Think your finances are too strapped to set aside money for retirement? Consider this: Assume that on Jan. 1 of each year a $5,000 contribution is made to a retirement savings plan. If implemented at age 25 and continued to age 70, retirement savings would total $1,641,122.
If implemented at age 35 and continued to age 70, the retirement savings would total $796,687.
In this scenario, it is also assumed that the plan is tax-deferred (tax is paid when withdrawn) and that the plan earns a 7% rate of return every year.
Why the staggering difference? Compounding. Over time, a retirement savings plan that is well invested will generate earnings from previous earnings.
Prioritizing financial responsibilities such as paying off debt, saving for a home, starting a business or a family and contributing to a retirement plan can be difficult. Consider the scenario above, tightening the wallet and saving today can mean a significant lifestyle difference during retirement. Still think you don’t have the cash to save for retirement?
“For the younger demographic, getting started is priority number one, even if it is only $25 a week,” said Christopher J. Dacey, an investment advisor for Next Financial Group. “Treat it like a bill. If you have it coming out of your paycheck automatically, you won’t miss it as much.”
Don’t despair if retirement savings has not been a priority. It is never too late to begin saving and for individuals age 50 and over, additional savings opportunities known as “catch-up contributions” are available.
“For the older demographic, the emphasis is on controlling or eliminating debt,” he added. Individuals who wait until they are 45 to set aside savings for retirement are not in dire straits. “They have a few things working for them,” Dacey said.
Older individuals are likely in their peak earning years, perhaps closer to paying off a mortgage, and may not be burdened with student debt. “If they control spending and debt, then they have the opportunity to move that part of their budget to max out retirement savings plans,” he explained.
Getting Started
Financial experts predict that individuals will require 75-85% of pre-retirement income during retirement years. Determining which type of retirement plan is right for you depends on your age, your target retirement date and your risk tolerance.
“Individuals have to be realistic with their time horizon and the rate of return (on investments),” Dacey said, adding, “Be wary of choosing an ‘investment of the day’ that promises great returns with little risks.”
Based on longstanding trends, an average rate of return on investments is 7-9%. Trendy investments promising 12% or 14% might not end up paying and could negatively impact a person’s entire retirement savings.
Retirement planning tools such as CNN’s retirement planning calculator (money.cnn.com/retirement) are available online to help you get started. Meeting with a financial consultant may also be a good place to start.
Developing a retirement savings plan also includes liquid assets available in a non-retirement fund. “An important part of a retirement plan is having funds for unplanned expenses so that an individual does not attack their retirement income,” Dacey said.
The amount of savings set aside in an “emergency fund” depends on each individual’s situation. However, the optimal “emergency fund” would be able to cover six months’ to one year’s living expenses.
“Though that is optimal, it is not always realistic, and as people get older that can get adjusted,” Dacey noted. “Rarely do I see or recommend any less than three months of living expenses.”
Understanding the types of retirement savings plans available is the first step. In general, there are two types of retirement savings plans: employer-sponsored plans and individual retirement accounts (IRAs).
Employer-Sponsored Plans
Employer sponsored plans often include “matching contributions.” Matching contributions are a specific percentage or specific sum of money that an employer contributes to an employee’s retirement savings annually.
For example, an employee that earns $50,000 and sets aside 6% contributes $3,000 annually to a retirement savings plan. In a situation where the employer offers a 6% matching contribution, the employee receives an additional $3,000 in retirement savings from the employer. However, if an employee elects a 3% contribution and the employer offers a 6% maximum matching contribution, the employer will only match the 3% the employee saves.
The type of employer-sponsored plan offered depends on the size of the company and the plan that best meets the needs of the business owners and employees. Options are diverse and cover small businesses, large businesses and owner/operator businesses.
Savings Investment Match Plan for Employees (SIMPLE) IRA
SIMPLE IRAs are an alternative for small businesses, with 100 or fewer employees with earnings of at least $5,000. Employees must earn at least $5,000 in the preceding year with expectations to earn $5,000 or more in the current year.
Employers are able to claim contributions as business expenses on tax returns and employees benefit from the ability to contribute on a pre-tax basis while receiving the benefits of tax-deferred growth.
Typically, employers provide a 3% matching contribution or a 2% non-elective contribution to employees. Participants are able to contribute up to 100% of annual compensation—up to $11,500 annually or $14,000 annually if the individual is age 50 or older.
401(k)
Public and privately owned companies with 20 or more employees have the option of offering a 401(k) plan. These types of plans allow for tax-deferred growth and are tax-deductible. The typical 401(k) plan includes an employer matching contribution.
Based on current IRS guidelines, participants can contribute up to $17,000 annually to a 401(k) with an additional “catch-up” contribution of $5,500 annually for individuals who are age 50 and older. Participants have the added benefit of taking a loan against their retirement savings if needed.
Self-Employed 401(k)
A Self-Employed 401(k) is limited to those who are self-employed or have owner-only businesses and partnerships. These plans also allow the owner’s spouse to participate in the retirement savings.
In 2012, participants were able to contribute up to $17,000 annually with that increasing to $17,500 in 2013. “Catch-up” contributions for individuals age 50 and over are allowed up to $5,500 annually.
A unique benefit of this plan is the ability for profit-sharing contributions. Currently, up to 25% of annual compensation can also be contributed to the plan. The annual maximum profit-sharing contribution in 2012 was $50,000, which will increase to $51,000 in 2013.
Simplified Employee Pension Plan (SEP)
Simplified Employee Pension Plans (SEPs) are an option for sole proprietors, business owners, partnerships or to individuals who earn self-employment income by providing a service.
Simplified employee pension plans provide the potential for tax-deferred growth and the contributions may also be tax deductible. Contributions to this plan must be made by the employer. The rate of contribution can vary from 0%-25%, but the same rate of contribution must be offered to every employee. In 2012, the maximum contribution an employer could make to a SEP was $50,000
IRA (Individual Retirement Account)
Enrolling in an employer-sponsored retirement plan is important, but that might not provide enough savings for your retirement needs. Participating in an IRA in combination with an employer sponsored retirement plan provides supplemental retirement savings and also might provide individuals the opportunity to select from a wider range of investment options.
Individuals who do not have the benefit of an employer based retirement plan can establish an IRA to begin saving for retirement.
IRAs are divided into three categories: the Traditional IRA, the Roth IRA and a Rollover IRA. The time tax is paid on money contributed to an IRA distinguishes each type of IRA. Taxes paid at the time the money is contributed to the plan is known as tax-free growth. Conversely, taxes paid when the funds are withdrawn are known as tax-deferred growth.
Traditional IRA
Contributions to a Traditional IRA are tax-deferred and may qualify as a deduction on annual tax returns. Individuals may begin to withdraw money from a Traditional IRA at age 59½ and must accept minimum disbursements at age 70.
Retirees might find that once they reach retirement age, their overall income might fall into a lower tax bracket than during their working life. Therefore, contributing to a tax-deferred retirement plan might mean the taxes on the money withdrawn will be taxed at a lower rate.
Individuals with a Traditional IRA may also be able to make contributions for a working or non-working spouse not covered by an employer-based plan. Contribution and deduction rates are determined by the Modified Adjusted Gross Income rate. Ask a financial planner or the company that manages the IRA for details.
Roth IRA
Contributions to a Roth IRA provide tax-free growth because the taxes are paid prior to depositing the money into the savings plan. The compounding earnings are also tax-free so that at the time of retirement, when the funds are withdrawn, no additional taxes are paid.
Specific conditions must be met for tax-free withdrawal. Funds are penalty-free when a five-year aging period is satisfied; the individual is 59 ½ years old or is deceased, becomes disabled or qualifies for a first-time home purchase.
Rollover IRA
A Rollover IRA is established in situations where individuals have an employer-sponsored 401(k) or 403(b) (a retirement plan only available for those in public education, some non-profits, cooperative health service organizations and self-employed ministers in the United States) and are no longer employed with the same company. The contributions in eligible retirement plans can be rolled over into an IRA.
Investment Options
Establishing a retirement savings plan is the first step. The next step is determining how the assets are invested. Investment type–be it stocks, bonds or mutual funds–depends on your openness to risk, as well as your age and target retirement date, but a well-planned diverse portfolio is key.
Not interested in selecting investments yourself? Most, if not all, retirement plans offer managed funds. A managed fund provides automatic diversification designed by professional money managers. These plans are for investors looking for a professionally managed, diversified portfolio that is based on their tolerance level for risk.
The portfolio is designed based on the investor’s risk tolerance and target date for retirement. Depending on the managed fund used, the portfolio’s asset allocation will becoming increasingly conservative as the investor reaches retirement age. A managed fund allows individuals to take advantage of diverse investments without having to build a portfolio on their own. Service fees will probably be incurred.
“Individuals have to do soul-searching before deciding on retirement savings investment options and decide which option is best for them,” Dacey said.
Take-Home Message
Develop a plan. What would you like your life during retirement to look like? Working with a financial planner can help you maximize your income to enjoy the highest quality of life today and in the future.
“Be methodical about retirement savings,” Dacey said, “I have clients in their late 60s, early 70’s who did not earn a ton of income, but because they were methodical about retirement savings, they are millionaires.”
At a minimum:
- Maximize employer matching. If your employer offers any type of matching program, contribute at least that portion of your salary. It is like free money, never pass that up!
- Use tax-advantaged savings plans.
- Increase your retirement savings contributions. At the beginning of each year make plans to increase your retirement savings contributions by at least 1%. Small incremental increases will not be as noticed in your wallet. If annual increases are not feasible, at a minimum, plan to increase your contributions when you earnings increase.
“Create good habits and stick to a plan,” Dacey concluded.
