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Retirement Planning
Most of us
know that retirement is something we must actively plan and save toward. Social
Security alone isn’t enough, and traditional pension plans that pay lifetime
defined benefits are becoming increasingly scarce. Yet the majority of Americans
typically don’t know how much to save and don’t save enough, according to
numerous polls and experts.
Moreover,
it is more than just a matter of accumulating enough money. People can expect to
spend 15 to 35 years or more in retirement. That’s a long time. What kind do you
want to have? How should you spend money at that stage? How can you prepare for
it and when should you start?
Getting
started… Your 20s and early 30s
Early in
your career is the perfect time to start a habit of saving for retirement
because you have one huge advantage you’ll never get again…TIME.
A dollar
invested early in life can grow, through the power of compounding, far larger
than the same dollar invested later in life.
Say you
open a tax-deductible Individual Retirement Account (IRA) at age 25 and invest
$100 a month until age 65. If the account earns eight percent a year, you’ll
earn $181,252 more by age 65 than if you wait until age 35 to start saving the
same $100 a month.
You may
shake your head at the recommendation of setting aside money for something you
won’t need for 30 or 40 years, especially if you’re still paying off college
loans, trying to save money for a home or just enjoying spending your first real
paychecks. Remember that every little bit helps.
Even
lower-income taxpayers have a new incentive to contribute to an IRA. For each
dollar they put in, up to $2,000, they receive a 50-cent tax credit on each tax
dollar they owe, up to a maximum tax credit of $1,000 (you must have a tax
liability in order to receive the credit).
Look at
it this way: you’re buying freedom from work on the installment plan, and the
sooner you start paying toward it, the less retirement will cost you.
Investing
opportunities
So where
can you start investing? Most likely, it will be through an employer-sponsored
plan, such as a 401(k), that depends mainly on you having money automatically
deducted from your paycheck on a pre-tax basis. As noted earlier, fewer and
fewer employers are offering defined-benefit plans.
Try to
save at least 10 percent pre-tax income in the plan, up to the limit the plan
allows. If 10 percent is too much on a tight budget, a smaller percentage can
still make a dramatic difference.
If the
employer matches your contributions—say 50 cents or $1 for every dollar you put
in—try to contribute at least enough to maximize the match—typically up to six
percent of your salary. Saving six percent with a six percent matching means you
earn 100 percent return on your money!
What if your employer offers
no plan? Your options are more limited. The only tax-deductible option is
through an IRA But you can put unlimited amounts into after-tax choices
including variable annuities (whose earnings grow tax deferred), stocks, mutual
funds and other investments.
If you’re
self-employed, you have more tax-deferred choices. You can open a simplified
employee pension (SEP) or Keogh plan.
See contribution limits
here.
What
types of investments should you choose? That depends on several factors,
including your tolerance for risk, your overall financial situation, job
stability and so on. In general, however, at a younger age, you can probably
afford to invest as aggressively as you’re comfortable with, say most investment
experts. You have the time to ride out the inevitable market downturns.
Learn more about Investing here
CAUTION:
Don’t
cash out your 401(k) or other employer-sponsored plan when you change jobs.
Younger workers often do this because the amounts are small and they want the
money to buy a new car or other purchases. You’ll pay income taxes and a penalty
tax on the withdrawal. In addition, you’ll lose the ability for the money to
grow tax deferred. So, roll it over into a self-directed plan.
Your 30s
through your 40s
At this
stage, you’re likely full stride into your career and your income probably
reflects that. The challenge to saving for retirement at this stage comes from
large competing expenses: a mortgage, raising children and saving for their
college, or perhaps financing your business.
As when
you were younger, it’s critical to find a way to squeeze out dollars.
Learn more about Budgeting here. Time is still on your side, though you’ve
begun to lose some of your compounding power. Try to invest a minimum of 10
percent of your salary.
One of
the classic conflicts is saving for college. Most CFP® professionals will tell
you that retirement should be your top priority. Your child can usually find
financial aid and help fund their education. You’ll be on your own for
retirement.
Some
expenses shouldn’t be avoided, however. Financial catastrophes could seriously
derail your retirement plans, so be sure to have adequate life insurance (for
your spouse’s retirement), disability insurance to replace lost income and
adequate health insurance. A cash emergency fund also can help avoid selling
tax-deferred investments should you need the dollars.
Your
investment portfolio probably shouldn’t change much from when you were in the
Getting Started stage. You still have considerable time before retirement.
CAUTION:
Try to
avoid tapping into your accounts for such things as a home down payment or
college. You can end up paying income taxes, penalties and you’ll suffer the
loss of further tax deferral. Calculate what realistic financial resources
you’ll have to pay when you finish working. Also, begin thinking about how
you’ll roll over your assets in ways that either preserve their tax deferral or
reduce potential taxes.
Little time
to save?
The home
stretch…Your 50s and 60s Now is the last opportunity to really sock away funds.
Try to boost your savings goal up to 20 percent or more of your income. Ideally,
you’re at your peak earning years and some of the major household expenses, such
as a mortgage or child-rearing, are behind you, or soon will be. Time to review
your Budget. Yes, again!
Learn more about Budgeting here. Perhaps you’ve inherited money from you
parents. (On the other hand, you might have parents who need your financial
help.)
Take
advantage of the catch-up provisions. Congress passed in 2001. Workers age 50 or
over can invest extra dollars into their employer’s plan (if the plan allows it)
once they’ve maxed out their regular contributions. The extra amount ranges from
$1,000 in 2002 to $5,000 in 2006 and beyond (adjusted for inflation).
See limits for 2007.
You also
can put catch-up amounts into your IRA, though the amount decreases to only
$1,000 by 2006.
Once you
maximize contributions to your employer’s plan, and IRAs if you qualify, invest
additional money into annuities or investments that don’t create much taxable
income.
Investing
at this stage typically needs to be more cautious. Planners recommend shifting a
portion of your higher-risk investments into less volatile (and usually lower
returning) assets such as bonds. But planners also recommend maintaining a
substantial exposure to stocks. You still have a lot of years ahead of you.
You’ll need some assets that can stay ahead of inflation.
What kind
of retirement?
It’s also
time to start focusing on what kind of life you want and what financial
resources you have to pay for it. Do you plan to stay home and garden, or travel
the world? Work part time? Go back to school? Start a new hobby? Move to a
vacation spot?
The
choices are many and so are the costs associated with them. Planners often
advise people to “practice” at their retirement. Want to move? Vacation there
several times—in all seasons. Try out that hobby you’ve always thought about.
Share
your dreams with your spouse. It’s important that both of you explore and work
out differences. What if one wants to travel and the other wants to stay home?
Calculate
what your dream life will cost—but watch out for rules of thumb. Arbitrarily
figuring you’ll need only 70 or 80 percent of your current income may prove too
low, or too high. Expenses also can vary during phases of retirement: typically
high at first
Your
options are more limited at this stage.
- Reduce expenses and invest the savings
- Increase income through a second or better-paying job
- Maximize plan
contributions
- Invest more aggressively, but not recklessly
- Postpone
retirement (or go part-time)
- Make smart withdrawals from accounts once you
retire
Retiring
Early?
The big
challenge—a problem most of us are glad to have—is that we’re living longer.
Retire in your mid-fifties and you could easily live 30 years, maybe 40 years,
after finishing our career.
For that,
you’ll need a larger nest egg than if you retired later, yet you’ll have fewer
years to build that nest egg. This means smaller monthly, and potentially
smaller lifetime, Social Security benefits. The same applies to traditional
pension plan benefits.
You may
need to replace corporate benefits you lose, such as life insurance and, if you
work part-time or on your own during retirement, disability insurance. You also
may need to come up with health insurance to cover the gap until you qualify for
Medicare. Retiring before age 59 1/2 also can present tax problems. And you may
still have major expenses to fund, such as a mortgage and college.
The
challenges of early retirement are not just financial, however. What are you
going to do all those years? Many CFP professionals find their retired clients
returning to work, often part time, out of boredom.
So
although early retirement may sound appealing, be sure you’ve thought through
the financial and non-financial issues before making the plunge.
CAUTION:
While
still in your 50s or early 60s, consider buying long-term care insurance. It’s
more affordable the earlier you buy it. Failing health requiring long-term care
is often the biggest single threat to a retirement nest egg. Medicare does not
pay for extended long-term care. Without insurance, you’ll have to pay out of
pocket—or become destitute in order to qualify for Medicaid assistance.
Retired at
Last…
Planning
doesn’t end once you retire. Like any financial plan, it requires periodic
adjusting.
Two of
the first and most important decisions are how much to withdraw annually from
your nest egg, and what accounts to withdraw from.
Considerable research in recent years has concluded that retirees should be more
conservative than once thought in how much they withdraw. People used to
routinely withdraw from their nest egg six to eight percent or more a year,
adjusted for inflation. Now, say some experts, withdrawal rates should be around
four or five percent in order to ensure that you don’t run out of money due to
periodic market declines.
People
who withdraw at higher rates should be prepared to immediately cut back should
their accounts suffer from a significant market downturn, or should their
personal circumstances change for the worse.
From which
accounts?
The
general advice is to first use taxable investments in order for assets in tax
advantaged accounts (IRA's, 401(k)s, etc) accounts to continue to grow tax
deferred. But this approach isn’t always appropriate. For example, if your
taxable investments are mostly bonds and your tax-deferred accounts mostly
stock, withdrawing only the bonds first would make your overall portfolio
riskier by becoming stock heavy.
Once you
reach 70 1/2, your choices are further limited because you’re required to start
minimum distributions from your IRAs and retirement plans (except for a plan run
by an employer you still work for).
Investment
decisions
What
should you be invested in? You’ll probably want to be more conservative than
before. Yet that doesn’t necessarily mean abandoning stocks. With potentially 20
or more years in retirement, inflation can eat away at lower-returning assets.
Even at a modest three percent annual rate, inflation could cut your standard of
living in half in 24 years.
Planners
may recommend that the portfolio hold at least two to three years of living
expenses in cash and bonds that can see you through a stock market decline.
Beyond that, there is no magic allocation of stocks/bonds/cash or other assets.
Much depends on your other sources of income, risk tolerance, age, financial
goals, such as leaving money to children, living expenses and so on.
Non-financial concerns
Besides
adjusting your investments during retirement, you may need or want to adjust
your lifestyle. Is it turning out as you envisioned? Did that “practice” you did
just before pay off?
As noted
earlier, it’s common today for retirees to return to work—not out of financial
necessity but for something stimulating to do. Playing golf every day or
traveling all the time can get boring for some. Besides work, you may want to
consider going back to school or doing volunteer work. Keeping mentally,
physically and socially active is key to an enjoyable retirement, say experts.
It also
can take some adjusting to be suddenly spending 24 hours a day with your spouse,
particularly if you have different retirement desires. Are you ready?
(C) 2004 The Financial
Planning Association
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