” fund and put all of your money into that fund. Usually, there are several different funds of this type, each of which “target” a specific retirement year. So, let’s say you’re 25 and you want to retire when you’re 64. That’s 39 years from now. Since I’m writing this in 2011, that puts your retirement date at 2050. Thus, you’d want to put your money into a “target retirement 2050″ fund. These funds take care of things like rebalancing for you so you don’t have to worry about it.

A 403(b) is almost identical to a 401(k). Why the different name? Generally, 403(b) plans are offered at non-profit organizations and institutions of public education, whereas 401(k) plans are offered from businesses. A 457 plan is also similar, except it’s typically offered by governments.

An IRA is a retirement account that you can set up on your own, usually with an investment house like Vanguard. You have to make your own contributions to this plan, which is usually done via an automatic deduction from your checking account.

Contributions to an IRA are tax-deductible, which means that when you do your taxes, you can subtract the amount you contribute to your IRA from the total amount of income you’ll be paying income taxes on. For many people, this means a larger rebate check from the IRS.

As with a 401(k), when you make withdrawals from an IRA at retirement age, you have to pay taxes on those withdrawals as though they were normal income.

An IRA involves a lot more effort than a 401(k) for most people. You have to independently sign up for an IRA with an investment house. Once signed up, you’re going to have many more investment options than you would have with a 401(k), which is both good (options are good) and bad (lots of options can be overwhelming). As before, I typically encourage people to use a “target retirement” fund for all of their retirement savings if they’re unsure, which you can read about above in the 401(k) section.

OK, so what does Roth mean? A Roth IRA or a Roth 401(k) work similarly to the plans described above, except that instead of using pre-tax money, you’re using post-tax money for contributions.

How does that work? Your contributions come out of your take-home money in the case of a Roth 401(k), and your contributions aren’t tax deductible in the case of a Roth IRA.

Well, what do you get in exchange for that? All of the money you withdraw from these accounts at retirement is tax free. You won’t pay a dime of tax on any of it.

Naturally, this causes people to start asking questions like “is it better to pay taxes now or pay taxes at retirement time?” This is a debate that’s gone on for years and, frankly, there is no clear answer to it. My usual suggestion to people is to diversify. If you can, put some money into a Roth IRA or a Roth 401(k) and put some money into a regular 401(k) or a regular IRA.

A final note: what about FERS? FERS is essentially a federal pension plan available to federal employees. Many states offer a similar program with similar benefits to their employees. Typically, these plans offer a retirement pension based on years of service and salary and, typically, you don’t have to make any decisions after the initial sign-up.

Hopefully, this article helps you with the basics of various retirement plan options and makes it possible to navigate more in-depth articles about setting up things to cover your retirement.

The post Help! I Don’t Know What Retirement Plan You’re Talking About! appeared first on The Simple Dollar.

One common request I get is more discussion on the specifics of retirement plans. For me, whenever someone mentions a topic that they want to hear more about, that means a trip to the library. I try to find books that cover the topic well, particularly from a fact-oriented point of view.

This is exactly the angle of A Commonsense Guide to Your 401(k) by Mary Rowland. Part of the “Bloomberg Personal Bookshelf,” a series of books on personal finance and investing topics, it seeks to discuss from a very fact-based perspective what a person needs to know about 401(k) plans and how to use them for retirement.

The Retirement Landscape
The book opens with a section briefly covering the retirement landscape in general, which is the one place where this book really looks at non-401(k) retirement options, particularly for the self-employed and other groups. The big idea here is that you need to be prepared for what’s going to happen down the road, and it’s going to take a lot of preparation, ideally starting now. The information here really moves almost too fast to really put non-401(k) plans into perspective, though.

401(k) Plans: The Basics
Here, Rowland carefully discusses what a 401(k) plan is, how it works, and why you should invest in it. It’s a retirement vehicle, of course, but it’s one tied to your employer and often restricted by whatever plan or arrangement your employer has set up with the investing house offering the plan. Usually, money is put directly into the account as a deduction from your paycheck before you ever take it home. That money usually comes out before taxes are calculated, meaning that Uncle Sam gets a smaller slice of your pay now but will get a slice of that 401(k) money later on when you’re retired.

How to Get In and Get Out
Rowland moves onto the key processes in opening a 401(k) account, which usually involve signing up through a plan representative in your workplace. On the flip side of that coin is the withdrawal phase, where you sign up to begin taking regular withdrawals from your 401(k) at retirement. The topic of rolling over a 401(k) is also touched on here a bit.

Investing It
The big part of signing up for a 401(k) is the question of investing, and it’s the part that often scares people. How do you know what to invest in? Generally, all you need to do is invest in a wide diversity of things and, as you get closer to retirement, slowly shift that diversity into less aggressive things (less stocks, more bonds, for example). Many plans offer a “target retirement” fund which does this for you automatically and is usually the best choice for people who don’t want to handle the minutae for themselves.

Preparing for Change
What things can you do as retirement nears and you’re about ready to begin collecting that 401(k) money? Rowland offers a ton of ideas here, most of which are simply really sound personal finance ideas. Pay off your debts. Understand what your new lifestyle and income level will be like. Delay collecting Social Security so that you can collect a bigger benefit.

Steps to Take in Retirement
What do you do when you’re actually retired? Many of the tactics here deal with specific situations that people may find themselves in, such as a temptation to take out lots of money and splurge (don’t) or how to utilize “alternative” retirement strategies like pension max (don’t). Instead, learn to maximize every dollar you have without risking the dollars that are yet to come.

403(b)s, 457 Plans, Etc.
This is something of a tie-it-together section that discusses alternatives to 401(k)s that some people may have, such as 403(b) and 457s. Mostly, these plans are really similar to 401(k)s for most purposes, and Rowland mostly just focuses on talking about the minor differences between them here.

Is A Commonsense Guide to Your 401(k) Worth Reading?
If you’re a fact-oriented person and are seeking information about how your 401(k) plan works in your workplace, A Commonsense Guide to Your 401(k) is exactly the book for you. It’s very informative, sticks to the facts, and teaches everything you might need to know about your 401(k) plan.

Having said that, it really doesn’t instruct you too much on broader retirement issues and other places to invest. This is a 401(k) book, through and through. Many people seem to substitute “401(k)” in their head for “retirement savings,” but the terms are not interchangeable. This book provides a great view of 401(k)s, but a narrow view of a total retirement picture.

This is a great read as part of your reading on retirement issues, supplemented by a book that provides a broader picture and other specialized books on retirement. It’s incredibly informative, but on a very narrow topic.

Check out additional reviews and notes of A Commonsense Guide to Your 401(k) on Amazon.com.

The post Review: A Commonsense Guide to Your 401(k) appeared first on The Simple Dollar.

On Facebook, Tyler wanted to know, “Should I stop my retirement contributions while i pay back my college loans? I am 23 and my employer will match up to 5% of my contribution. Should i continue? or hold off until my loans are paid?”

The challenge with any question like this is that it relies so much on future events. What will the stock market do over the next thirty or forty years? That’s unknown. What path will Tyler’s life take over the next ten years or so? That’s unknown as well. Both of these factor enormously into answering the question above.

The best thing we can do is follow some reasonable approximations and rules of thumb for future investment growth while also striving to give Tyler as much freedom as possible in the coming years.

The Ghost of Investing Future
In order to get an estimate of how much someone should be investing for retirement, you have to come up with a few basic assumptions.

When will the person retire? This lets us know how many years of investing we’ll be able to account for. I’ll asume that Tyler will retire at 75, giving us 52 (!) years to work with.

How much of an annual raise can we assume? I usually just match this at the same rate as inflation. Speaking of inflation…

How much inflation should we assume? I usually peg this at 3%, which is pretty sound based on the economy of the last twenty five years.

How much of an annual return on stocks can we assume? Warren Buffett projects a 7% annual return over the long haul in the American stock market, so I’ll use that number.

Do you see how tenuous all of these calculations are? When you estimate retirement savings, you’re making a lot of guesses for the future.

What you’re going to shoot for is an amount high enough so that the person’s annual expenses equal 4% of the total savings at the time of retirement.

I ran the numbers, assuming that Tyler is able to live on about 75% of his salary each year. My calculations showed that Tyler should be saving somewhere between 9% and 10% of his annual income for retirement, so we’ll use 10%.

10% is an excellent thumbnail to use. In this case, Tyler has the advantage of a long period until retirement, but I’m also using some pretty conservative returns on his investments for my calculations.

Tyler’s Choice Today
In order to make it to a healthy retirement, Tyler needs to be saving 10% of his annual income starting today. He can choose to delay it a few years, but then he’ll be locking down 11% or 12% or more to make it to his goals. He’s a lot better off locking things down at 10% starting today.

Tyler’s employer will match up to 5% of his contribution, so if Tyler contributes just 5% of his salary today, he’ll be on pace for what he needs for retirement. This is exactly what I would recommend that Tyler does.

Once that’s taken care of, he should throw every dime that he can at his debts. It is far easier to live a little lean now when you’re single and aren’t weighted down with responsibilities than to live lean later on when you’re burdened with career and personal requirements.

Should Debts Ever Delay Retirement Contributions?
This is a tricky one to answer. Quite often, people eschew retirement savings in order to pay off debts because they don’t want to make lifestyle changes. This is a giant mistake. If you find that you’re in a situation where you can’t make your minimum debt payments, a small retirement contribution, and live your current lifestyle all at once, changes need to be made with regards to your lifestyle first and foremost.

If you are in a situation where further lifestyle changes genuinely are not possible – meaning you have no cable or satellite bill, no cell phone, no new or nearly-new car, no living quarters larger than you need, etc. – then you should take care of your high-interest debts before renewing your retirement savings. Of course, this does need to be coupled with an emergency fund and a commitment to avoid debt in the future, because without that, this is all a moot point.

Personal finance almost always comes back to impulse control, and this is no different. If you can’t control your impulses and desires when it comes to spending money, financial success will almost always be elusive in your life. You won’t get ahead if you can’t control yourself.

The post Retirement Contributions: When Should They Delay Debt Repayment? appeared first on The Simple Dollar.

Yes this is good advice – work for 45 years, squirrel away your income the whole time, and when you are ready to die, you will be rich (*disclaimer – rich in 2011 dollars, maybe not so rich in 2043 dollars)

First of all, I have no interest in being rich. My impression of being rich is that I have enough money saved that my children will have an easy life. I have no interest in that at all.

My goal is financial independence, which means simply that if I choose to engage in activities that don’t earn an income for the rest of my life, I’ll survive financially with a standard of living roughly similar to what I have now (and I don’t live like a rich person). I might choose to earn an income at that point so I can spoil my grandchildren or sponsor a charity or fulfill some other goal, but I don’t need it to survive and I certainly have no interest in supporting my children as adults.

Of course, the core of Donald’s point is that long-term savings goals are pointless because of a perceived short life and low quality of life you would have once you reach a retirement age. Donald mentions working for 45 years and, assuming that you’d start such work at age 25, you would be working until age 70.

Here’s the thing, though. The average person at age 70 can expect to live another fifteen years on average (see Table 6 in the 2007 CDC life expectancy report for the numbers). The simple fact is that people at age 70 aren’t sitting on their deathbeds. This may have been the reality fifty or sixty years ago, but it’s not the reality now. Health care and standards of living have given people much longer healthy and productive lifespans than ever before. The majority of people at age 70 have a decade or more or productive life ahead of them and the percentage will just continue to go up as time marches on.

I don’t know about you, but my plans for when I’m seventy don’t involve me sitting down in a chair and waiting for the end. I plan on being engaged with my family and with charities and other community activities until I’m truly unable to do it any more, and the statistics indicate that, for me in my early thirties, that time is a long way into the future. Estimates on life span increases indicate that I have more than fifty years of productive life yet to live and I’ve already been in the workforce for more than a decade.

Simply put, if you are young today, saving for the future doesn’t mean saving for retirement and life’s end; it means saving for financial independence and a second career.

Now, with regards to the comment of “rich in 2011 dollars, not in 2043 dollars”: you have to go back for two decades to find a year with an inflation rate higher than 4%, and some recent years have seen microscopic inflation rates. 2008 and 2009 had extremely low inflation and, by some estimates, had deflation. This is the inflation metric you’re trying to beat and if you’re investing over the long term (40 years), a well-diversified investment with diverse stocks and other assets will annihilate these returns, giving you much better than inflation. Simply put, saving properly for a second career over the long term will handle the inflation problem.

But what about the economic bogeyman? You know, the fear of a financial apocalypse that political opportunists and media members who know how to sell fear love to trot out all the time? The only thing we have to fear is fear itself. Most of the people preaching fear have been preaching fear for several years now. All I see is a prolonged recession and a national debt that was worse in the 1940s than it is now.

The things that have worked for the long term throughout human history work now. Spend less than you earn. Invest the rest in a diversity of things because you don’t know exactly what the future holds. Invest in yourself, too, and make sure you have skills and education to handle both the needs of your life and the needs of the marketplace.

One final thing: think and plan for the long term, because the long term is longer now than it ever has been – and it’s full of more opportunity than ever as well.

The post Some Thoughts on the Long Term appeared first on The Simple Dollar.

There’s an important fact to consider, though, that’s been left out of this story. In 1935, the average American lifespan was 61.7 years. You had to exceed the average American lifespan by more than three years to begin receiving Social Security benefits.

Let’s roll forward to today. The “retirement age” set by Social Security is still 65. However, today the average American lifespan is 78 years and continuing to rise.

In other words, the national “retirement age” of 65 has remained unchanged for 75 years, but the lifespan of the average American has gone up by 16 years.

Yes, this is an easy explanation for why Social Security is seeing financial problems, but there’s a more vital issue at work here, one that we’re seeing at work all over the place in America.

40 is the new 20. 60 is the new 40. Simply put, people are living far longer and enjoying excellent health much later in life than ever before.

In 1935, a person aged 65 was often quite elderly and in poor health. In 2011, a person aged 65 is often full of vitality and has two more decades of lively activity ahead of them (at least).

There are two key points to pull out of this.

First, if you’re under 50 or so, you’re probably not going to be able to retire when you’re 65. In the past, Social Security could sustain you by providing enough income between the age of 65 and the end of your life that you could survive. Unfortunately, as lives grow longer and future generations grow smaller in size, one of two things will eventually have to happen: either the Social Security age will move back or the amount of benefits will fall.

That means that either you’re going to be going on full Social Security benefits at a later age than 65 or Social Security benefits are not going to be enough to sustain you in retirement at all. In either case, retirement at 65 simply because Social Security is now available is quickly becoming a myth – and will completely become a myth in a decade or two.

At the same time, however, 65 is the new 45. Over the last 75 years, the quality of life for people over the age of 65 has increased drastically. Rather than beginning to lose control of their faculties, most people between the ages of 65 and, say, 80 are quite valuable and have a ton to offer in the workplace and in the marketplace.

Simply put, at the same time that retiring at age 65 is becoming less feasible because of longer lifespans and demographic shifts, it’s becoming much more worthwhile to continue being productive at 65.

What does this mean for retirement planning?

At this point, I don’t view retirement planning as saving for true retirement. Most retirement savings plans allow you to begin taking money out at age 60, which means you likely have a quarter of a century of good health ahead of you at that point.

Instead, I look at retirement planning as building a backbone for a second career. At age 65, I won’t have enough retirement savings or Social Security income to fully sustain me for the rest of my life, but I will have enough retirement income to make it possible to take some significant career risks. I can take a low-paying position with a charity or even do volunteer positions with some perks. I could retreat for a year and write the novel I’ve always wanted to write. I can take a very low-stress job as a greeter or a position on a community board that gives a stipend.

These are all things that are difficult to do right now in my life, yet sound appealing to me and have a firm place on my to-do list.

Simply put, my retirement savings aren’t just for retirement; instead, they create possibilities for a second career or other opportunities later on during my healthy adult life.

Don’t fear the changes coming in retirement savings. Embrace them for the opportunity that they are.

The post The Truth About Retiring at 65 appeared first on The Simple Dollar.

I asked my mother a few days ago about what she considered to be the “long term.” She basically pointed to a point about ten or fifteen years down the road when my children are graduating high school.

I asked my oldest son what he thought about the future and what he thought of as the biggest thing that would happen in his life. He thought about it and he said it would be when he was a parent, roughly when he was my age. Let’s call it twenty years.

I asked my father-in-law what he thought of when I said the words “long term” and he pointed to a point about eight years down the road when he hoped to retire.

Seven years. Twelve years. Twenty years. Thirty years.

One of us is looking at that long term with (relatively) shorter-term retirement savings in mind as a tool to get there. Another sees the route to the long term coming through health maintenance. Yet another sees it as a natural outcome of growing up. For me, it’s all about the long-term retirement planning.

We all have very different definitions of the long term. We all have very different actions we need to take to get there.

Whatever your definition of the long term is, though, you don’t just get there by wandering in the wilderness. It takes work, and it takes a plan.

I’m saving steadily for retirement and putting that money into investments that are fairly high-risk. As time marches on, I’ll be pulling the throttle back and moving into less risky investments.

My son is so excited about school starting in August that he’s already wondering about school supplies.

My mother rather carefully watches the food she eats.

My father-in-law is saving for retirement hand over fist.

We each have our own visions of the long term. We each have our own path to get there.

The key word in personal finance is personal. We all have different goals and dreams. Those goals could be as close as a year into the future or it could be several decades down the road. Depending on where we’re at right now, the things we need to do to get to that point might be drastically different, even if the goals are similar.

What’s the point? You’ll find the most success with personal finance – and with life – if you don’t just copy someone else’s plan. Instead, learn the principles and figure out your own plan that takes you to wherever (and whenever) your long term happens to be. Along the way, don’t be afraid to grab great ideas from others and add them to your own plan, just as long as it keeps taking you to wherever it is you want to go.

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I’m reading about retirement and I see terms like Traditional IRA and Roth IRA and 401(k) thrown around without really explaining what they are or what the differences between them are. Do you have a summary of these plans and how they work?

There’s no better time than the present to offer up some great fundamental personal finance information like this. I’m going to ask a series of basic questions about retirement plans and provide the answers for each type of plan so that you can clearly see how they differ in each area.

I myself have had a 403(b) in the past and I currently have a Roth IRA.

One important point to make: this is a summary of the differences between the plans. Plans often change over time as the government alters the tax code and many plans have loopholes that appear and disappear as the years go by. The goal here is to not provide a be-all-end-all reference, but to make clear the big differences between the plans.

Right off the bat, let’s clarify a key point. A 401(k) and a 403(b) are essentially the same thing. The difference between the two is whether or not your employer is a for-profit entity (a business) or a certain type of non-profit entity (such as an educational institution). In terms of the employee, they’re virtually identical in their usage. Some types of non-profit entities also offer a 457 plan, which is very similar to a 401(k)/403(b) except with a few less restrictions on withdrawals.

Who Offers the Plan?
How can you get involved in each type of plan?

A Traditional IRA is offered directly from investment houses. In order to open a Traditional IRA for yourself, you have to open an account with an investment house. Some well-known investment houses that I use (or at least somewhat recommend) include Fidelity and Vanguard.

A Roth IRA is offered in the same way as a Traditional IRA. You have to set up your account yourself with an investment house (like Fidelity or Vanguard).

A 401(k)/403(b) is offered through your employer. Your employer sets up an arrangement with an investment house to provide individual 401(k)/403(b) accounts to their employees. Rather than having a choice of investment houses, you are stuck with using whatever investment house your employer provides.

Which has the advantage? The IRAs have the advantage here. Because you have the freedom to choose which investing house to use and can move from investing house to investing house, these companies have good reason to offer you strong investment options. With a 401(k)/403(b), you’re locked into whatever investment house your employer negotiates with, which may or may not provide you with the best investment options. This doesn’t mean that the investment choices in a 401(k)/403(b) are terrible; usually, it just means that the fees are a bit higher than they would be with your own IRA.

Who Is Eligible?
Which people are eligible for each type of plan?

You are eligible for a Traditional IRA if you are under the age of 70 1/2. You must also earn some sort of income from work or be married to someone who earns income from work.

You are eligible for a Roth IRA if you are eligible for a Traditional IRA. The requirements are the same.

You are eligible for a 401(k)/403(b) if you are employed by an organization that offers such a plan to its employees.

How Much Can You Invest?
How much money can you invest in each plan each year?

In a Traditional IRA, you can invest $5,000 per year if you are under 50, or $6,000 per year if you are over 50. These numbers are accurate for 2011 and may go up in future years (they’ve gone up in the past).

In a Roth IRA, you can invest the same amount as in a Traditional IRA. However, there are income caps for investing in a Roth IRA. If you are single and earning between $107,000 and $122,000 or if you’re married and earning between $169,000 and $179,000 per year, your upper limit is less than $5,000 or $6,000 per year. If you’re over the top end of that range, you can’t invest money at all into a Roth IRA this year.

In a 401(k)/403(b), you can invest up to $16,500 per year as of 2011.

Obviously, in this regard, 401(k)/403(b) plans are the big winner as you can invest more in them.

What Tax Advantages Are Included?
The purpose of a retirement plan is to take advantage of tax breaks. What tax breaks do you get with each of these plans.

A Traditional IRA offers the ability to make contributions that are fully tax-deductible. In other words, if you contribute $5,000 to a Traditional IRA in 2011, you will be able to subtract $5,000 from your taxable income when you file your taxes early next year. This results in a smaller tax bill right now.

A Roth IRA contribution does not offer the tax deductibility of a Traditional IRA contribution. Instead, once you contribute to a Roth IRA and have the account for at least five years, you can withdraw any money in the account tax-free (gains or otherwise) once you’re 59 1/2 years old. This results in a smaller tax bill later on, as Traditional IRAs require you to pay taxes with all withdrawals from the account.

A 401(k)/403(b) operates much like a Traditional IRA in this regard. You make contributions today that are fully tax-deductible with regards to your taxes for the coming year. However, there are no tax benefits when you withdraw.

Which is better? It depends strongly on what you think tax rates will do in the future. If you expect them to stay the same or go down, then the Traditional IRA and the 401(k)/403(b) route is better. If you expect them to go up, then the Roth IRA is better. I expect them to go up, so I give the Roth IRA the nod here.

When Can I Withdraw?
I have this money in the account. When can I take it out without a stiff tax penalty?

You can withdraw from a Traditional IRA at age 59 1/2 or any time after that. Withdrawals made from a Traditional IRA will be viewed as income and taxed as such. You must start taking withdrawals at age 70 if you haven’t already started.

You can withdraw from a Roth IRA at any time (once you’ve had the account for five years) as long as you merely withdraw your contributions. You can begin to withdraw your investment gains at age 59 1/2. You do not have to start withdrawing at age 70.

You can withdraw from a 401(k)/403(b) in almost exactly the same way as a Traditional IRA. You may start withdrawing at age 59 1/2. The withdraws you make are taxed. You must start withdrawing at age 70.

The Roth IRA is clearly the most flexible account here. There are no tax penalties for withdrawing contributions early. There’s also no requirement to begin withdrawing at age 70.

How Can I Withdraw Early?
What if I desperately need the cash early? This is usually a bad idea, but it’s worth knowing.

You can withdraw early from a Traditional IRA if you pay a 10% additional tax penalty on your withdraws. This is beyond the normal income tax you’d have to pay on it. So, if you withdraw $10,000 from a Traditional IRA early and are in the 25% tax bracket, you’ll pay $2,500 in taxes on it plus an additional $1,000 penalty. There are some exceptions to these rules for special situations.

You can withdraw early from a Roth IRA if you’ve had the account more than five years. At that point, you can withdraw contributions with no penalty and no tax. If you’ve not had the account for that long, you’ll have to pay a 10% tax penalty on your early withdrawal. If you withdraw above and beyond your contributions before you’re 59 1/2, you’ll have to both pay taxes and a 10% penalty on those additional withdrawals. There are some exceptions to these rules for special situations.

You can withdraw early from a 401(k)/403(b) much like a Traditional IRA. You pay a 10% additional tax penalty on your withdraws beyond the normal income tax you’d have to pay on it. As always, there are some exceptions to these rules for special situations.

Again, the Roth IRA is the best deal here. It offers more flexibility with early withdrawals than the other plans.

A Final Factor
At this point, a 401(k)/403(b) plan looks like the worst option, but there is one huge factor in that plan’s favor. With many employers, the employer will offer matching contributions. For example, one employer that I know of offers one-to-one matching of every dollar an employee contributes to their 401(k)/403(b) up to 6% of the employee’s pay. So, if the employee makes $50,000 per year and contributes 6% of that – which would be $3,000 per year – the employer would match that, giving that employee a total of $6,000 invested each year.

This blows away the benefits offered by other plans. The strength of this kind of multiplying of retirement funds is the best tool you have available to you – if your employer offers it.

What Should I Do?
Here’s my take on the plans as a whole and how I invest for my own retirement.

If my employer offers matching funds on my 401(k)/403(b) plan, I take advantage of those matching funds first. I would contribute as much as possible to retirement to get every drop of matching funds. This is free money that you should never turn down.

After that, I would fully fund a Roth IRA if I were eligible for it. If you make less than $100,000 a year, you’re eligible for it. Find a trustworthy investment house – I use Vanguard, but do your own research – and open a Roth IRA with them. They’ll make it easy for you to open the account and set up an automatic investment plan that pulls money from your checking account.

If I wasn’t eligible for a Roth IRA, I would fully fund a Traditional IRA.

If I was still not saving 10% of my income for retirement, I would invest enough in my 401(k)/403(b) to add up to 10% of my salary. So, for example, if I were making $100,000 a year and I contributed $4,000 to my 401(k) to get matching and $5,000 to my Roth IRA to fully fund it, I’d still only be saving 9% per year. I’d contribute another $1,000 to my 401(k) to get to that 10% threshold.

I would then pay off any and all debts I have. Before contributing more than 10%, I would get myself to complete debt freedom. I would also take care of buying whatever house I wanted to live in for the long term and make sure that I was saving for major purchases like automobiles. Riding a merry-go-round of debt eats away at your retirement like anything else.

If I were completely and securely debt free, I would increase my personal retirement savings to 15% of my income. This might mean fully funding a Roth IRA, contributing more to a 401(k), or even just saving money in a savings account or non-retirement investment account.

That is the plan I would follow at my age (32, as I write this). My only exception to that is that if I were over 35 and hadn’t saved for retirement yet, I’d put the 15% total savings at a higher priority than total debt freedom, as you have some retirement ground to make up for the years you weren’t saving.

Good luck!

The post Which Retirement Plan Is Right for Me? Traditional IRAs Versus Roth IRAs Versus 401(k)s and 403(b)s appeared first on The Simple Dollar.

Don’t rely on Social Security for any part of your retirement. When you’re thinking about retirement, assume that you’re going to be paying your own way.

That’s not a statement that a lot of people like to think about, but the data pretty much points to this as an inevitability. Let me explain why.

Take a look at the birth rate by year in the United States. During the years when the “baby boomers” were arriving on the scene (the early 1950s, for example), you saw a birth rate of 25 babies per 1,000 people in the population. By the 1970s, this birth rate had dropped to 15 babies per 1,000 people in the population and never really recovered. In fact, the current birth rate is the lowest it’s ever been – 13.5 babies per 1,000 people.

To put it another way, the age of the average American is rising. According to this data, the average American is about 0.2 years older each year and is currently 36.7 years old.

With the population getting older and with fewer babies being born, you have more people reaching retirement age with less people entering the workforce. That means more people are moving to the point of taking money out of Social Security and fewer people are joining the workforce to pay into Social Security.

What happens to any pool of money if you suddenly start paying out more than you’re paying in? It dries up. The sheer numbers say that’s what’s going to happen to Social Security.

Well, why can’t something change? The problem with touching Social Security in its current form is that it’s a political nightmare. Politicians are afraid to touch the issue because people who are retired and receiving Social Security benefits are also the people who often have the most time to vote and to get involved in political causes.

There aren’t very many ways that this problem can be solved. The most likely solution will be to simply raise the benefits age for Social Security – and raise it again – and raise it again. What that would mean is that by the time we retire, we’ll have to be very, very old before we see Social Security money.

What that means is that unless we want to work until we’re in our eighties, we’d better start planning for our own retirement now, not later.

Even if this doesn’t come to pass and a great new solution somehow solves the Social Security problem, saving for your own retirement is still incredibly beneficial, because it allows you to have financial means in retirement that go far beyond the small Social Security benefits.

What can you do? It’s simple. Start saving for retirement now, whether you’re 22 or 35. The earlier you start, the better off you are.

If you have a 401(k) plan at work, that’s usually a good place to start. If your employer matches your contributions, that’s even better. Don’t worry about not knowing anything about investing – it’s far more important to start contributing than to find the “perfect” investment. Head over to your benefits office and get this set up today.

If you don’t have a 401(k) (or a 403(b) or something similar) at work, you can do it yourself by setting up a Roth IRA. It’s really easy to do – just open an account at an investment house (I use Vanguard) and set up an automatic contribution out of your checking account.

Think of it as a little thing you can do right now to help your future self a lot when he or she is in their sixties. Giving up a magazine subscription or something else small now can give you the freedom to control your own destiny when you’re older. That’s a great trade if you ask me.

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Daniel Solin’s series of The Smartest X Book You’ll Ever Read have turned me off for their title alone, and thus, to this point, I’ve not read them. The title set off a big “questionable investment planning” warning light inside my mind and, with a lot of other options to choose from, I just kept passing on books in this series.

As is often the case, though, a long-time reader emailed me and strongly encouraged me to give this specific book a shot, mostly because he felt it addressed retirement savings from new angles that he hadn’t considered before.

I do enjoy reading personal finance books, particularly ones that add new ideas to familiar topics, so I headed out to my local library and picked this one up. I do have to say that it did include some ideas and angles on retirement savings that were certainly intriguing and provided food for thought.

Let’s dig in.

One | Rethink Retirement Investing
Right off the bat, Solin makes the vital point that if you don’t protect your portfolio against inflation, you’re going to run out of money much sooner than you would like. Inflation is a force that constantly pushes against your retirement savings, making every dollar you save today worth less when you retire. This is a particular problem for conservative investors who would like to keep their money low risk and “safe” – they won’t lose money, but they’ll often earn at a rate lower than inflation, which means the real value of their money is actually decreasing over time. The best solution, then, is to balance the two – keep a healthy portion of your money in stable things (like cash or CDs or savings accounts or treasury notes), but put some of it into other things with more growth potential that can keep your overall portfolio ahead of inflation.

Two | Stocks Made Simple
Individual investors shouldn’t invest in individual stocks (unless it’s just for fun) because the risk is just too great. You don’t want to bet your retirement on one company lest it turn out to be the next Enron. Instead, you want to mix it up: invest in broad-based index funds, some of them with lower risk and some of them with higher risk. So, for example, your overall portfolio might be 1/3 in cash or treasury notes, 1/3 in a total stock index, and 1/3 in an international total stock index. The key is to buy index funds for your investments – they spread out your risk while also keeping the fees very low. (I do this myself – I have my money with Vanguard.) Obviously, as you move closer to retirement, you’re going to want less of your money at risk, so over time you’ll migrate more and more to cash and treasury notes and less and less in stocks. One easy way to do that is to just buy “target retirement funds” which automatically handle that transition for you (again, making sure that these “target retirement funds” are made up of low cost index funds).

Three | Bonds Made Simple
Bonds are a great way to get solid returns in your portfolio with relatively low risk. Solin recommends that most investors should have at least some of their retirement money in a broadly diversified, low-cost bond index fund. It’s important to remember, though, that bonds aren’t riskless. They have less risk than stocks, but they’re not entirely free of risk. Solin also suggests that investors worried about inflation should not buy TIPS (Treasury Inflation-Protected Securities) because they’re very volatile and they earn very poorly in times of low inflation (like right now, for example).

Four | Cash Made Simple
You should never keep cash in a bank that doesn’t have FDIC insurance, and you should make sure that your cash savings never exceeds the FDIC insurance cap (currently $250,000). Solin encourages searching around for banks if you’re just looking for a place to sock away your cash savings (I suggest using BankRate).

Five | Annuities Made Simple
Solin is a big fan of immediate annuities – annuities in which you give a cash sum to an investment house and receive payments for the rest of your life from them. He argues that they greatly reduce the risk of outliving your money, even if the returns aren’t stellar. Another option is a charitable annuity, where you give a lump sum to a charity and they issue you payments for the rest of your life – this ensures that your annuity lump sum winds up in the hands of a charity you care about instead of a business. If you do get an annuity, though, Solin recommends a fixed rate annuity, not a variable rate one – they carry too much risk. Your annuity should have a fixed rate, period.

Six | Mining Your Money
Do not trust historical returns when you’re trying to figure out how much you can safely withdraw from your retirement each year. Instead, you should simply focus on withdrawing as little as you can get away with each year. Solin suggests aiming to withdraw between 2% and 4% of the total each year – I think that’s a great target (he offers some more math-intensive guidelines as well). He also offers a few exceptions to that “2-4%” rule that involve market timing, a subject that I don’t agree with him on (I don’t think market timing is usually a good move).

Seven | Simple Steps to Stretch Your Money
When you start taking withdrawals, withdraw from your taxed accounts first (like any ordinary savings or investment accounts), then deferred retirement savings accounts (like a 401(k)), then Roth IRAs last. Why? The longer money stays in a tax-deferred account, the longer it has to grow in value without Uncle Sam feeding off of it. If you have a 401(k), Solin recommends rolling it over into an IRA if you can because this gives you more control and the ability to utilize lower-cost investments. He also thinks converting your IRA to a Roth IRA (and everyone with an IRA can do this in 2010) is a good move for almost everyone, but particularly high income earners.

Eight | Social Security and Pensions: Critical Choices
If there is any possible way to delay taking Social Security, do it. If you can wait until you’re older, you’ll get higher payments for life. It can also adversely affect the quality of life of a spouse that survives you. Also, don’t bank everything on a pension because, as we’ve seen recently, companies sometimes aren’t 100% reliable in paying out the pensions they’ve promised. If you do have a pension, avoid taking the lump sum option (if you have it) and take monthly payments instead.

Nine | Is Sixty-Five the New Fifty?
People are living longer lives and staying healthy much longer. What this means, to put it simply, is that if you retire at the traditional retirement age, you’re going to have to cover many more years than the generations before you had to cover for themselves. The solution, of course, is a simple one: work longer. Turn your early “retirement” years into a continuation of your career or the crest of a second one. Don’t rely on age discrimination laws to help you, either – everyone is responsible for keeping their skills up and building their own paths.

Ten | Financial Lifelines for Desperate Times
What if you’re running out of money? A reverse mortgage (meaning you give your home’s deed to someone else and in exchange you receive regular payments) is an option, but it should be your absolute last one. Why? They’re expensive – they’re loaded down with tons of fees and you’ll get nothing close to what your home is actually worth out of it. Instead, seek other options. The AARP is a spectacular resource for the elderly, as are local churches and civic organizations.

Eleven | Care Costs
One of the major costs a person often has in retirement is medical care. Before you even consider retirement, you’ve got to know what your medical care options are when you retire. Is there any continuing coverage from your current job? Can you make ends meet with Medicare? Do you need long term care insurance? Solin spends quite a few pages on long term care insurance and basically argues that the lower your net worth is at retirement, the better an idea long term care insurance is (because if you have more money, you can pay for more care out of pocket).

Twelve | The State of Your Estate
Everyone needs a will, but a will has severe limitations that can hurt you if you’ve spent a lifetime building wealth. A better option for people with a high net worth that wish to pass on their money is to set up a living trust, assign their assets to that trust, and receive payments from that trust until they pass away, at which point their instructions for further management of the trust (i.e., who gets the money) is followed. Also, older couples are very well served by having prenupital agreements that specify that some assets get left to children when one member of the marriage dies.

Thirteen | Wolves in Sheep’s Clothing
If you need financial advice, be careful – there are a lot of sharks in the water. Avoid people who are offering you free things (like lunch) to listen to their pitch. Instead, seek out assistance on your own terms. Look for financial advisors who are fee-based, can explain things clearly, and aren’t seeking to constantly beat the market (such people often wind up way over their heads and you’re left holding the bag).

The book closes with a large handful of appendices and additional documentation for many of the points made in the book.

Is The Smartest Retirement Book You’ll Ever Read Worth Reading?
I think The Smartest Retirement Book You’ll Ever Read is a very strong retirement book for high income earners – the people who aren’t having to make hard decisions about whether to save for retirement or accomplish other life goals. It pretty much assumes you’re going to be socking away plenty and that your questions revolve around where to put it.

If you’re in that group, The Smartest Retirement Book You’ll Ever Read is a very worthwhile read. Solin keeps an eye on the real world (inflation, business failure, etc.) and explains the logic behind every move he recommends in a very clear and straightforward fashion.

If you’re really hitting your income stride and are looking for some sound advice on what investments to put your retirement money in, The Smartest Retirement Book You’ll Ever Read is a pretty strong choice for a good read, in my opinion.

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