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The Retirement Guide
With the future of Social Security and pension plans as unstable as ever, saving for retirement carries a whole new meaning today. In 1950, there were 16.5 people paying into Social Security for every beneficiary. In 2010, that ratio became 2.9 to 1. If this trend continues, depending on how young you are, Social Security may not even exist for you in its current form.
As for pensions, they are simply rare these days. If you do receive this employer-sponsored plan, you would only get up to 25% of your pre-retirement income. Is that enough to retire on?
It’s no longer enough to rely on these types of funding for your retirement. You need to take your retirement in your own hands — intelligently plan, save, and invest your own money to ensure you live comfortably during your post-work years.
Your Personal Retirement Guide
Here are the four basic steps this guide will follow:
- Calculate how much you are likely to need in retirement.
- Look for wiggle room in your monthly budget and expenses.
- Max out your tax-advantaged options.
- Allocate additional savings to one or more non-tax-advantaged plans.
The 2 Most Important Concepts for Saving and Investing
Before anything, there are two general concepts you need to bear in mind when it comes to retirement planning. Understanding these is the true key to making your money work for you.
#1: Time is your greatest financial asset.
Whether you’re a new college grad or in your peak earning years, start today.
It goes without saying: The earlier you start saving, the more money you’ll amass. But remember you aren’t simply collecting cash in a bucket. Because of compound interest, the interest earned every year is added to your principal so your final amount grows at an increasing rate–not in a linear fashion.
Consider this example: Let’s say Kevin and Becky both save $100 every month. Kevin started saving when he was 20 years old, while Becky started at 40. If they both save at an interest rate of 8% and retire at age 65, Kevin will have $41,743 and Becky will have about $7,895. A whopping difference!
As you can see, you reap the most benefit from saving as early as possible. However, if you’re starting to save now and you’re much closer to retirement, look toward the end of this guide for some tips.
#2: Invest to beat inflation.
You’ve probably heard someone say a Hersheys bar cost a penny in the 20s and a dime in the 70s. Today, it’s over a dollar. Inflation eats away at our purchasing power, so simply leaving our savings under the mattress for 30 years really doesn’t do us any good.
What this boils down to is real vs. nominal interest rates. The nominal interest rate is simply the stated rate that you might see on a savings account (e.g. a 1% on your $10,000 savings). The real interest rate, on the other hand, factors in inflation, as measured by the government’s Consumer Price Index (CPI). The real rate is the nominal rate minus inflation.
For example, nominal savings account rates are extremely low. You’d be lucky to find a 1% savings rate today. But let’s say you had $10,000 in a savings account that earned 1% per year. At the end of year 1, you would expect to have $10,100 before tax… nice! However, considering that inflation is averaging around 2% right now, the picture looks less flattering.
What 2% inflation means is that, on average, the things you buy every day are 2% more expensive than they were last year. So, your $10,100 is really worth $9,898 in purchasing power! Doing a quick calculation, your “real” interest rate is roughly -1%.
This is not just theory. Right now, short-term real rates are negative, so you’re actually losing purchasing power if you leave your money in cash. Therefore, it’s in your best interest to invest in accounts that can keep up with or exceed inflation.
STEP 1: Calculate how much you are likely to need in retirement
If you haven’t already, the first important step is to figure out the amount you’ll need to accumulate by the time you retire.
As a rule of thumb, many financial experts believe that, by a certain age, you should accrue a certain amount based on your current salary multiplied by a designated factor, as follows:
For example, if you’re making $100,000 per year, you should have $300,000 in retirement savings by the time you’re 45.
Ultimately, these numbers are different for every person and family. Consider the following factors, and adjust to your specific needs.
- Consider the lifestyle you want. If you just need enough to cover basic expenses and some extra cash for leisure, you won’t need as much as someone who plans on traveling extravagantly, for example.
- Consider healthcare costs. Healthcare is rapidly changing. Will you be eligible for Medicare or Medicaid? Will you have private insurance? Or are you currently experiencing a medical condition? If you predict you’ll need frequent hospital visits or stays, prescriptions, and medical treatments in your later years, you’ll need to save for that too. Think about funding your health savings account (HSA). In 2014, you’re able to contribute $6,550 for each family, compounded tax-free.
- Consider when you expect to retire. Just a few years of extra work will make a marked difference in the amount you’ll end up with (remember the concept of compound interest). Social Security benefits will also be higher if you delay retirement.
- Estimate monthly Social Security payments. If you’re in fact able to take advantage of Social Security benefits, calculate how much you’ll receive. Your monthly payments will be larger the longer you wait. You can start requesting payments at age 60 and as late as 70, but also keep in mind that, depending on the year you were born, your “Full Retirement Age” will affect the percentage you receive. For example, if you were born in 1940, you’ll get 77.5% of the monthly benefit at age 62. However, if you were born in 1960 or later, you will receive 70% at age 62. You can find your Full Retirement Age here.
- Estimate monthly pension payments. If you’re lucky enough to receive a pension payment, ask your company how much you should expect to receive.
- Calculate how much you need to save yourself. After taking into account your monthly Social Security and pension payments, subtract that from the monthly expenses you expect to have. The remaining is what you’ll need for retirement through other savings methods.
*TIP: Use a Retirement Calculator: There are many calculators on the Internet to help you gain a better sense of your retirement-saving needs.
Try these retirement calculators:
STEP 2: Look for wiggle room in your monthly budget and expenses.
Now that you’ve figured out how much you’ll need when you retire, rethink and evaluate your current income and expenses if needed. Given how much you can possibly accumulate and earn through compound interest, you should aim to stash away as much as possible to meet your goals.
Here is an example of how you could approach this issue:
- Create a spreadsheet with two columns: A) your current expenses and B) revised expenses. Fill out column A.
- Determine which of your expenses you can reduce or eliminate altogether (think dining out, luxury items, grocery bills, etc…). Input the new numbers into column C.
- Calculate the total from column B minus the total from column C. The resulting number represents the extra money you can save directly into a retirement account.
A great tool to use for managing your personal finances is Mint.com. You can see all of your financial transactions, set budgets, and see how your income, spending, and investments are linked over time.
Make sure you take into consideration other savings priorities, such as your emergency fund. No two financial plans are the same, so make your calculations based on your unique situation. For example, if you’re a freelancer whose income waxes and wanes, you might have to first save to compensate for slower months before you invest in a retirement account.
STEP 3: Max out your tax-advantaged options
After you’ve calculated how much you need to save, you can now start stashing your monthly savings in a number of “buckets.” Your first bucket should be your tax-advantaged retirement savings plans.
- If your employer matches certain contributions, e.g. 401(k), fund this at least up to the contribution match. This is FREE MONEY. Then, if you can, max out your contribution limit to reduce your taxable income.
- After you hit the max on your 401(k), look into any other tax-advantaged plans you’re eligible for, such as a Roth IRA. Max out this second plan as well.
- Other potential tax-advantaged vehicles for savings include whole life insurance and annuities.
- Finally, once all these are taken care of, use a non-tax advantaged account, like a regular brokerage account or bank, to invest.
Tax-Advantaged Savings Options
In the U.S., several tax-advantaged vehicles help you financially prepare for retirement by allowing you to save your hard-earned money in a tax-efficient way. These accounts are set up to either help you garner earnings on savings tax-free, meaning you accrue compound interest on your total amount without it being subject to taxes first, or shelter current income from income tax.
Below are the main types of retirement savings accounts. The vast majority of people will be eligible for one of these but, if you believe there’s another type of account that suits you, consult a financial adviser. Regardless of what you choose, make sure you understand the contribution limits, eligibility requirements, and other terms before you open an account.
A 401(k) is an employer-sponsored plan that allows you to save a portion of your paycheck without paying taxes, which is means your earnings will grow tax-deferred. You only pay taxes when you take out the money. Many employers match by contributing a certain percentage of your salary, typically 50 cents for every dollar invested. Most plans comprise stocks, bonds, and money market investments. Target-date funds, which combine stocks and bonds that become less and less risky as you approach retirement, are very common.
2014 Contribution Limits: $17,500
Withdrawal Penalty (cashing out before age 59½): 10%.
Roth 401(k)s are similar to traditional 401(k)s except for two main differences: With the Roth 401(k), you pay taxes when you contribute the money (as opposed to when you take out the money). Because of this, Roth 401(k)s are ideal if you know your tax rate is lower now than it will be at the time of withdrawal.
2014 Contribution Limits: $17,500. If you turn 50 by the end of the calendar year, you can contribute an additional $5,500.
Withdrawal Penalty (cashing out before age 59½): 10%. However, you are only penalized if you cash out earnings (not contributions) before 59½.
A 403(b) plan (a.k.a. tax-sheltered annuity) is a retirement plan for certain employees of public schools, government agencies, and nonprofits. Similar to the traditional 401(k), a 403(b) plan allows public employees to make tax-free contributions. One thing to note is it’s rare for employers to match 403(b) contributions.
2014 Contribution Limits: $17,500. If you’re older than 50, you can add another $5,500.
Withdrawal Penalty (cashing out before age 59½): 10%. However, in special cases, you can withdraw at any time if you retire at age 55 or older.
A traditional IRA (Individual Retirement Account) allows you to save pre-tax dollars, but is not sponsored by an employer. You can open an IRA account at mutual fund company, brokerage, or bank institution. You can invest in a variety of assets, such as stocks, bonds, mutual funds, or certificates of deposit (CDs).
If you’re supplementing your employer-sponsored retirement plan, the tax deduction for traditional IRA contributions is phased out if you have a modified adjusted gross incomes between $60,000 and $70,000 ($96,000 and $116,000 for couples).
2014 Contribution Limits: $5,500. If you’re 50 or older, you can add another $6,500.
Withdrawal Penalty (cashing out before age 59½): 10%.
With a Roth IRA account, you contribute after-tax money and withdraw tax-free. People usually use Roth IRAs after they have maxed out their 401(k) plans and want another retirement savings account. As of 2014, eligibility to make Roth IRA contributions is phased out once your income is between $114,000 and $129,000 ($181,000 to $191,000 for couples).
2014 Contribution Limits: $5,500. If you’re 50 or older, you can add an extra $6,500.
Withdrawal Penalty (cashing out before age 59½): 10%. If your account has been open for less than five years, your earnings are taxable and subject to penalty, but not your contributions. However, your earnings are tax- and penalty-free if you’ve had the account for at least five years.
A SEP IRA is used by small businesses, including sole proprietors and self-employed workers. The employer makes contributions with pre-tax dollars and the earnings grow tax-deferred. Both contributions and earnings are subject to income tax when withdrawn. If you have an employee who earns less than $500, you can exclude them from the plan; however, all other employees who’ve worked for you three out of the last five years must be included.
2014 Contribution Limits: A maximum of $52,000, up to 25% of your gross income up to $260,000.
Withdrawal Penalty (cashing out before age 59½): 10%.
A Simple IRA allows employees to make pre-tax contributions while employers match savings. Employers have the option to contribute up to 3% of earnings each year, or they can chip in 2% of the employee’s salary even if the employee does not save. Contributions and earnings grow tax-deferred and are both subject to income tax when withdrawn.
2014 Contribution Limits: $12,000. If you’re 50 by the end of the calendar year, you can add an extra $2,500.
Withdrawal Penalty (cashing out before age 59½): 10%.
A Solo 401(k) allows sole proprietors to contribute pre-tax dollars and earn tax-deferred. Earnings and contributions are subject to income tax paid when withdrawn. The Solo 401(k) is popular among those who are self-employed with no employees because of the plan’s relatively high contribution limit.
2014 Contribution Limits: $17,500. If you’re 50 by the end of the calendar year, an extra $5,500.
Withdrawal Penalty (cashing out before age 59½): 10%.
*TIP: Saver’s Credit. This is a tax benefit for low- and moderate-income workers who save for retirement. Individuals with an adjusted gross income of less than $30,000 ($60,000 for couples) who stash savings in a 401(k) or IRA plan can claim this credit on their taxes. This tax credit can range from $1,000 to $2,000.
*TIP: Transferring from one retirement account to another. If you have a retirement savings plan under your employer and are changing jobs, you can probably roll over your balance to a traditional IRA or another employer-sponsored plan–without paying taxes. This isn’t always a guarantee, so make sure you confirm with both companies. It’s advised not to have the balance paid out to you since 20% will be withheld in taxes.
Withdrawal Rules to Note
The IRS imposes different stipulations on each type of tax-advantaged savings account. Two general rules, however, apply across all types:
Required Minimum Distribution
When you reach the age of 70½, you must start taking distributions from your retirement accounts to avoid a penalty fee, typically 50% of the minimum distribution amount. The Roth IRA is an exception to this rule, which means you can let your money sit indefinitely as long as you’re alive. The first payment can be delayed until April 1 of the following year after you turn 70½. You must then take the RMD by December 31 of each year thereafter.
Early Withdrawal Penalty
If you cash out any portion of your retirement fund before age 59½, you must pay a 10% tax penalty fee and report it in your taxes. There are a few exceptions to this rule, below:
- You perform a direct rollover from one retirement account to another.
- You roll over a lump-sum payment to a qualified retirement account within 60 days.
- You are permanently or totally disabled.
- You are unemployed and need to pay for health insurance.
- You are paying for college expenses for yourself or a dependent.
- You bought a house and did not own a home in the last two years. You can receive a penalty-free IRA distribution of up to $10,000 ($20,000 for couples) to purchase, build, or rebuild your home.
- You need to pay for medical expenses exceeding 7.5% of your adjusted gross income.
- You inherited assets as a beneficiary of a deceased person’s IRA.
- The IRS levied your retirement account to pay off tax debts.
- You are are military reservist who was ordered or called to active duty after September 11, 2001.
Qualified Retirement Plans, e.g. 401(k) or 403(b)
- Distributions upon your death or disability.
- You are an employee who is leaving your job or retiring at age 55 or older.
- You are receiving the distribution as part of “substantially equal periodic payments.”
- You paid for medical expenses exceeding 7.5% of your adjusted gross income.
- The distributions were required by a divorce decree or separation agreement.
Non-Tax Advantaged Saving & Investing
You don’t need to stop saving once you’ve exhausted all your tax-advantaged options. You can save even more through other channels even if you won’t necessarily enjoy the same benefits.
As mentioned earlier, you should never let your cash sit without growing. Brokerage accounts enable you to buy and sell stocks, bonds, mutual funds, and other investments types. You can go through a traditional broker, such as Merrill Lynch, who will help you create a personalized investment strategy and offers comprehensive financial services. Alternatively, you can use a discount broker such as E-Trade where you can buy and sell your assets through a self-directed platform. All brokerage accounts require a minimum initial investment.
*TIP: Diversify. It’s generally not advised you put all your eggs in one basket. A popular approach is to diversify, which means investing in a mix of stocks, bonds, and other assets to reduce risk while optimizing growth.
*TIP: Stocks. History has thus far shown that stocks are the best option to grow your funds as much as possible. Based on the S&P 500 index, stocks have posted an average annual return of nearly 10% since 1926. This level of growth is higher than the growth of all other investment types, with bonds following second. However, stocks are also the riskiest investments with a lot more variability. This is why they’re usually recommended for younger savers, as they have more time to make up for any losses.
*TIP: Asset allocation investment funds. will help you beat inflation and accrue more cash over the years leading up to retirement. Allocation investment funds automatically invest your money to suit your age or investment objectives.
Traditional Bank Accounts
Add extra funds to your savings account. Most banks will allow you to open a second savings account if you already have one for other purposes. A separate account is helpful by enabling you to distinguish between your retirement savings and others, such as your six-month emergency fund.
Certificate of Deposits (CDs)
A CD is a savings certificate issued by a commercial bank that enables you to receive interest. A CD can last between one month to five years. If you withdraw money within that time period, you will likely be subject to a penalty fee. This penalty fee serves as great motivation to keep your savings untouched.
Rental Income Property
If you are financing or own a home, consider renting it out to a family. This might make sense if you can afford a place of your own that costs less than the rent you receive from your property.
Life Insurance Annuities
Life insurance annuity is when you make payments to a life insurance company in either one lump sum or regular payments. Once you retire, your provider begins making monthly payouts to you until your death. Payments cease at death, but any beneficiaries might receive the remainder if they’re written into the contract.
You may be able to qualify for a reverse mortgage if you’re 62 years or older. A reverse mortgage is essentially a loan that enables you to access your home equity and receive mortgage payments from the bank. However, this type of loan often comes with high fees and interest rates. Also, if you move out of your home, you’ll be required to start paying your mortgage again while you’re still alive. Reverse mortgages don’t always make sense for everyone, so make sure the benefits outweigh the costs before you commit.
Savings Tips to Get the Most out of Retirement
Tips for Any Age
Start NOW. Don’t wait! Don’t delay saving because you’re young and think you have lots of time. The earlier you start, the more money you’ll earn. And don’t give up because you’re close to retirement. No matter what your circumstances are, start saving ASAP.
Consult a financial adviser. If you have no idea where to start, feel uncomfortable opening a new IRA account, or need guidance on how to invest your money, it may behoove you to consult a professional, otherwise known as a Certified Financial Planner (CFP). If you want to open a 401(k) through your work, visit your company’s benefits office first.
Like with all services, not all CFPs are created equal, and choosing one very well depends on the size of your investments, income, and the stage you are in your life, among other factors. Look for a “fiduciary,” which basically indicates the CFP has made a pledge to act in your best interest. Be wary of commission-based planners, as they have more incentive to push investments that will benefit them more than they benefit you.
The best way to start searching for a CFP who suits you is to ask people you know for recommendations. If you can’t find a referral, visit the National Association of Personal Financial Advisors website at www.NAPFA.org to find fee-only planners.
Consider the age at which you started saving. Are you starting to save for retirement at 21 or 35 or 50? This will make a huge impact on your monthly contributions. You may also have to make some budgetary changes if you want to ensure you’re on the right path.
Save at the highest levels possible. Regardless of your age, make a budget. Cut any unnecessary expenses. If you can do without your cable subscription and dining out multiple times per week, save that extra cash for your retirement fund or investments. Increase your deferral rate, which is the amount your employer automatically deducts from your paycheck and adds to your 401(k). Continue increasing your deferral rate as your salary grows.
Invest in a diversified asset mix based on how much you’re willing to risk. As previously mentioned, don’t invest in just one type of asset. Generally, you can take more risks if you’re younger and less as you get older.
Tips For 20s and 30s
- If your employer offers a retirement plan, enroll as soon as you can.
- Ask your employer to automatically invest a portion of your paycheck in your 401(k). Many employers will start you off at 2-3%, but you can specifically ask them to transfer more. Start with 10%-15% if your budget allows it.
- Should you save for retirement or pay off student loans?
Close To Retirement Tips
- Cutting down expenses and adding more to your savings is more important than ever if you’re pressed for time.
- Use the catch-up options on your tax-advantaged plans if you’re over 55.
- If you’re eligible for Social Security benefits, consider delaying payments for a few years. The longer you wait, the more you’ll receive.
- Once you start withdrawing money at age 70½, cash out from tax-advantaged accounts last. Even a few years of compounding will make a noticeable difference.
- Consider working part-time even after you retire. Maybe you’ve always wanted to dabble in writing or help design bouquets at a flower shop. Now is a good time to do it, especially if you like staying busy!
- Consider relocating to an area with a lower cost of living.