Retirement Planning
It’s said that we human beings stand out from other species by virtue of our ability to think and plan ahead. While that may be true, most of us also have great trouble thinking about or preparing for the long term, as we’re continuously caught up in everyday tasks. It’s difficult enough to plan something six months ahead, like a summer vacation. How are we supposed to think about something in the distant future — like retirement?
Nevertheless, thinking in advance and acting on those thoughts is key to being ready when the future becomes the present. The younger you are, the more distant your retirement — and the greater your ability to compound your returns over time. That window of time is your greatest advantage.
Retirement planning is the process of shaping retirement income goals and the actions and decisions required to achieve those goals. Retirement planning includes recognizing estimating expenses, sources of income, implementing a savings program and managing assets. Future cash flows have to be projected to try to determine if the retirement income goal can be attained.
BREAKING DOWN Retirement Planning
In the most basic sense, retirement planning is the planning to be prepared for life after paid work ends, not just financially but in all aspects of life. The non-financial aspects include lifestyle choices such as how to spend time in retirement, where to live, when to completely quit working, etc. All these areas are taken under consideration using a holistic approach to retirement planning.
The emphasis one puts on retirement planning changes throughout different life stages. Early in a person’s working life, retirement planning is primarily about setting aside enough money for retirement. During the middle of a career, it might also include setting specific income or asset targets and taking the steps to achieve them. Once you reach retirement age, you go from accumulating assets to what planners call the distribution phase. You’re no longer paying into your retirement accounts. Instead, your decades of saving are paying out.
Retirement Planning Goals
Remember that retirement planning starts long before you retire — the sooner, the better. Your “magic number,” the amount you need to retire comfortably, is highly personalized, but there are numerous rules of thumb that can give you an idea of how much to save.
Some people say that you need around $1 million to retire comfortably. Other professionals use the 80% rule¹, i.e., you need enough to live on 80% of your income at retirement. If you made $100,000 per year, you would need savings that could produce $80,000 per year for roughly 20 years, or $1.6 million1. Other retirement planners espouse that most retirees aren’t anywhere near saving enough to meet those benchmarks and should adjust their lifestyle to live on what they have².
Whatever method you and possibly a financial planner decide to use to calculate your retirement savings needs, one thing remains constant: start as early as you can.
Stages of Retirement Planning
Below are some guidelines for successful retirement planning at different stages of your life.
Young Adulthood (Ages 21-35)
Those embarking on adult life may not have a lot of money free to invest, but they do have time to let investments mature, which is a critical and valuable piece of retirement saving. This is because of the principle of compound interest. Compound interest allows interest to earn interest, and the more time you have, the more interest you will earn. Even if you can only put aside $50 a month, it will be worth three times more if you invest it at age 25 than if you wait to start investing at age 45, thanks to the joys of compounding. You might be able to invest more money in the future, but you’ll never be able to make up for lost time.
Young adults should take advantage of employer-sponsored 401K or 403B plans. An upfront benefit of these qualified retirement plans is that your employer has the option to match what you invest, up to a certain amount. For example, if you contribute 3% of your annual income to your plan account, your employer may match that, investing the equivalent sum into your retirement account, essentially giving you a 3% bonus. However, you can and should contribute more than the amount that will earn the employer match if you are able to.
Additional advantages of 401K plans include earning a higher rate of return than a savings account (although the investments are not risk-free). The funds within the account are also not subject to income tax until you withdraw them. Since your contributions are taken off your gross income, this will give you an immediate income-tax break. Those who are on the cusp of a higher tax bracket might consider contributing enough to lower their tax liability.
Other tax-advantaged retirement savings accounts include the IRA and Roth IRA. A Roth IRA can be an excellent tool for young adults, as it is funded with post-tax dollars. This eliminates the immediate tax deduction, but it avoids a bigger income-tax bite when the money is withdrawn at retirement. Starting a Roth IRA early can pay off big time in the long run, even if you don’t have a lot of money to invest at first. Remember, the longer money sits in a retirement account, the more tax-free interest is earned.
Roth IRAs have some limitations. There are caps on how much you invest in your IRA each year. This amount varies for taxpayers filing as single vs as a couple.
Like a 401K, a Roth IRA has some penalties associated with taking money out before you hit retirement age. But there are a few notable exceptions that may be very useful for younger people or in case of emergency. First, you can always withdraw the initial capital you invested without paying a penalty. Second, you can withdraw funds for certain educational expenses, a first-time home purchase, healthcare expenses and disability costs.
Once you set up a retirement account, the question becomes how to direct the funds. For those intimidated by the stock market, consider investing in an ETF that requires little maintenance, as it simply mirrors a stock market index like the Standard & Poor’s 500.
Early Midlife (36-50)
Early midlife tends to bring a number of financial strains, including mortgages, student loans, insurance premiums and credit card debt. However, it’s critical to continue saving at this stage of retirement planning. The combination of earning more money and the time you still have to invest and earn interest makes these years some of the best for aggressive savings.
People at this stage of retirement planning should continue to take advantage of any 401K matching programs their employers offer. They should also try to max out contributions to a 401K and/or Roth IRA (you can have both at the same time). For those ineligible for a Roth IRA, consider a traditional IRA. As with your 401K, this is funded with pre-tax dollars, and the assets within it grow tax-deferred.
Finally, don’t neglect life insurance and disability insurance. You want to ensure your family could survive financially without pulling from retirement savings should something happen to you.
Later Midlife (50-65)
As you age, your investment accounts should slowly become more conservative. While time is running out to save for people at this stage of retirement planning, there are a few advantages. Higher wages and potentially having some of the aforementioned expenses (mortgages, student loans, credit card debt, etc.) paid off by this time can leave you with more disposable income to invest.
And it’s never too late to set up and contribute to a 401K or an IRA. One benefit of this retirement planning stage is catch-up contributions. They allow more of your income to be redirected into your retirement accounts.
For those who have maxed out tax-incentivized retirement-savings options, consider other forms of investment to supplement your retirement savings. CDs, blue-chip stocks or certain real estate investments (like a vacation home you rent out) may be reasonably safe ways to add to your nest egg.
You can also begin to get a sense of what your Social Security benefits will be, and at what age it makes sense to start taking them. Eligibility for early benefits begins at age 62, but the retirement age for full benefits is 67.
The Social Security Administration offers a calculator here.
This is also the time to look into long-term care insurance, which will help cover the costs of a nursing home or home care should you need it in your advanced years. Such health-related expenses can decimate your savings if not properly planned for.
Other Aspects of Retirement Planning
Retirement planning includes a lot more than simply how much you will save and how much you need. It takes into account your complete financial picture.
Your Home: For most Americans, their home is the single biggest asset they own3. How does that fit into your retirement plan? In the past, a home was considered an asset – but since the housing-market crash, planners see it as less of an asset than they once did. With the popularity of home-equity loans and home equity lines of credit, many homeowners are entering retirement in mortgage debt instead of well above water.
Once you reach retirement there’s also the question of whether you should sell your home. If you still live in the home where you raised multiple children, it might be larger than you need, and the expenses that come with holding onto it might be considerable. Your retirement plan should include an unbiased look at your home and what to do with it.
Estate Plan: Your estate plan addresses what happens to your assets after you pass. It should include a will that lays out your plans, but even before that, you should set up a trust or use some other strategy to keep as much of it as possible shielded from estate taxes. Most estates are exempt from estate taxes unless they exceed a predetermined threshold.4, but more and more people are finding ways to leave their money to their children in a way that doesn’t pay them in a lump sum.
Tax Efficiency: Once you reach retirement age and begin taking distributions, taxes become a bigger problem. Most of your retirement accounts are taxed as ordinary income tax. That’s why it’s important to consider a Roth IRA or a Roth 401K, which allow you to pay taxes upfront rather than upon withdrawal. If you believe you will make more money later in life, it may make sense to do a Roth conversion. An accountant or financial planner can help you work through such tax considerations.
Insurance: A key component to retirement planning is protecting your assets. Age comes with increased medical expenses, and you will have to navigate the often-complicated Medicare system. Many people feel that standard Medicare doesn’t provide adequate coverage, so they look to a Medicare Advantage or Medigap policy to supplement it. There’s also life insurance and long-term-care insurance to consider.
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