Retirement Income Planning
So we have an idea of where you’ll be spending your money during retirement. Where will this money be coming from?
There’s a few different sources of money in retirement. The main ones are:
- Social security
- Company-sponsored plans (401(k), 403(b), pensions, etc.)
- Continued employment
- Personal savings/investments
Once you estimate the first two, you can make a well-informed decision about how much additional money you need to invest and whether or not you’d like to continue working during your retirement.
When planning for the income you will need in retirement, don't forget about inflation. Keep in mind that what $1 dollar buys in today’s money is not what it can purchase 20 years from now. For example, assuming a 4% inflation rate, what you can buy today for $1 dollar, you would need $2.19 dollars to buy 20 years down the road. That’s why the money you save needs to be invested—the goal is for your investments to grow faster than inflation. If you just keep your money under the mattress or in an account earning less than 4%, it will actually be losing value over time.
This has become a topic of hot debate in recent years. Will social security still exist 20 or 30 years from now? The general consensus (from places like The Motley Fool) is yes.
There are many factors that affect the amount of your social security benefits, such as length of time you worked, how much you earned, and when you start taking your benefits. The best way to gauge what your social security benefits will be is to ask.
The Social Security Administration (SSA) mails out an annual report called the Social Security Statement letting you know your work history and predicting future earnings and benefits. If you need to know now, you can visit the SSA website and request a report. Or visit the website of Kiplinger’s Personal Finance magazine to use their social security calculator. According to an article on CNN.com, if you want to plan conservatively, plan for a 25% reduction in benefits from what is estimated.
Company Retirement Plans
These are a great idea. Here's why:
- The money you put into a retirement plan like a 401(k) or a 403(b) (for nonprofits) is tax deferred. This means that if you put $100 into your 401(k) every month, $100 really goes into it. In contrast, if you were to plan on saving that money after you get your paycheck, it will already be reduced by an average of $40 in payment of federal, state, and local taxes as well as contributions to social security, and Medicare. That means you only have $60 left to invest.
- Many companies make matching donations to your plan up to a certain percent. A general rule of thumb is to put 10% of your income toward retirement savings. So if your company matches your contributions dollar for dollar up to 4% of your income, that means that when you save 4%, you actually get 8% in your account. You would only need to save 2% more to reach the goal of 10% per month.
The most popular company retirement plans, as mentioned above are 401(k)s or 403(b)s. These are named for the section of IRS code that created them. 401(k)s are for used by for-profit companies, while 403(b)s are used by nonprofit organizations and 457s are for state and local government employees. If you are self-employed, you may have a Keogh or SEP IRA, or a SIMPLE IRA if you work for a company that employees less than 100 people.
All of these plans fall under the umbrella of “defined contribution” plans. Employees usually have a lot of flexibility in determining how their money is invested and can change their asset allocation on a yearly basis.
Something that used to be popular but has fallen out of favor is the “defined benefit” plan. These are pension funds where employers promise to pay retired employees a certain monthly amount based on age, length of service, and salary.
Because these tax-advantages are meant to encourage people to save for retirement, you will be penalized if you withdraw money too soon. If you make withdrawals before you reach age 59½, your withdrawals will be taxed and you will pay an additional 10% penalty tax.
Megan—when can you pull the money out? Don’t you pay tax for it when you pull the money out? what happens if you want to pull your money out of your 401(k)? Do you pay a penalty? Any exceptions? How big of penalty? You then have to pay the tax on top of the penalty right? What’s that % tax rate or does it depend on your income level?
Oftentimes, after a lifetime of gainful employment, retirees have a hard time quitting the rat race completely and living a life of leisure. Because people are retiring at an age where they are still healthy and energetic, it is possible to work many years past your official retirement.
Some people use this as an opportunity to take a lower-paying job that benefits society or has other advantages. (Maybe you’ve always wanted to work at a bookstore, or at a gardening store.) Others would like to stay involved in their chosen field, but as part-time workers or occasional consultants.
If you feel confident that you will keep working in some capacity after retirement, factoring this into your retirement income will give you more room in your budget today.
Personal Savings and Investments
Let’s imagine you have maxed out your contribution to your company’s plan but you want to save more for retirement. This is a good problem to have.
Some investment options were created specifically for retirement—the Individual Retirement Account (IRA). Like company plans, these are tax-sheltered plans.
With the traditional IRA, your contributions are not taxed initially, but when you start making withdrawals the money will be taxed. As with a company retirement plan, you cannot make withdrawals from your traditional IRA before age 59½ or you will pay a 10% penalty in addition to taxes on your withdrawal. You can avoid the 10% penalty for the following exceptions:
- Medical expenses or disability
- Buying a first home
- As a benificiary of a deceased IRA owner
- Receiving distribution as an annuity
- Distributions are not more than higher education expenses
- Distribution is due to an IRS levy of a qualified plan
In contrast, the newer Roth IRA taxes your contributions and not your withdrawals. You can withdraw your initial contributions at any time without penalty; however, to withdraw earnings, you would need to meet the same conditions listed above for traditional IRAs. Many financial advisors recommend a Roth instead of a traditional IRA if you are saving the maximum amount each year or you are currently in a lower tax bracket than you expect to be when you retire.
Many other taxable investment opportunities exist, including mutual funds, bonds, and stocks.
Many financial planning websites offer calculators to help you figure out whether you are saving enough money for retirement. The Retirement Calculator at MSN Money is pretty simplistic, but will give you a starting point. Kiplinger’s Personal Finance offers a worksheet to help you determine if you’re saving enough, but requires much more detailed information from you. The Motley Fool also has several retirement calculators to determine if you’re saving enough, how your expenses might change in retirement, and more.
Between all of the options mentioned above, your retirement costs should be covered. It’s just a matter of figuring out the balance between each type of income. In the next section, we’ll cover your savings and investment options in more detail, giving you the pros and cons of each.