This is part 5 in our series on creating a financial plan for retirement. Below, we’ll discuss specific retirement savings options.
“Life is difficult. This is a great truth, one of the greatest truths. It is a great truth because once we truly see this truth, we transcend it.” -M. Scott Peck, The Road Less Traveled
If you took nothing else from parts 1-4 in this series, we hope you’ve learned this: The responsibility for saving the money needed to take you through retirement has shifted.
In prior generations, most workers could count on employer-funded plans for the bulk of their retirement income. Today, funding your retirement is primarily on you.
Is that a good thing?
It depends on whether you’re a glass-half-empty or glass-half-full sort of person, though it’s doubtful that retirees who benefited from employer-funded, guaranteed pensions would ever call them “bad.” (And remember, up until recently, that’s what a lot of people relied on for their retirement.)
Still, the truth is inescapable. Such plans are disappearing fast. We need to accept that truth and learn about the tools and strategies we have for empowering ourselves. You actually have plenty of options for establishing retirement savings.
Let’s begin with your tools for building retirement savings.
Employer-Sponsored Retirement Savings Plans
For generations, employer-sponsored plans have been the backbone of retirement savings and income for Americans. They still are, but most are a far cry from the employer-funded pensions our parents enjoyed.
Today, most employers instead offer what’s called a traditional 401(k).
If you work for a nonprofit or the government, you might have a 403(b) or 457 plan. The 403(b) is typically offered by educational and certain nonprofit organizations, while 457s are the retirement saving tool typically offered by government agencies.
But wait, there’s more!
Small employers might offer SEP and SIMPLE IRAs. Similar to the “400 series” plans just listed, these are specially designed to give employees and owners of small companies equivalent opportunities to save significant money for retirement.
Together these comprise a category called defined contribution plans, and each works the same way. Employees—the plan’s documents usually call them “participants”—define the amount they’ll contribute, and each participant has their own account.
Most participants fund their accounts with pre-tax earnings. Some employers offer the option of contributing from after-tax (net) pay. (More on those “Roth-type” plans in a moment.)
Besides the contributions employees make from their paychecks, some employers offer to “match” them, usually up to a given percentage of the employee’s total salary. Those percentages vary from employer to employer. Some might make contributions as a form of profit sharing, whether in addition to or in place of the percentage match.
The maximum employee contribution is subject to change, but as of 2019, participants below the age of fifty can set aside up to $19,000 per year. If you’re fifty or older, you can make “catch-up” deposits of an additional $6,000, for a maximum of $25,000 per year.
If your employer offers a match and/or profit sharing, the combination of their contributions and yours cannot exceed $53,000 per year, whatever your age. High-income earners who get a large employer match and/or profit sharing take note, because this limit could come into play.
Most 401(k) participants choose the traditional tax-deferred option. Contributions come out of their gross pay, and taxes are deferred on both the principal and on any appreciation—the gains made through investments—until they start taking distributions in retirement.
This option has two big advantages. Besides delaying the tax liability on your retirement savings, contributing to the plan from your gross pay lowers your taxable income. That means you pay less income tax while you’re still in the workforce.
The “Roth” Plan Distinction
Depending on your situation, however, it might actually benefit you to consider the after-tax option, if your employer offers it.
This is known as a “Roth 401(k).” Your contribution is taken from your net pay instead of your gross. The advantage? You never pay taxes on your money again—neither the principal nor any appreciation. But depending on your bigger picture, the Roth option may not be your best choice, either.
As already discussed, employer-funded pensions—defined benefit plans—are quickly vanishing, but they still factor prominently in the retirement resources of many baby boomers. If you’re one of them, you should feel truly blessed and fortunate.
Once the gold standard of retirement, pensions used to be widely offered by both public- and private-sector employers. Together with Social Security benefits, they pretty much guaranteed seniors a financially secure retirement.
These days, however, few private-sector employers offer pension plans, due to their cost and the profit demands of stockholders.
Most of the pensions still being offered today, therefore, go to state and federal government workers and employees of public education institutions like school districts and state colleges.
The longer the employee stays, the bigger their defined benefit. This guarantee of income in retirement helps public-service entities retain workers, many of whom could be making much higher salaries in the private sector.
Pensions are a cornerstone of public service compensation. The advantages are numerous:
- The employer makes all contributions (in most cases).
- The employees are not responsible for choosing investments, thereby eliminating the risk of making bad investment decisions.
- Employees typically know how much they will receive, based on earnings and length of service at retirement.
- Employees pay no taxes until they begin drawing money in retirement.
We’d include a similar list of the disadvantages of pensions, but it’s just not that long!
For workers, pensions are the goose that lays the golden egg. There are, however, a couple of very important—if rare—risks.
First, the performance of the investments your employer chooses to back your pension could affect its solvency. If things go wrong, then there’s a small chance you wouldn’t get the full benefit, even though pensions are federally insured.
Perhaps more worrisome is that public-sector pensions have come under increasing attack, particularly in states experiencing budget crises. A few years ago in Wisconsin, lawmakers cut the state’s pension contributions in half and required employees to contribute the difference.
If you work in a cash-strapped state, it’s smart to keep on top of developments in your legislature—and, if possible, have alternate sources of retirement savings.
Other Types of Retirement Savings Plans
Though employer-sponsored plans like 401(k)s and pensions are the most common, there are a host of other tools for building retirement savings. IRAs, Social Security, and investment portfolios top the list.
IRAs—individual retirement arrangements—offer tax advantages like employer-sponsored plans, but are opened and directed entirely by you.
They also offer unlimited investment choices for growing the principal you put in: stocks, bonds, mutual funds, annuities, CDs, money market funds, real estate—all of these investments can be held in an IRA.
One point that should be made clear is this: The IRA itself is not the investment. It’s an account, just like a 401(k)-type plan, a place you put money to save for retirement. It’s the investment choices you make for the money within the account that drive your savings’ growth.
You’ve probably heard of traditional and Roth IRAs. There’s also what’s called a “Roth conversion IRA,” 401(k)-to-IRA rollovers, and others.
These options might help you save more efficiently and reduce your tax liability in retirement. For now, let’s focus on the two most common types of IRA: traditional and Roth.
Like the money employees put in traditional 401(k)-type plans at work, contributions to a traditional IRA can be deducted on your income tax. Limits are based on your income and set by the IRS.
Besides the reduction in current income (and therefore, income tax) thanks to your contributions, you pay no taxes on those contributions, or on gains from investing them, until you start taking money out of your IRA in retirement.
Contribution limits differ depending which side of age fifty you are on. Folks fifty and older can put away additional funds per year, a “catch-up” provision for increasing savings as retirement gets closer.
Probably the biggest plus with a traditional IRA is that you can make a contribution until the tax deadline of April 15, and deduct it on the return you’re about to file—the one documenting your income in the prior year.
This means you can make a contribution in April to reduce last year’s tax bill just as it comes due.
Is a Traditional IRA Right for You?
Whether a traditional IRA is right for you depends on your other retirement savings, your income, and your filing status. Here’s a quick hypothetical example, showing the basics of contributing to a traditional IRA.
Spouses John and Jane are under fifty years of age. John works and has a 401(k) with his employer. Jane is a stay-at-home mom. She takes care of the kids and runs the household, but has no earned income. John and Jane file their taxes jointly.
John makes below the income limit for contributing to a traditional IRA. Though Jane does not have earned income, she qualifies for an account of her own.
That means John and Jane can set up separate IRAs, contribute the maximum to both, and fully deduct the contributions on their joint tax return.
One important note: While many focus on getting that tax deduction, you’re allowed to contribute to an IRA regardless of whether you meet the deduction rules.
Contributing right up to the limit is perfectly legal, even if you can’t claim the deduction. Doing so actually makes sense in some cases, but in many others, contributing to a Roth IRA instead is the better choice.
Though the contribution limits, effects of filing status, and income guidelines are the same with Roth IRAs as for traditional ones, Roth plans carry several key differences.
First and foremost, there are no deducting contributions to a Roth IRA on your tax return. Sounds like a big sacrifice, but guess what?
Like the Roth 401(k) we’ve already covered, you never pay taxes on income from your Roth IRA. Every dollar you put in, and the gains you realize through investment—for the entire life of the account—is yours. Uncle Sam doesn’t get one cent.
Another big difference is that, with a traditional IRA, you must start withdrawing specific amounts each year—called required minimum distributions (RMDs)—beginning in the year you turn age seventy and a half. Not so with a Roth IRA. Your money can continue to grow, tax free, for as long as you’d like, and no distributions are required.
Just like traditional IRAs, Roths give you unlimited investment choices. The catch-up provision for people fifty and older applies too.
More good news: Remember John and Jane? They can have more earned income—a lot more—than they could under a traditional IRA and still contribute the maximum to Roth IRAs, one in each of their names.
Whichever type of IRA you’re considering, a trusted financial advisor can give you the current income and contribution limits.
You might wonder why anyone would even think about a traditional IRA, given what we just learned about the tax advantages of a Roth?
That’s understandable. At first blush, the Roth sounds like the best way to go, hands-down. But whether it is, however, depends on many factors, things you simply might not consider on your own—for example, your current tax rate, versus the rate you anticipate in retirement.
Balance is the key, and ensuring you achieve the proper balance for your particular situation is where your financial advisor can really earn their keep.
Products that sound like “sure things” can be found across the financial product landscape. But remember, there is no such thing as a sure thing.
And the more carefully you plan, the more likely you are to select the right balance of retirement savings vehicles—and ultimately, to realize your retirement goals.
Let’s shift gears to a whole different realm of retirement savings—or really, income: Social Security.
The origins of this longtime government program date to Germany in 1889, forty-six years before President Franklin D. Roosevelt duplicated it here in the U.S. The Germans wanted to get aging workers out of the factories so a younger, more productive workforce could replace them.
Social Security is funded by a payroll tax on employers and their employees.
Both pay the same amount. (If you’re self-employed, you pay both portions.) Your benefit—the monthly amount Social Security pays you—is based on your earnings history and when you claim eligibility, which can be as early as age sixty-two.
Social Security’s goal of constantly rejuvenating the workforce is somewhat ironic, given what’s happened to worker demographics since the program’s inception.
For starters, we’re all living longer. Many believe it may be necessary to raise the retirement age if Social Security is to remain viable, something that’s happened only once so far, back in 1983.
Perhaps more critical to the fiscal challenges facing Social Security is that back in 1945, one person was taking benefits for every forty-two people working. By 2011, the ratio was one beneficiary to just two workers.
For a program funded by a tax on current wages, that’s a big deal; the math just doesn’t add up. If Social Security is going to be there for our retirement and our children’s too, something must change.
The first question most people ask me about Social Security is whether it will be there for them.
It’s estimated that with no changes, Social Security can continue to pay 100 percent of benefits through the year 2033, after which just under 80 percent would be funded.
Clearly, some changes will be needed for people to continue getting their full benefit.
We can hope that Congress doesn’t wait until the eleventh hour. But if its track record is any indication, plans for saving Social Security probably won’t get to the floor until 2032.
Once people realize that Social Security isn’t going to simply disappear today or tomorrow, their questions shift: They’re most interested in when to apply for benefits and how to maximize them.
We’ll explore strategies for maximizing all your retirement income later. For now, let’s get an overview of how Social Security works and how the monthly amount you’ll receive is affected by when you claim benefits.
The Mechanics of Social Security
Social Security’s payment formula takes your thirty-five highest years of earnings, indexes them for inflation, derives an average, and then calculates what’s called your “primary insurance amount” (PIA).
Many retirees think that stands for something else—but no, PIA is the amount you’ll receive at what Social Security calls “full retirement age.”
Once you’ve claimed benefits, they are subject to annual COLAs—cost of living adjustments. As noted in part 4, there have recently—for the first time since COLAs were instituted—been a few years where no COLA was made.
The biggest potential adjustment to your PIA, however, relies on whether you claim benefits before, at, or later than your designated “full retirement age.” This chart shows how profound that adjustment can be.
It’s important to note that Social Security’s “full retirement age” is being adjusted, thanks to the longer life expectancies we’ve already discussed. If you were born between 1943 and 1954, that age is sixty-six.
If you’re in that group and you claim Social Security at sixty-two, as the chart shows, then your benefit will be 25 percent below your PIA. If your full retirement age is sixty-seven and you claim at age sixty-two, then your payment will be 30 percent less.
Similarly, if you wait until you must take benefits at age seventy, your benefit increases by 8 percent per year. That’s simple interest, not compounded. So, if your full retirement age is sixty-six and you don’t claim benefits until you turn seventy, you would net a 32 percent increase.
Though many would like to wait, for some it’s just not realistic. It can put too much pressure on other assets (like investments or a pension) or significantly impact your lifestyle. You might need to claim Social Security earlier.
So the answer to “When should I claim Social Security benefits?” depends greatly on determining the best sequence for drawing on your retirement assets to bridge your income gap.
Your Investment Portfolio
Besides the investments you choose for your IRA and 401(k)-type plans, you might hold non-qualified accounts, so called because they’re not tax advantaged specifically for retirement.
Also called brokerage accounts, these host your stock market portfolio of non-retirement-plan investments. They can be an important financial resource that complements your retirement savings and offers instant liquidity for major expenditures in the here-and-now.
The investments held in your nonqualified accounts might include stocks, bonds, mutual funds, CDs at the bank, and different types of annuities (insurance vehicles designed to produce income).
Whether you’re a baby boomer on the cusp of retiring or a forward-thinking member of the Gen-X or Millennial generations, you’ve likely heard of annuities. But it’s also probable that what you’ve heard about them has you a bit confused.
The insurance industry, which created and thereby cornered the annuities market, has saturated the media with advertising about these instruments.
Unfortunately, the ads offer precious little information to help people determine whether annuities might be beneficial to their financial plans. So, people call the number on their screen in hopes of figuring things out.
Sometimes, however, aggressive sales reps will turn curious interest in these vehicles into done deals—leaving many boomers who have purchased annuities without a full understanding of how they actually work.
Annuities can help some people manage their income streams during retirement. They’re a longevity tool that can help protect your money. If you expect to live to a ripe old age, an annuity might help fill your income gap by synchronizing how you draw on a portion of your retirement savings.
Still—despite what some of the people selling them have to say—not everyone needs an annuity, and they are not growth vehicles.
You simply cannot grow retirement savings as profoundly or efficiently with annuities as you can through wisely investing the funds you’ve saved in some of the vehicles we’ve already discussed.
A Special Note on Help With Medical Expenses: HSAs and FSAs
The harder you find it to save for retirement, the more susceptible your savings become to a simple fact of life: As we age, our health declines. Medical expenses can quickly decimate even significant savings, but three savings tools modeled on IRAs might help.
Health savings accounts (HSAs) and flexible savings accounts (FSAs) are designed to help you meet out-of-pocket medical expenses.
Both are funded with pre-tax contributions from you and—in some cases—your employer, and you never pay tax on withdrawals that cover qualified medical expenses.
HSAs are available only to people with HDHPs: high-deductible health insurance plans, as defined by the IRS.
People without HDHPs can open FSAs to save for future medical expenses.
Another type of plan, limited-purpose FSAs, are used to supplement HSAs, covering dental and vision care.
All three plans follow strict rules, which include penalties for non-qualified withdrawals. Features within employer-administered versions vary from one employer to the next.
Consult a qualified financial advisor to learn how one or a combination of these plans can help cover the increasing and, as you age, inevitable cost of medical care, while preserving as much of your retirement savings as possible.
Other Potential Retirement Income
There are a few other sources of retirement income to consider.
Employment income and retirement may seem mutually exclusive, but today more people age sixty-five and up are still working, whether full- or part-time. Why?
For one thing, the income you’re permitted to earn is seriously curtailed after you’ve claimed Social Security benefits. Since the “official” retirement age has not kept pace with our increased longevity, people have realized that working later in life can be a great hedge against their income gaps.
Working can also help retirees solve the “time gap,” all those extra hours retirement requires them to fill. The chance to interact with others for a few hours a week—say, at the local hardware store, while mixing up paint—can help keep your mind sharp, get you out of the house, and put some extra money in your pocket.
What about inheritances or gifts you might receive? As someone who creates conservative financial plans for people from all walks of life, my advice is simple. Unless you know for certain how much you’ll receive and when, omit these from your financial plan.
The circumstances of others’ lives can change in a heartbeat and often, quite literally, do. That’s why we prefer to leave “anticipated” inheritances and gifts out of the equation. If you’re fortunate enough to receive these extra dollars, then let them be a pleasant surprise because they will only help your situation.
The Problem With Reverse Mortgages
Finally, there’s what we believe is nearly always a bad retirement income option for seniors: reverse mortgages. These are loans marketed heavily to retirees by celebrities from the generations that the companies are targeting.
Folks like Henry Winkler (“the Fonz” on the TV show Happy Days), the late senator (and actor) Fred Thompson, and even game show host Chuck Woolery have promoted reverse mortgages.
Issued by the Federal Housing Administration, reverse mortgages are home equity loans, taken out after your house is paid off. You must be age sixty-two or older to qualify, and there can be no liens or outstanding mortgages on the property.
Reverse mortgages provide a lump sum, a regular payment, or a combination of both. The amount is based on your home’s value, your credit score, your life expectancy, and current interest rates.
We view them as a possible alternative only when both of two conditions exist: (1) You just don’t have enough other retirement savings, and (2) you’re absolutely determined never to leave that home.
If you’re willing to sell the home and move, my advice is to do so. Get the full equity, give yourself the income you need, and find a different housing arrangement.
Reverse mortgages just don’t make economic sense. All you’re really doing is paying interest to receive some of your own equity in return—equity you worked to build over the course of your lifetime. Why pay interest on that money, let alone the fees you’ll incur for the loan’s origination?
Unless that second factor also applies—you simply can’t bear to give the property up—we find these loans hard to justify. Even then, try to remember that emotion is your greatest enemy when it comes to making financial decisions.
Client Example: A Reverse Mortgage Gone Wrong
A client came into our office. Her mother, who had just died, had taken out a reverse mortgage on the family cabin because she didn’t have enough money to meet her expenses in retirement. She needed the equity but never told the kids she had taken out the loan.
Meanwhile, the kids had always planned on either buying or inheriting the cabin, which was on a beautiful lake in northern Minnesota. They’d been going there as a family all their lives and loved spending time at such an idyllic retreat. They wanted to keep it in the family for the next generation.
But when my client’s mom passed, the kids learned about the reverse mortgage by way of the bank, which told them they had to come up with the capital to pay it off very quickly, otherwise the cabin would be sold.
The family couldn’t pull together the funds to buy it and lost their getaway.
With a little planning and better communication, the kids could have bought that cabin from Mom while she was still alive. They would have not only kept it in the family but also given Mom the income she needed.
There is almost always a better alternative than a reverse mortgage, but there’s an even bigger lesson in this story. The sooner you get a financial plan for retirement in place, the less likely it becomes that you’ll have to sacrifice the things you’ve worked for all your life in order to fund your retirement.
Position Yourself for a Better Future
We’ve just covered a broad range of options for establishing and growing your retirement savings. Cultivating a diverse mix of these vehicles can be a big part in overcoming your income gap.
But the biggest key in bridging that gap—and in positioning yourself and your family for the future—is growing your retirement savings.
Investing your savings wisely is the surest way to do that.
You can learn more about Minnesota’s premier retirement planners, the financial advisors at Pine Grove Financial Group, or click below to contact an advisor today!