So now you've done it. You've retired from the rat race, and you're enjoying the good life. You're sipping on your Mai Tai and contemplating the mysteries of your navel. You're on the verge of developing that One True Theory of Lint.
Working again is the farthest thing from your mind. Who needs that routine when there's so much more to do? Suddenly, a wild thought intrudes on your meditations. Is it possible that you could (gasp!) reenter the workforce? But why would you want to?
You might -- particularly if you retired before you became eligible for Social Security payments. As you recall, that check can't come until you are at least age 62. Even if you're already drawing Social Security, you may decide to resume work simply because you enjoy the personal contact with others.
Maybe you want to feel more productive, desire some "mad" money, or just want to have time away from your life's partner. Many retirees do. Further, they work because they want to, not because they have to. They just enjoy it. But what does it mean financially when they return to work?
The financial impact of a second career depends largely on the age at which you resume work. For those younger than age 62, a job serves to increase the ultimate benefit they will receive when they take Social Security.
In computing that benefit, the system looks at a person's entire working life. The computations are complicated, and use the best 35 of the 40 highest years' earnings. If you have a lot of zero-income years, that will lessen your ultimate benefit. Retire early, and you're bound to have a lot of those zero-income years. They will cause your Social Security check to be smaller than it could be. Resume work, and you'll pay into the Social Security system again, thus offsetting those zero-income years and increasing your benefit.
Is that a reason to go back to work? It might be. Then again, it might not. It's entirely up to you. If you've done a good job in planning for retirement, increasing your ultimate Social Security payment may not be an important factor to you. But be aware that an early retirement may come at a higher cost than you might have otherwise thought.
For those who do go back to work, at ages 65 and older there is no worry. Younger retirees, though, may see a reduction in their Social Security checks, depending on how much they earn in wages during the year. From ages 62 through 64, if you receive a Social Security check, you must forfeit one dollar of that check for every two dollars you earn above a certain maximum earnings limit.
That limit moves upward each year with inflation. In 2001, the limit is $10,680. Thus, a Social Security recipient who was age 63 and who receives $11,680 in wages in 2001 will be over the maximum earnings limit by $1,000. That excess will cause a $500 reduction in the Social Security benefits that person receives in 2001.
If you are under age 65 and return to work after you begin receiving your Social Security benefit, estimate what you will earn for the year and compare that amount to that year's maximum earnings limit. If you see you will exceed that limit, tell Social Security immediately. The agency will reduce your monthly check accordingly.
Fail to do so and those earnings will be reported to Social Security anyway when you file your income tax return for the year. The Social Security Administration (SSA) will then notify you of an overpayment because of excess earnings. It will recoup that overpayment from the following year's checks. You might not be working that year and may need your full Social Security payment.
What if your estimate was wrong and you didn't earn as much as you thought you would? In that instance, the SSA will restore the previously withheld benefit. You won't have lost a penny, but you will have avoided an overpayment.
Working after retirement has its good points and its bad points. Each of us must evaluate both. The point to remember here is to recognize the impact such work has on our Social Security benefits. Our endeavors may increase what we get from the system and -- possibly at the same time -- reduce the check we currently receive.
At this point, let’s take into consideration a few issues that need to be addressed.
domingo, 24 de junio de 2007
SOCIAL SECURITY
"Social security? Fahgeddaboutit! There'll be no Social Security by the time we need it. The system is broke, and it ain't gonna be fixed. It'll be all used up before you and I ever get there."
Do you really believe that? Many of those under the age of 50 do, and the younger the age, the more prevalent that belief. We don't think so -- we know who votes and that our fearless leaders can count.
We accept the fact that Social Security is here to stay, but we also recognize that the system will almost assuredly give future recipients less than it does today. Therefore, because it will continue to play an important part in how we plan for retirement, we seek to understand today's system and will closely watch how it evolves in the future. By doing so, we know we can plan for retirement with more precision than we could by ignoring it.
With few exceptions, wage earners today see a payroll deduction for FICA (Federal Insurance Contributions Act) that reduces each paycheck by 7.65%. Those who are self-employed see twice that shrinkage from their gross pay.
These involuntary "contributions" are really taxes that go toward Social Security (6.2%) and Medicare (1.45%). For now, let's concentrate on that part of your earnings that goes to Social Security. What does this "contribution" get you?
Basically, the taxes you pay for Social Security buy you three things: income in retirement, income for survivors, and income in case you become disabled before you are eligible to retire. You must work and pay into the system to be eligible to receive these benefits.
Generally, to qualify for full benefits you need to work at least ten years. The size of the benefit is based on your earnings and the number of years you have paid into the system. You may receive retirement benefits on or after age 62 and the longer you wait to do so, the higher that income will be.
Your spouse and, in some cases, your dependent children may also receive a benefit when you retire. If you die before or after retirement, a survivor's benefit may provide income to your spouse and dependent children depending on their age and work status. Become disabled and you, your spouse, and your dependent children may receive disability income based on your work record up to the point of disability.
In and of themselves, each of these benefits is a valuable asset to us all. They provide income protection to the family during and after our working careers. But do you know how much protection? Not unless you ask. And you should do so at least every three years.
If you do, you will receive something called a Social Security Statement (SSS), which is a great tool in helping you determine how much you need to set aside today to supplement Social Security in retirement. Remember, the system was designed to provide for minimum income needs in retirement, not all. Your own savings must add to that income so you can retire with the living standard you desire.
If you don't know how much you can expect from Social Security, you may devote more than you need to retirement savings, thus needlessly decreasing amounts available for other areas of your life today. The SSS will show you how much you can expect to receive if you elect to retire at age 62, your normal retirement age (65 or older depending on birth date), or 70.
Additionally, it will show you the earnings credited to your Social Security account for each year you have paid into the system; how much you would receive if you became disabled; and how much survivors would receive if you died. All that information is very important data on which to base your plans.
How do you get this data? Call the Social Security Administration at (800) 772-1213 and ask for Form SSA-7004, Request for Social Security Statement. When you get it in the mail, fill it out and return it. In about four weeks, you will have your SSS for review.
In a hurry, you say? Then visit The Social Security Administrations website and make your request online. Either way, just do it.
Then, when it arrives, look at the statement closely. See an error in your reported earnings? It happens, and it could affect your benefit. If there is an error, contact the SSA immediately to see how it can be corrected. Often, all that's required is for you to send in a copy of the Form W-2 you received for the year in question to get the error fixed. Sometimes it takes more effort to fix the mistake. Regardless, you want to ensure all data is correct, and the only way to do so is to take action now.
Most people just want to enjoy their retirement and not have to worry about working anymore. Still others find that the sedentary lifestyle just isn’t for them and they decide to delve into a second career.
Do you really believe that? Many of those under the age of 50 do, and the younger the age, the more prevalent that belief. We don't think so -- we know who votes and that our fearless leaders can count.
We accept the fact that Social Security is here to stay, but we also recognize that the system will almost assuredly give future recipients less than it does today. Therefore, because it will continue to play an important part in how we plan for retirement, we seek to understand today's system and will closely watch how it evolves in the future. By doing so, we know we can plan for retirement with more precision than we could by ignoring it.
With few exceptions, wage earners today see a payroll deduction for FICA (Federal Insurance Contributions Act) that reduces each paycheck by 7.65%. Those who are self-employed see twice that shrinkage from their gross pay.
These involuntary "contributions" are really taxes that go toward Social Security (6.2%) and Medicare (1.45%). For now, let's concentrate on that part of your earnings that goes to Social Security. What does this "contribution" get you?
Basically, the taxes you pay for Social Security buy you three things: income in retirement, income for survivors, and income in case you become disabled before you are eligible to retire. You must work and pay into the system to be eligible to receive these benefits.
Generally, to qualify for full benefits you need to work at least ten years. The size of the benefit is based on your earnings and the number of years you have paid into the system. You may receive retirement benefits on or after age 62 and the longer you wait to do so, the higher that income will be.
Your spouse and, in some cases, your dependent children may also receive a benefit when you retire. If you die before or after retirement, a survivor's benefit may provide income to your spouse and dependent children depending on their age and work status. Become disabled and you, your spouse, and your dependent children may receive disability income based on your work record up to the point of disability.
In and of themselves, each of these benefits is a valuable asset to us all. They provide income protection to the family during and after our working careers. But do you know how much protection? Not unless you ask. And you should do so at least every three years.
If you do, you will receive something called a Social Security Statement (SSS), which is a great tool in helping you determine how much you need to set aside today to supplement Social Security in retirement. Remember, the system was designed to provide for minimum income needs in retirement, not all. Your own savings must add to that income so you can retire with the living standard you desire.
If you don't know how much you can expect from Social Security, you may devote more than you need to retirement savings, thus needlessly decreasing amounts available for other areas of your life today. The SSS will show you how much you can expect to receive if you elect to retire at age 62, your normal retirement age (65 or older depending on birth date), or 70.
Additionally, it will show you the earnings credited to your Social Security account for each year you have paid into the system; how much you would receive if you became disabled; and how much survivors would receive if you died. All that information is very important data on which to base your plans.
How do you get this data? Call the Social Security Administration at (800) 772-1213 and ask for Form SSA-7004, Request for Social Security Statement. When you get it in the mail, fill it out and return it. In about four weeks, you will have your SSS for review.
In a hurry, you say? Then visit The Social Security Administrations website and make your request online. Either way, just do it.
Then, when it arrives, look at the statement closely. See an error in your reported earnings? It happens, and it could affect your benefit. If there is an error, contact the SSA immediately to see how it can be corrected. Often, all that's required is for you to send in a copy of the Form W-2 you received for the year in question to get the error fixed. Sometimes it takes more effort to fix the mistake. Regardless, you want to ensure all data is correct, and the only way to do so is to take action now.
Most people just want to enjoy their retirement and not have to worry about working anymore. Still others find that the sedentary lifestyle just isn’t for them and they decide to delve into a second career.
STOCKS AND BONDS
We start this discussion with a quote from James Bryant Conant, American diplomat:
Behold the turtle. He makes progress only when he sticks his neck out.
He knew that cracks along the sidewalk would trip up the turtle from time to time. But the one who finds a comfortable pace and keeps his eye on the horizon will go places.
In our investing analogy, those cracks represent market risk. When it comes to retirement planning, you’re going to have to cross those cracks in order to get anywhere.
Market risk (the chance you will lose money) and reward (the chance that your investments will head skyward) travel hand-in-hand in the daily marketplace. The greater the risk, the greater will be the potential return for taking that risk.
Equally true is the potential for loss, which quite handily explains why taking that risk should pay a greater reward. By and large, however, risk is pretty much a short-term phenomenon. That's particularly true in the stock market, which many regard as a quite risky investment.
Let's take a look at what various investments have returned over time.
Since 1926, U.S. Treasury Bills, which serve as a pretty efficient proxy for money market accounts, have yielded roughly 3.8% annually on average as of December 31, 2000, according to Ibbotson Associates.
While this may not seem like a lot today, remember that for much of this century, inflation was nonexistent, making a 3.8% average return very attractive until the 1960s. Had you put one dollar into T-Bills in 1926, you would have amassed $16.40 as of December 31, 2000.
Long-term government bonds have returned around 5.3% per year since 1926. The best 10-year holding period for bonds since then was that ending on December 31, 1991, when bonds returned 15.56% annually. The worst was that ending on December 31, 1959, when bonds had a negative return of 0.07% per year. Had you invested one dollar in long-term bonds in 1926, you would have $48.10 as of December 31, 2000.
Stocks have also been very good to investors. The Standard & Poor’s 500 composed of 500 international corporations, has returned an average of 11.1% per year since 1926 -- quite a bit higher than bonds. Surprisingly, the range of the returns for stocks is not that much larger than the range for bonds over the same period.
The worst 10-year holding period was that ending on December 31, 1938 when stocks declined 0.89% per year, including dividends. The best 10-year holding period for stocks since 1926 was that period ending on December 31, 1958, when stocks increased by 20.06% annually. Had you put one dollar into stocks in 1926, you would have seen it rise to $2,682.59 as of December 31, 2000.
The long-term odds are overwhelmingly in your favor. We know the market shifts everyday, sometimes sharply downward. That can be absolutely gut wrenching when it occurs, but history shows us that the inexorable pressure on the stock market is upward. The biggest bang for our buck will be found in stocks.
When you are looking for a vehicle for growth over the long-term, stocks are excellent choices. Of course, there is some risk, bu there is great reward to be made on the stock market.
Think now about your retirement. When will it occur -- 20 years from now, five years, tomorrow? If you're close to it, or are already retired, how long must the money last? Now think about your retirement investments. Is the bulk of your money positioned for long-term growth (read: stocks) or short-term stability and income (read: bonds and bills)?
The mix you have in these instruments is something you must decide for yourself. After all, you're the one that has to sleep at night. Recognize, though, that investing for retirement is a long-term goal. Hence, you truly want to shoot for the best growth in your investments that you can get. That won't be found in bonds or bills over the long haul. If you elect to keep most of your money there, almost assuredly in retirement you will be eating franks and beans for dinner because you have to, not because you want to.
Recognize, too, that you probably still have many years of productive life ahead of you after you finally do retire. While bonds and bills may appear appealing for the income and safety they provide, half or more of your portfolio must still be invested for growth to ensure you can maintain purchasing power.
Average inflation for the 10-year period ending December 31, 2000, has been 2.71% per year. At that rate, the cost of all we buy doubles every 26 years. To a retiree living on a fixed income, that can be nothing short of devastating. That’s why you see the need for growth in a retiree's portfolio.
The lesson here is to avoid overly conservative investing, both now and after you retire. Too much safety can be costly to your financial health in retirement. If you are a mutual fund investor (and most 401(k) or 403(b) plan participants are), focus your attention on stock funds.
Compare their records over time to that of the S&P 500 index and each other. For 5- and 10-year periods, most funds will be below the market. In a company plan, though, you won't have much choice. Use the fund that comes closest to the S&P 500 average.
If your plan offers a stock index fund, that will probably be your best choice. Outside of a company plan, an S & P 500 index fund invariably is better than a managed stock fund for the long haul.
If your company plan allows you to purchase your own securities or if you are investing outside of a plan, you have many more options.
Of course, you’ve been paying into social security for years. This, too, can provide you with some income.
Behold the turtle. He makes progress only when he sticks his neck out.
He knew that cracks along the sidewalk would trip up the turtle from time to time. But the one who finds a comfortable pace and keeps his eye on the horizon will go places.
In our investing analogy, those cracks represent market risk. When it comes to retirement planning, you’re going to have to cross those cracks in order to get anywhere.
Market risk (the chance you will lose money) and reward (the chance that your investments will head skyward) travel hand-in-hand in the daily marketplace. The greater the risk, the greater will be the potential return for taking that risk.
Equally true is the potential for loss, which quite handily explains why taking that risk should pay a greater reward. By and large, however, risk is pretty much a short-term phenomenon. That's particularly true in the stock market, which many regard as a quite risky investment.
Let's take a look at what various investments have returned over time.
Since 1926, U.S. Treasury Bills, which serve as a pretty efficient proxy for money market accounts, have yielded roughly 3.8% annually on average as of December 31, 2000, according to Ibbotson Associates.
While this may not seem like a lot today, remember that for much of this century, inflation was nonexistent, making a 3.8% average return very attractive until the 1960s. Had you put one dollar into T-Bills in 1926, you would have amassed $16.40 as of December 31, 2000.
Long-term government bonds have returned around 5.3% per year since 1926. The best 10-year holding period for bonds since then was that ending on December 31, 1991, when bonds returned 15.56% annually. The worst was that ending on December 31, 1959, when bonds had a negative return of 0.07% per year. Had you invested one dollar in long-term bonds in 1926, you would have $48.10 as of December 31, 2000.
Stocks have also been very good to investors. The Standard & Poor’s 500 composed of 500 international corporations, has returned an average of 11.1% per year since 1926 -- quite a bit higher than bonds. Surprisingly, the range of the returns for stocks is not that much larger than the range for bonds over the same period.
The worst 10-year holding period was that ending on December 31, 1938 when stocks declined 0.89% per year, including dividends. The best 10-year holding period for stocks since 1926 was that period ending on December 31, 1958, when stocks increased by 20.06% annually. Had you put one dollar into stocks in 1926, you would have seen it rise to $2,682.59 as of December 31, 2000.
The long-term odds are overwhelmingly in your favor. We know the market shifts everyday, sometimes sharply downward. That can be absolutely gut wrenching when it occurs, but history shows us that the inexorable pressure on the stock market is upward. The biggest bang for our buck will be found in stocks.
When you are looking for a vehicle for growth over the long-term, stocks are excellent choices. Of course, there is some risk, bu there is great reward to be made on the stock market.
Think now about your retirement. When will it occur -- 20 years from now, five years, tomorrow? If you're close to it, or are already retired, how long must the money last? Now think about your retirement investments. Is the bulk of your money positioned for long-term growth (read: stocks) or short-term stability and income (read: bonds and bills)?
The mix you have in these instruments is something you must decide for yourself. After all, you're the one that has to sleep at night. Recognize, though, that investing for retirement is a long-term goal. Hence, you truly want to shoot for the best growth in your investments that you can get. That won't be found in bonds or bills over the long haul. If you elect to keep most of your money there, almost assuredly in retirement you will be eating franks and beans for dinner because you have to, not because you want to.
Recognize, too, that you probably still have many years of productive life ahead of you after you finally do retire. While bonds and bills may appear appealing for the income and safety they provide, half or more of your portfolio must still be invested for growth to ensure you can maintain purchasing power.
Average inflation for the 10-year period ending December 31, 2000, has been 2.71% per year. At that rate, the cost of all we buy doubles every 26 years. To a retiree living on a fixed income, that can be nothing short of devastating. That’s why you see the need for growth in a retiree's portfolio.
The lesson here is to avoid overly conservative investing, both now and after you retire. Too much safety can be costly to your financial health in retirement. If you are a mutual fund investor (and most 401(k) or 403(b) plan participants are), focus your attention on stock funds.
Compare their records over time to that of the S&P 500 index and each other. For 5- and 10-year periods, most funds will be below the market. In a company plan, though, you won't have much choice. Use the fund that comes closest to the S&P 500 average.
If your plan offers a stock index fund, that will probably be your best choice. Outside of a company plan, an S & P 500 index fund invariably is better than a managed stock fund for the long haul.
If your company plan allows you to purchase your own securities or if you are investing outside of a plan, you have many more options.
Of course, you’ve been paying into social security for years. This, too, can provide you with some income.
JUST SIGN HERE
You're there. The magic day has arrived. The desk has been cleared, all personal mementos have been carted home, and you have received the proverbial gold watch. All that's left is to get with the Personnel Direction to tie up some remaining loose ends, and then you're out the door forever.
The Personnel Director smiles sardonically as you enter his office and says, "We just need you to fill out a few forms, and you'll be on your way. Tell us how you want to take your money, sign this irrevocable option form, and you're out of here. You've got to make the choice on your own, though.
I can't advise you at all. You know why: liability issues, fiduciary responsibilities, lawyers, etc. But you're a bright guy. After all, you managed to last a whole career here, didn't you? You'll figure it out. Just tell me how you want to handle your distribution in the next five minutes, though, okay? I'm a busy guy and can't spend all day chewing the fat with ex-employees."
Making that choice is a piece of cake isn't it? Just grab the money and run, right? It isn't often that you see six-or-seven figure sums staring you in the face, and it's all yours. Snatch that check, deposit it in your bank, and board that cruise liner to luxury land.
You can work out the nitty-gritty with your tax advisor at the end of the year. Right now your better half is waiting with luggage in hand and the camera slung over her shoulder. Get a move on, guy, 'cause time's a-wasting!
Now, don't be too hasty, or you may be in for a very rude awakening. This choice is a one-time decision. Go the wrong way now, and you could very well lose about half of the money you've accumulated through your working career.
The taxman would steal it away while you weren't looking. This decision is not one that can be ignored or left to the last minute. You must know all of your options, and you must know the tax impact of each choice. Without that knowledge, it's too easy to make a mistake that could haunt you for the rest of your life.
For most of us, the sums that become available at retirement are the largest amounts of money that we will control in our entire lives. The decision on how we handle that money is probably the most important one we will make, as well. Knowing that, you need to know that this is one of the times in our lives when it makes sense to consult the experts.
In this case, about six months prior to retirement we would see a skilled tax practitioner who's experienced in retirement plan distributions. We would have that expert run the various scenarios for us to see the potential results. Then, armed with that knowledge, we would choose the option that best fits our personal situation.
How much would that cost? Anywhere from $200 to $750 is a good guess. Measure that against a possibly huge loss from your retirement stash, and most people would agree the advice is well worth the cost.
Generally, normally, usually, the best choice for a retirement plan distribution is to transfer that money to an Individual Retirement Account. By doing so, the tax-deferred status of that sum continues and we reduce our current tax burden.
Be aware, though, an IRA is not always the right choice, which is another reason to seek expert tax advice regarding these distributions. Once the money is in the IRA, it is subject to IRA rules. That's no problem when a person is older than 59 ½. We're free to withdraw as much money as we want at any time, and we will only pay ordinary income taxes on that sum. But what if you retire at a younger age?
Retire at age 55 or older, but younger than age 59 ½, and two factors come into play. At age 55, you may retire and receive qualified retirement plan proceeds without penalty. You will pay ordinary income taxes on any sum you keep.
Put that money in an IRA, though, and now you must play by those rules. Take money out of the IRA, and you'll pay ordinary taxes plus a 10% early withdrawal penalty because you are under age 59 ½. Bummer! You don't want to pay taxes all at once on your retirement plan money. You want the tax deferral of the IRA.
You don't want to pay that lousy 10% penalty on IRA withdrawals. And you still need money to live on each year until you can get at the IRA. What do you do? Add another reason to go see the tax consultant, Fool. You have several options, but to choose one of them you need to know their ramifications. The expert can outline them for you.
You could keep just enough money from your retirement plan to live on until you reach age 59 ½, and transfer the rest to the IRA. You'd have to pay taxes on the sum you keep, though. You could transfer all the money to the IRA and then make withdrawals under Section 72(t) of the Internal Revenue Code.
That's an exception that allows you to avoid the 10% penalty. But do that and you have to live with the income the computations produce, which may not be enough cash. Further, you have to take that income for the longer of five years or until you reach age 59 ½. Therefore, once started, you can't stop at will. What's the best choice? Ask your tax consultant.
A great way to build up your retirement income is to invest in the stock market.
The Personnel Director smiles sardonically as you enter his office and says, "We just need you to fill out a few forms, and you'll be on your way. Tell us how you want to take your money, sign this irrevocable option form, and you're out of here. You've got to make the choice on your own, though.
I can't advise you at all. You know why: liability issues, fiduciary responsibilities, lawyers, etc. But you're a bright guy. After all, you managed to last a whole career here, didn't you? You'll figure it out. Just tell me how you want to handle your distribution in the next five minutes, though, okay? I'm a busy guy and can't spend all day chewing the fat with ex-employees."
Making that choice is a piece of cake isn't it? Just grab the money and run, right? It isn't often that you see six-or-seven figure sums staring you in the face, and it's all yours. Snatch that check, deposit it in your bank, and board that cruise liner to luxury land.
You can work out the nitty-gritty with your tax advisor at the end of the year. Right now your better half is waiting with luggage in hand and the camera slung over her shoulder. Get a move on, guy, 'cause time's a-wasting!
Now, don't be too hasty, or you may be in for a very rude awakening. This choice is a one-time decision. Go the wrong way now, and you could very well lose about half of the money you've accumulated through your working career.
The taxman would steal it away while you weren't looking. This decision is not one that can be ignored or left to the last minute. You must know all of your options, and you must know the tax impact of each choice. Without that knowledge, it's too easy to make a mistake that could haunt you for the rest of your life.
For most of us, the sums that become available at retirement are the largest amounts of money that we will control in our entire lives. The decision on how we handle that money is probably the most important one we will make, as well. Knowing that, you need to know that this is one of the times in our lives when it makes sense to consult the experts.
In this case, about six months prior to retirement we would see a skilled tax practitioner who's experienced in retirement plan distributions. We would have that expert run the various scenarios for us to see the potential results. Then, armed with that knowledge, we would choose the option that best fits our personal situation.
How much would that cost? Anywhere from $200 to $750 is a good guess. Measure that against a possibly huge loss from your retirement stash, and most people would agree the advice is well worth the cost.
Generally, normally, usually, the best choice for a retirement plan distribution is to transfer that money to an Individual Retirement Account. By doing so, the tax-deferred status of that sum continues and we reduce our current tax burden.
Be aware, though, an IRA is not always the right choice, which is another reason to seek expert tax advice regarding these distributions. Once the money is in the IRA, it is subject to IRA rules. That's no problem when a person is older than 59 ½. We're free to withdraw as much money as we want at any time, and we will only pay ordinary income taxes on that sum. But what if you retire at a younger age?
Retire at age 55 or older, but younger than age 59 ½, and two factors come into play. At age 55, you may retire and receive qualified retirement plan proceeds without penalty. You will pay ordinary income taxes on any sum you keep.
Put that money in an IRA, though, and now you must play by those rules. Take money out of the IRA, and you'll pay ordinary taxes plus a 10% early withdrawal penalty because you are under age 59 ½. Bummer! You don't want to pay taxes all at once on your retirement plan money. You want the tax deferral of the IRA.
You don't want to pay that lousy 10% penalty on IRA withdrawals. And you still need money to live on each year until you can get at the IRA. What do you do? Add another reason to go see the tax consultant, Fool. You have several options, but to choose one of them you need to know their ramifications. The expert can outline them for you.
You could keep just enough money from your retirement plan to live on until you reach age 59 ½, and transfer the rest to the IRA. You'd have to pay taxes on the sum you keep, though. You could transfer all the money to the IRA and then make withdrawals under Section 72(t) of the Internal Revenue Code.
That's an exception that allows you to avoid the 10% penalty. But do that and you have to live with the income the computations produce, which may not be enough cash. Further, you have to take that income for the longer of five years or until you reach age 59 ½. Therefore, once started, you can't stop at will. What's the best choice? Ask your tax consultant.
A great way to build up your retirement income is to invest in the stock market.
UNCLE SAM’S PART
Conventional wisdom holds that it's almost always better to invest in a tax-deferred vehicle like a 401(k) plan or IRA than in an after-tax investment. This gospel holds that even if the initial investment itself is made with money that's already been taxed, the earnings accumulate untaxed, and this adds immeasurably to the positive power of compounding.
Because your earnings (and often the contribution) are untaxed until you begin withdrawing money in retirement, the government is in effect providing you leverage in the investment. This boost thus allows you to amass far more money for retirement than you could in a taxable alternative.
Additionally, you control when it gets taxed, and at what rate, by deciding on the amount of the withdrawal and when to take it. By contrast, in conventional investments, you are taxed on all money going in and on all dividends and gains in the year they are received.
All things being equal, that general idea is true. But all things are not equal. When should you elect to invest in a tax-deferred vehicle as opposed to a taxable alternative? Use the plan at least up to the level where you obtain the maximum matching contribution from your employer. Don't turn down that free money.
Let's say your employer matches any contribution up to 6% of your salary. Most people would contribute that 6%, but beyond that they would compare the returns available in the plan investments to those outside of the plan.
Here's a simple comparison between a tax-deferred investment like a 401(k) plan and an ordinary taxable investment. Let's assume that ultimately you'll withdraw all your money from the tax-deferred account, and you'll be taxed on that amount at today's marginal tax rates.
Of course, it's not quite that simple because, in reality, you'll decide how that money eventually comes out -- maybe all at once, maybe piecemeal, leaving the rest to compound. But for this simplistic analysis, let’s just say it’s enough. Let's also agree that all gains in the taxable account will be taxed at ordinary rates, even though we know that at least half would be taxed at the lesser capital gains rate.
For our example:
TR = your marginal tax rate
Ra = the return you expect in the after-tax investment
Rp = the return you expect in the tax-deferred investment
Any earnings in the after-tax account will be taxed. Therefore, the equivalent rates of return in a tax-deferred or after-tax account can be expressed as (1-TR) * Ra = Rp, which can be restated as Ra = Rp / (1-TR).
All right now uncross those eyes. This formula gives you the rate of return you need in an after-tax account to equal the return you would get in a tax-deferred account after it, too, had been taxed at some point in the future. Let's take an example.
Let's say I'm in a 28% federal tax bracket, that I get no matching contribution from my employer or have already reached the maximum match, and that I deposit $100 into my tax-deferred account. I expect to earn 10% on that deposit. What rate of return do I have to get in an after-tax investment to equal what I'm getting in that plan?
Well, by using the formula, I get:
Ra = Rp / (1 - TR)
Ra = 0.10 / (1 - 0.28)
Ra = 0.10 / 0.72 = 0.138888 = ~13.89%
Therefore, if I deposited $72 in an after-tax investment (the equivalent of $100 deposited in a tax-deferred account) and I earned at least 13.89% on that investment, I would do just as well after taxes as I would in a tax-deferred investment earning a 10% return. If I could get more than 13.89%, I would do better.
Need a little proof? In the tax-deferred account a $100 deposit would earn $10 at a 10% return, giving a total of $110. Withdrawing that $110 and paying taxes at 28% would leave $79.20. $72 in an after-tax account would earn $10 at 13.89% or $7.20 after taxes, leaving $79.20 total in that account after taxes.
Use a 401(k) or similar plan to get the maximum employer matching contribution available. Beyond that level, compare your before-tax and after-tax investment options and select the one that provides the highest after-tax return.
But remember this: If you choose an alternative to the 401(k), then you must be just as dedicated and disciplined within that investment as you would have been within the 401(k). That means you must make your deposits in that investment each and every payday without fail.
It also means your deposit must increase at the same time and at the same rate as your pay does. Fail to adhere to that regimen, and you will neither equal nor beat the 401(k). The 401(k) demands these contributions and increases via automatic payroll deduction, so to keep pace with or to better that vehicle you must apply the same technique in any alternative.
The Taxpayer Relief Act of 1997 provides a unique opportunity to those of us who have reached the maximum contribution we wish to make to our employer plans. It's called a Roth IRA and may be established anytime after January 1, 1998.
With a Roth IRA, you may make a nondeductible deposit of up to $2,000 per year, allow the earnings to accumulate tax-free through the years, and ultimately withdraw all of the proceeds tax-free. This is an excellent vehicle for monies to be invested outside of an employer-provided plan.
Many people think the following phrase is true: "Retirees enjoy a lesser tax burden than those who work.” That may have been true in the grey and distant past, but it certainly isn't true now. Today, many retirees end up in exactly the same marginal income tax bracket after retirement as before. That situation will definitely be true for those who follow a Foolish path in their retirement planning.
Nevertheless, retirees as a group do tend to pay the taxman less in absolute dollars than they did before. Common sense should tell us why: they have less taxable income. The money they live on usually comes from savings (taxable), pensions (taxable), and Social Security (potentially taxable in part).
The addition of Social Security, which is never fully taxed, reduces the actual taxable income. Thus, a retiree could draw exactly the same annual income as she did when she worked, but pay less total dollars in taxes because part -- if not all -- of the Social Security income is received tax-free. Despite paying less dollars, though, that same retiree will still be in the same marginal tax bracket, albeit at the lower end of that range.
Throw some work in the mix and the plot thickens. Wages from work get taxed as usual. Social Security is trimmed as the retiree exceeds the maximum earnings limit for the year. In extreme cases, work could cause a confiscatory tax of over 80% on those wages when ordinary income taxes are added to the Social Security forfeiture. Kind of makes one wonder why anyone would want to work under that scenario, doesn't it?
If you're looking for a greatly reduced tax burden in retirement, forget it. The best you will achieve is a lower average tax rate on all the money flowing into the household for the year. Compute that rate by dividing your total taxes by all of your income, both taxable and nontaxable. For many retirees, the significant proportion of that income represented by untaxed Social Security payments does indeed cause the average tax rate to drop.
When and how does Social Security get taxed, you ask? The computation, like all Infernal [sic] Revenue Service requirements, is a tad complicated. In fact, they have a special worksheet just for that purpose. The math starts with your Adjusted Gross Income.
To that you add one-half of all Social Security benefits and all unearned income received during the year. The latter almost always comes from tax-exempt interest received from municipal bonds (a favorite retiree investment). If the computed total is larger than $25,000 (single) or $32,000 (married filing jointly), then up to 50% of the Social Security benefit will be taxed. If the amount is larger than $34,000 (single) or $44,000 (married filing jointly), then up to 85% of the Social Security benefit will be taxed.
To determine the exact amount that will be taxed; you must complete the handy-dandy worksheet supplied by the IRS for that purpose. Doesn't that sound like fun?
OK! Now we know retirees have to pay taxes, too. But don't they get any breaks? What happened to the senior citizen discounts? Surely the government can't be that cruel. What is this, the Spanish Inquisition? Heck, I remember Gram and Gramps each getting an extra personal exemption because they were older than age 65. That's just gotta be there for today's retirees, too, right?
Uh... well... actually, no it's not. It's true that exception did exist at one time, but it got wiped out during one of the efforts by Congress to "simplify" our tax laws. Our leaders left something in return, though.
Currently, those over age 65 who do not itemize deductions on their income tax return get a higher standard deduction than a similar filer who is younger. The amount varies each year just as the regular standard deduction does. Hey... it isn’t much, but at least it's something. Provided, that is, you don't itemize on your tax return after you retire. Retirees who itemize get zilch.
There is one more situation in which retirees possibly can lessen their tax burden, and that's in the area of real estate taxes. Many states will grant real estate tax exceptions to homeowners of a specified age, usually age 60 or older.
These exceptions vary and may take the form of a partial exemption, a waiver, a freeze on assessment rates, or a suspension of payment until death. For those pressed for income, investigation in this area is definitely warranted to determine what the state of residence will permit.
While it's highly unlikely the tax can be avoided completely, it's equally true that when cash is tight, every dollar counts. In financial situations like that, every dollar not given to the taxman is a dollar earned.
As my daddy says, "There was a time when you saved up for your old age; now you save up for April 15th." I guess he's telling the truth. He's been retired for over 20 years now, and he still screams when he pays Uncle Sam.
Let's wind up with another old saw, "Only two things are certain: death and taxes." So you pay some taxes. It's better than the alternative, no?
When you retire, you’ll be presented with papers to sign regarding any bonuses or pension funds.
Because your earnings (and often the contribution) are untaxed until you begin withdrawing money in retirement, the government is in effect providing you leverage in the investment. This boost thus allows you to amass far more money for retirement than you could in a taxable alternative.
Additionally, you control when it gets taxed, and at what rate, by deciding on the amount of the withdrawal and when to take it. By contrast, in conventional investments, you are taxed on all money going in and on all dividends and gains in the year they are received.
All things being equal, that general idea is true. But all things are not equal. When should you elect to invest in a tax-deferred vehicle as opposed to a taxable alternative? Use the plan at least up to the level where you obtain the maximum matching contribution from your employer. Don't turn down that free money.
Let's say your employer matches any contribution up to 6% of your salary. Most people would contribute that 6%, but beyond that they would compare the returns available in the plan investments to those outside of the plan.
Here's a simple comparison between a tax-deferred investment like a 401(k) plan and an ordinary taxable investment. Let's assume that ultimately you'll withdraw all your money from the tax-deferred account, and you'll be taxed on that amount at today's marginal tax rates.
Of course, it's not quite that simple because, in reality, you'll decide how that money eventually comes out -- maybe all at once, maybe piecemeal, leaving the rest to compound. But for this simplistic analysis, let’s just say it’s enough. Let's also agree that all gains in the taxable account will be taxed at ordinary rates, even though we know that at least half would be taxed at the lesser capital gains rate.
For our example:
TR = your marginal tax rate
Ra = the return you expect in the after-tax investment
Rp = the return you expect in the tax-deferred investment
Any earnings in the after-tax account will be taxed. Therefore, the equivalent rates of return in a tax-deferred or after-tax account can be expressed as (1-TR) * Ra = Rp, which can be restated as Ra = Rp / (1-TR).
All right now uncross those eyes. This formula gives you the rate of return you need in an after-tax account to equal the return you would get in a tax-deferred account after it, too, had been taxed at some point in the future. Let's take an example.
Let's say I'm in a 28% federal tax bracket, that I get no matching contribution from my employer or have already reached the maximum match, and that I deposit $100 into my tax-deferred account. I expect to earn 10% on that deposit. What rate of return do I have to get in an after-tax investment to equal what I'm getting in that plan?
Well, by using the formula, I get:
Ra = Rp / (1 - TR)
Ra = 0.10 / (1 - 0.28)
Ra = 0.10 / 0.72 = 0.138888 = ~13.89%
Therefore, if I deposited $72 in an after-tax investment (the equivalent of $100 deposited in a tax-deferred account) and I earned at least 13.89% on that investment, I would do just as well after taxes as I would in a tax-deferred investment earning a 10% return. If I could get more than 13.89%, I would do better.
Need a little proof? In the tax-deferred account a $100 deposit would earn $10 at a 10% return, giving a total of $110. Withdrawing that $110 and paying taxes at 28% would leave $79.20. $72 in an after-tax account would earn $10 at 13.89% or $7.20 after taxes, leaving $79.20 total in that account after taxes.
Use a 401(k) or similar plan to get the maximum employer matching contribution available. Beyond that level, compare your before-tax and after-tax investment options and select the one that provides the highest after-tax return.
But remember this: If you choose an alternative to the 401(k), then you must be just as dedicated and disciplined within that investment as you would have been within the 401(k). That means you must make your deposits in that investment each and every payday without fail.
It also means your deposit must increase at the same time and at the same rate as your pay does. Fail to adhere to that regimen, and you will neither equal nor beat the 401(k). The 401(k) demands these contributions and increases via automatic payroll deduction, so to keep pace with or to better that vehicle you must apply the same technique in any alternative.
The Taxpayer Relief Act of 1997 provides a unique opportunity to those of us who have reached the maximum contribution we wish to make to our employer plans. It's called a Roth IRA and may be established anytime after January 1, 1998.
With a Roth IRA, you may make a nondeductible deposit of up to $2,000 per year, allow the earnings to accumulate tax-free through the years, and ultimately withdraw all of the proceeds tax-free. This is an excellent vehicle for monies to be invested outside of an employer-provided plan.
Many people think the following phrase is true: "Retirees enjoy a lesser tax burden than those who work.” That may have been true in the grey and distant past, but it certainly isn't true now. Today, many retirees end up in exactly the same marginal income tax bracket after retirement as before. That situation will definitely be true for those who follow a Foolish path in their retirement planning.
Nevertheless, retirees as a group do tend to pay the taxman less in absolute dollars than they did before. Common sense should tell us why: they have less taxable income. The money they live on usually comes from savings (taxable), pensions (taxable), and Social Security (potentially taxable in part).
The addition of Social Security, which is never fully taxed, reduces the actual taxable income. Thus, a retiree could draw exactly the same annual income as she did when she worked, but pay less total dollars in taxes because part -- if not all -- of the Social Security income is received tax-free. Despite paying less dollars, though, that same retiree will still be in the same marginal tax bracket, albeit at the lower end of that range.
Throw some work in the mix and the plot thickens. Wages from work get taxed as usual. Social Security is trimmed as the retiree exceeds the maximum earnings limit for the year. In extreme cases, work could cause a confiscatory tax of over 80% on those wages when ordinary income taxes are added to the Social Security forfeiture. Kind of makes one wonder why anyone would want to work under that scenario, doesn't it?
If you're looking for a greatly reduced tax burden in retirement, forget it. The best you will achieve is a lower average tax rate on all the money flowing into the household for the year. Compute that rate by dividing your total taxes by all of your income, both taxable and nontaxable. For many retirees, the significant proportion of that income represented by untaxed Social Security payments does indeed cause the average tax rate to drop.
When and how does Social Security get taxed, you ask? The computation, like all Infernal [sic] Revenue Service requirements, is a tad complicated. In fact, they have a special worksheet just for that purpose. The math starts with your Adjusted Gross Income.
To that you add one-half of all Social Security benefits and all unearned income received during the year. The latter almost always comes from tax-exempt interest received from municipal bonds (a favorite retiree investment). If the computed total is larger than $25,000 (single) or $32,000 (married filing jointly), then up to 50% of the Social Security benefit will be taxed. If the amount is larger than $34,000 (single) or $44,000 (married filing jointly), then up to 85% of the Social Security benefit will be taxed.
To determine the exact amount that will be taxed; you must complete the handy-dandy worksheet supplied by the IRS for that purpose. Doesn't that sound like fun?
OK! Now we know retirees have to pay taxes, too. But don't they get any breaks? What happened to the senior citizen discounts? Surely the government can't be that cruel. What is this, the Spanish Inquisition? Heck, I remember Gram and Gramps each getting an extra personal exemption because they were older than age 65. That's just gotta be there for today's retirees, too, right?
Uh... well... actually, no it's not. It's true that exception did exist at one time, but it got wiped out during one of the efforts by Congress to "simplify" our tax laws. Our leaders left something in return, though.
Currently, those over age 65 who do not itemize deductions on their income tax return get a higher standard deduction than a similar filer who is younger. The amount varies each year just as the regular standard deduction does. Hey... it isn’t much, but at least it's something. Provided, that is, you don't itemize on your tax return after you retire. Retirees who itemize get zilch.
There is one more situation in which retirees possibly can lessen their tax burden, and that's in the area of real estate taxes. Many states will grant real estate tax exceptions to homeowners of a specified age, usually age 60 or older.
These exceptions vary and may take the form of a partial exemption, a waiver, a freeze on assessment rates, or a suspension of payment until death. For those pressed for income, investigation in this area is definitely warranted to determine what the state of residence will permit.
While it's highly unlikely the tax can be avoided completely, it's equally true that when cash is tight, every dollar counts. In financial situations like that, every dollar not given to the taxman is a dollar earned.
As my daddy says, "There was a time when you saved up for your old age; now you save up for April 15th." I guess he's telling the truth. He's been retired for over 20 years now, and he still screams when he pays Uncle Sam.
Let's wind up with another old saw, "Only two things are certain: death and taxes." So you pay some taxes. It's better than the alternative, no?
When you retire, you’ll be presented with papers to sign regarding any bonuses or pension funds.
EMPLOYER PLANS
You've done your homework and now you know how much you have to accumulate to be able to retire and live comfortably. What now? The next step is to milk your employer for everything you can.
No, we don't mean that you should confiscate post-its for at-home use or try to create a black market for hole punchers. We're talking about retirement plans.
Most mid-size and large employers have a retirement plan in place for their employees. Many have two and some three or more. These plans come in a wide variety of flavors, some good and some not so good. All of these, though, can help you achieve your retirement desires if you understand them fully and integrate them into your planning.
Remember that employee handbook you received on the day you were hired -- the drab document you tucked away under some papers next to the half-eaten Snickers bar? Dig it out, dust it off, and read it. Buried in those pages you will find a summary plan description of the retirement plan(s) available to you as an employee.
Those pages will tell you what kind of plan you have, when you become eligible to participate, and the ultimate benefit you will receive. Is it boring reading? You betcha! But what you'll find in those pages is your FREE MONEY.
What will that free money look like? It might be called a "defined benefit plan" or a "company pension" -- phrases used to describe one type of plan commonly offered by employers. In this vehicle, employers typically do all the funding with no contributions by employees.
The final benefit is determined by a formula often based on years of service, an average wage, and a percent of pay. For instance, the plan could say your final benefit will be a "joint and 50% annuity calculated as 1.5% times your years of credited service times the average of your last three years' base annual wage."
What does that mumbo-jumbo mean to you? It means that with 30 years of service, at retirement your pension will replace 45% of your average annual wage for the last three years of work. It means it's less money you have to save each year between now and retirement because your employer is relieving you of part of that burden. And that means more of your resources can be devoted to other goals that are also important, like maybe putting the kids through college.
The summary plan description will also tell you your options at retirement. You may be able to receive a lump sum payment instead of a lifetime annuity. That way, if the plan has no automatic cost of living adjustment to the annuity payment, you can invest the money to achieve that growth.
Maybe you can take an annuity that will give a surviving spouse more than half your benefit after you die, something like two-thirds or 100% instead. And the summary plan description will tell you how long you have to be on the job until the money is 100% yours (the vesting schedule); it will tell you what happens if you leave your job before retirement, and what happens should you leave this world earlier than you anticipate.
This is all valuable information because it helps to refine the assumptions we must make in the calculation of our retirement needs.
Say your company offers a 401(k) plan. Take out your 401(k) summary plan description and look for:
• When you may participate
• The types and perhaps the risks of the investment options you have within the plan
• How often you may switch between those options
• Whether early withdrawals for hardships or personal loans are permitted
• What distribution options are available when you separate or retire
• How much your employer will contribute to the plan on your behalf, and when you will vest in those contributions? This is the FREE MONEY.
Why is it free? For one, your contributions to a 401(k) plan help reduce your tax bill because they don't count against your taxable income for the year. That means tax-free money towards your retirement savings.
Of far more importance, though, is an employer's contribution on your behalf. While these contributions will vary from employer to employer, typically employers match your contribution from 50 cents on the dollar up to 6% of your pay. That means if you put in 6% of your paycheck, your employer will match that by contributing 3%. (That's 3% of your paycheck in free money.)
You should jump at this opportunity. Rarely, if ever, should you turn it down. We know there is no risk-free, untaxed way to get an immediate 50% return on our money in any alternative investment we can make. Sure, most 401(k) plans use high-cost, mediocre performing mutual funds as their investment of choice.
Yet, even there, the immediate return of 50% on our money in every year we contribute would take years to top in anything else. Spurn this offer by an employer, and you exchange needless risk and taxes to leave found money on the table. When it comes to 401(k) plans, you should follow this path by grabbing all the free money your employer offers. What better way to lessen your savings burden?
You will still have to worry about taxes and things of that nature.
No, we don't mean that you should confiscate post-its for at-home use or try to create a black market for hole punchers. We're talking about retirement plans.
Most mid-size and large employers have a retirement plan in place for their employees. Many have two and some three or more. These plans come in a wide variety of flavors, some good and some not so good. All of these, though, can help you achieve your retirement desires if you understand them fully and integrate them into your planning.
Remember that employee handbook you received on the day you were hired -- the drab document you tucked away under some papers next to the half-eaten Snickers bar? Dig it out, dust it off, and read it. Buried in those pages you will find a summary plan description of the retirement plan(s) available to you as an employee.
Those pages will tell you what kind of plan you have, when you become eligible to participate, and the ultimate benefit you will receive. Is it boring reading? You betcha! But what you'll find in those pages is your FREE MONEY.
What will that free money look like? It might be called a "defined benefit plan" or a "company pension" -- phrases used to describe one type of plan commonly offered by employers. In this vehicle, employers typically do all the funding with no contributions by employees.
The final benefit is determined by a formula often based on years of service, an average wage, and a percent of pay. For instance, the plan could say your final benefit will be a "joint and 50% annuity calculated as 1.5% times your years of credited service times the average of your last three years' base annual wage."
What does that mumbo-jumbo mean to you? It means that with 30 years of service, at retirement your pension will replace 45% of your average annual wage for the last three years of work. It means it's less money you have to save each year between now and retirement because your employer is relieving you of part of that burden. And that means more of your resources can be devoted to other goals that are also important, like maybe putting the kids through college.
The summary plan description will also tell you your options at retirement. You may be able to receive a lump sum payment instead of a lifetime annuity. That way, if the plan has no automatic cost of living adjustment to the annuity payment, you can invest the money to achieve that growth.
Maybe you can take an annuity that will give a surviving spouse more than half your benefit after you die, something like two-thirds or 100% instead. And the summary plan description will tell you how long you have to be on the job until the money is 100% yours (the vesting schedule); it will tell you what happens if you leave your job before retirement, and what happens should you leave this world earlier than you anticipate.
This is all valuable information because it helps to refine the assumptions we must make in the calculation of our retirement needs.
Say your company offers a 401(k) plan. Take out your 401(k) summary plan description and look for:
• When you may participate
• The types and perhaps the risks of the investment options you have within the plan
• How often you may switch between those options
• Whether early withdrawals for hardships or personal loans are permitted
• What distribution options are available when you separate or retire
• How much your employer will contribute to the plan on your behalf, and when you will vest in those contributions? This is the FREE MONEY.
Why is it free? For one, your contributions to a 401(k) plan help reduce your tax bill because they don't count against your taxable income for the year. That means tax-free money towards your retirement savings.
Of far more importance, though, is an employer's contribution on your behalf. While these contributions will vary from employer to employer, typically employers match your contribution from 50 cents on the dollar up to 6% of your pay. That means if you put in 6% of your paycheck, your employer will match that by contributing 3%. (That's 3% of your paycheck in free money.)
You should jump at this opportunity. Rarely, if ever, should you turn it down. We know there is no risk-free, untaxed way to get an immediate 50% return on our money in any alternative investment we can make. Sure, most 401(k) plans use high-cost, mediocre performing mutual funds as their investment of choice.
Yet, even there, the immediate return of 50% on our money in every year we contribute would take years to top in anything else. Spurn this offer by an employer, and you exchange needless risk and taxes to leave found money on the table. When it comes to 401(k) plans, you should follow this path by grabbing all the free money your employer offers. What better way to lessen your savings burden?
You will still have to worry about taxes and things of that nature.
WHAT WILL IT COST
Pundits say you will need 60% to 85% of your gross household income today to sustain the same lifestyle after you retire. In theory, the higher your income today, the closer you are to the lower end of that scale. Fair enough, but you should look at this issue in a slightly different fashion.
Sure, we could sit down to a long, drawn-out process in which we look at our expenses and try to anticipate what they would be in retirement. But why bother? After all, retirement is a long way off, and we have no real idea of what those expenses will be then.
You do, though, know that you live comfortably today (we hope) and that it's unlikely you'll be saving money or paying FICA (unless you choose to work) after you retire. Therefore, excluding those items from your gross income, you can come up with a number that's fairly close to what it would take to sustain your current lifestyle.
Simply put, you want a retirement income that equals our gross income today less all savings and all FICA taxes.
But you still have to decide what income you will need in retirement to live the way you want. Some folks can get by on much less than they use now, while others may decide they want more. It's a personal choice for all of us. So, pick a number.
Now, let's talk about inflation. How much does our retirement savings have to be in the year we retire after it has been adjusted for inflation over the years between now and then? What should that inflation rate be anyway?
For how many years will you draw that income? Should it keep pace with inflation throughout those years? Will you draw down your starting retirement portfolio to support your income needs or just live off the earnings while never touching the principal? If you can answer those questions, then you can determine the starting portfolio you need at retirement to support you for the rest of your life.
We're getting into the realm of some pretty sophisticated calculations based on several assumptions that, if changed, could radically alter our results. What we need is a quick-and-dirty way to give us an idea of what we need to do to get started. We'll save the more esoteric efforts for later.
So forget about inflation for the moment. Ignore Social Security and any company pension you may get. Pretend your money gets no return now or after retirement. But do count whatever you have saved for retirement as of today.
Let's say that amounts to $20,000. Further, let's say you want an annual income of $30,000 in today's dollars after you retire. You expect to retire in 25 years, that you will live 20 years after you retire, and that you expect to meet your maker waving your last dollar bill.
How much do you need to amass by the start of your retirement to support yourself in your golden years, and how much do you have to save each year between now and then to get there?
Let's see. You need $30,000 a year for 20 years, so that comes to $600,000 needed in the first year of retirement. You already have $20,000 of that, so that means you're only $580,000 short. Divide the shortage by the 25 years you have to save it up, and you discover you only have to cough up $23,200 annually between now and the time you retire to a life of leisure.
Too much is omitted from this simple approach to provide a meaningful answer to the question at hand. Worse, the answer we do get makes the whole idea of saving for retirement seem to be an impossible task, but this is far from true.
To do things right, we must take a cold, hard, objective look at our desired income, subject it to a rational choice of assumptions, and make some detailed calculations.
The best way to do the calculations is with one of the readily available software packages available commercially, such as Quicken Financial Planner or you can find many different financial calculators online that can help.
Before you use any of these tools, you need some preliminary information. At a minimum, you want to:
1. Decide on the annual income you desire in today's dollars.
2. Pick a retirement date.
3. Determine your lifetime average inflation rate.
4. Determine the average rate of return you expect on your investments before and after retirement.
5. Determine the current market value of all your investments to include regular accounts, IRAs, and company tax-deferred savings plans like 401(k) plans.
6. Obtain an estimate of any company-provided pension benefit.
7. Obtain an estimate of future Social Security benefits
8. Armed with this data, you can determine the annual savings required for you to enjoy the good life. You will also be able to play "what if" games and see the results quickly should you decide to vary things like inflation, rates of return, date of retirement, and desired income.
We'll leave you with one last thought. The earlier you start, the easier it will be for you to amass the dollars you will need on the day you retire.
Say you put $1,000 per year for 25 years into an investment earning 10% annually, you would have $108,182. Wait just five years before starting that process, and on the same date in the future you would end up with $63,002. That $5,000 you "saved" by waiting just cost you $45,180 in tropical drinks.
Your employer can be a great place for you to start with to find the money that you need.
Sure, we could sit down to a long, drawn-out process in which we look at our expenses and try to anticipate what they would be in retirement. But why bother? After all, retirement is a long way off, and we have no real idea of what those expenses will be then.
You do, though, know that you live comfortably today (we hope) and that it's unlikely you'll be saving money or paying FICA (unless you choose to work) after you retire. Therefore, excluding those items from your gross income, you can come up with a number that's fairly close to what it would take to sustain your current lifestyle.
Simply put, you want a retirement income that equals our gross income today less all savings and all FICA taxes.
But you still have to decide what income you will need in retirement to live the way you want. Some folks can get by on much less than they use now, while others may decide they want more. It's a personal choice for all of us. So, pick a number.
Now, let's talk about inflation. How much does our retirement savings have to be in the year we retire after it has been adjusted for inflation over the years between now and then? What should that inflation rate be anyway?
For how many years will you draw that income? Should it keep pace with inflation throughout those years? Will you draw down your starting retirement portfolio to support your income needs or just live off the earnings while never touching the principal? If you can answer those questions, then you can determine the starting portfolio you need at retirement to support you for the rest of your life.
We're getting into the realm of some pretty sophisticated calculations based on several assumptions that, if changed, could radically alter our results. What we need is a quick-and-dirty way to give us an idea of what we need to do to get started. We'll save the more esoteric efforts for later.
So forget about inflation for the moment. Ignore Social Security and any company pension you may get. Pretend your money gets no return now or after retirement. But do count whatever you have saved for retirement as of today.
Let's say that amounts to $20,000. Further, let's say you want an annual income of $30,000 in today's dollars after you retire. You expect to retire in 25 years, that you will live 20 years after you retire, and that you expect to meet your maker waving your last dollar bill.
How much do you need to amass by the start of your retirement to support yourself in your golden years, and how much do you have to save each year between now and then to get there?
Let's see. You need $30,000 a year for 20 years, so that comes to $600,000 needed in the first year of retirement. You already have $20,000 of that, so that means you're only $580,000 short. Divide the shortage by the 25 years you have to save it up, and you discover you only have to cough up $23,200 annually between now and the time you retire to a life of leisure.
Too much is omitted from this simple approach to provide a meaningful answer to the question at hand. Worse, the answer we do get makes the whole idea of saving for retirement seem to be an impossible task, but this is far from true.
To do things right, we must take a cold, hard, objective look at our desired income, subject it to a rational choice of assumptions, and make some detailed calculations.
The best way to do the calculations is with one of the readily available software packages available commercially, such as Quicken Financial Planner or you can find many different financial calculators online that can help.
Before you use any of these tools, you need some preliminary information. At a minimum, you want to:
1. Decide on the annual income you desire in today's dollars.
2. Pick a retirement date.
3. Determine your lifetime average inflation rate.
4. Determine the average rate of return you expect on your investments before and after retirement.
5. Determine the current market value of all your investments to include regular accounts, IRAs, and company tax-deferred savings plans like 401(k) plans.
6. Obtain an estimate of any company-provided pension benefit.
7. Obtain an estimate of future Social Security benefits
8. Armed with this data, you can determine the annual savings required for you to enjoy the good life. You will also be able to play "what if" games and see the results quickly should you decide to vary things like inflation, rates of return, date of retirement, and desired income.
We'll leave you with one last thought. The earlier you start, the easier it will be for you to amass the dollars you will need on the day you retire.
Say you put $1,000 per year for 25 years into an investment earning 10% annually, you would have $108,182. Wait just five years before starting that process, and on the same date in the future you would end up with $63,002. That $5,000 you "saved" by waiting just cost you $45,180 in tropical drinks.
Your employer can be a great place for you to start with to find the money that you need.
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