This is the fifth and final installment of a five-part personal financial planning series sponsored by the H. Taylor Peery Institute of Financial Services.
Stashing cash may be ok for a rainy day, but it’s not a particularly wise idea for retirement. To ensure a good night’s sleep, you’ll want to do some sound planning for the future.
On 14 August 1935, the Social Security bill was signed by President Franklin D. Roosevelt. This law was meant to provide a financial security system for every American but was never meant to cover every need. Life expectancy was also much lower in 1935 than it is today, so people did not have as many retirement years to plan for. It is, therefore, incumbent on all adults to prepare for the years when they must rely on their savings to augment what Social Security provides.
Successful savings is one key to a retirement free from financial concerns. Savings and retirement planning are closely linked. While you can save for any financial objective, retirement planning should be your largest financial objective. It is a larger objective than saving for a house, car, or mission because it lasts longer and is critical to your well being in the years when you no longer generate an income.
The key to retirement planning is to carefully assess your current lifestyle so you can accurately project your retirement needs and establish a retirement savings goal. Once you have done this, take advantage of retirement accounts that qualify for special tax treatment to maximize your returns on a tax-deferred or tax-free basis.
CALCULATIONS
There are four steps to calculating your retirement needs:
- Determine your current lifestyle expenses,
- Project expenses in the first and subsequent years of retirement using a conservative inflation rate,
- Project and document how much after-tax retirement income you expect between Social Security, pension, and other resources, and
- Calculate each year’s deficit and the net present value of the stream of annual deficits during your retirement years.
Step 1: Monitor Spending During Your Working Years
Spending can be easily monitored: Microsoft Money, Intuit’s Quicken, or other budgeting and money management software programs allow you to precisely record expenditures. Alternatively, you can simply write down what you spend. Figure 1 provides a format to summarize your annual expenditures. You can either complete a worksheet manually or use a spreadsheet program.
Consider your retirement aspirations. Maybe you want to serve a mission, travel the world, or regularly visit children and grandchildren. As best you can, envision that retirement lifestyle and monetize those desires. You know roughly what you would have to pay today for these activities. You also know what obligations you have now that will not be required in retirement. Once this is done, apply an annual conservative percentage inflation factor of 3.5 percent or 4 percent for every year until you retire. This calculated amount is now your goal for the year you retire. See Figure 2.
Step 2: Project Retirement Expenses
For years subsequent to retirement, continue to apply the inflation factor using a spreadsheet approach until you cover the years you expect to live. Once you have determined the amount needed for each year of your remaining life following your working years, you can calculate the present value of that stream of payments to determine the lump sum needed at the time you retire. See Figure 3, Goal 1. An Excel spreadsheet will accomplish this task nicely using its future value (“FV”) and present value (“PV”) self-explanatory functions. You can also calculate the annual savings amount needed during your remaining working years using the payment (“PMT”) function.
Step 3: Project Retirement Income
Retirement income sources will reduce the lump sum you need at retirement. You may have a “defined benefit” pension from your employment. This means the amount you receive during your retirement years is defined during your working years. Some employers provide an annual projection of what you can expect from pension payments when you retire. This would come typically in an annual summary, which outlines your total benefit package. Providing this benefit summary is not mandated by law, but many employers do so as a courtesy to their employees.
There is also Social Security. The Social Security Administration will provide you with a free projection of your Social Security benefits if you were to retire. This projection can be obtained by either calling 800-772-1213 or by requesting the statement online at www.socialsecurity.gov. In 1999, the Social Security Administration started sending annual statements to workers twenty-five or older about three months prior to their birthday.
Most likely, the combination of defined benefit pension and Social Security benefits will not be adequate. You are responsible to provide the rest. Providing a lump sum is not as daunting if you start a savings plan early in your career. It is much more challenging if you start later in your working life.
Step 4: Calculate Your Retirement Deficit (using numbers from Figures 1, 2, and 3)
Suppose you are forty years old and spending $48,000 per year after taxes on lifestyle expenses. This $48,000 includes $14,400 per year for mortgage payments on your home, and $33,600 per year on non-mortgage expenses, or $2,800 per month.
Let’s also assume that you plan to retire at sixty-five, and statistically you should live to age eighty-five. Using a 3.5 percent inflation factor and 1 percent for contributions, this $2,800 per month now will be $5,698 per month the year you retire. Let’s say your projected after-tax Social Security benefit is $2,000 per month. Combine this with your after-tax pension benefit of $3,500 per month and you would have $5,500 per month. To maintain your current lifestyle, with your mortgage paid off and preserving $200,000 in today’s dollars as a cushion/inheritance, you need to provide $198 per month from other sources to fill this gap—your first retirement year deficit.
This amount can be generated from sources that today are either in taxable accounts (accounts on which the earnings—interest and dividends—are currently taxable), or from accounts that are “defined contribution” savings vehicles. Income tax laws allow tax-deferred buildup on these accounts during your working years. With defined contribution accounts you pay no income tax on any account earnings until you withdraw the funds, and any after-tax contributions to the accounts are exempt from further taxation either while invested in the accounts or when withdrawn.
Figure 3 elaborates on this example and projects subsequent retirement year deficits. Assuming your mortgage will be paid off five years following retirement, you will need approximately $582,000 in savings to generate annual earnings at an after-tax investment rate of 6 percent to fund the annual inflated $17,000 approximate deficit in the first year of retirement, see Goal 2. Starting from a zero balance at age forty, your savings would need to be about $11,000 per year until you retire at sixty-five. Without considering pension and Social Security, you would need approximately $1.3 million. (Note that lifestyle adjustments may be appropriate in older years because spending needs generally decrease with age.)
TAX-DEFERRED SAVINGS OR DEFINED CONTRIBUTION ACCOUNTS
Investment accounts are in two broad categories: 1) taxable accounts, meaning that the earnings—interest and dividends—are currently taxable, and 2) tax-deferred accounts.
Tax-deferred accounts are those that, under the tax law, are not charged income tax on earnings before any withdrawals are made. However, once funds are withdrawn, those funds are subject to income tax.1 The government’s intent with this type of account is to allow a buildup in the balance through regular contributions during the working life of the owner, without having to pay income tax on the earnings and possibly on a portion of the contributed amounts.
The amount you place in a tax-deferred account is a defined amount. Thus, these are labeled “defined contribution” accounts. Retirement benefits from these accounts are not defined up-front, but depend on the success of the investments. When retirement occurs, a lower level of income would put the account owner in a lower tax bracket, and any withdrawals from the account at that time would be taxed at a lower rate. The objectives are to fund retirement income and minimize the income tax burden, in return for government-encouraged buildup of individual savings. This allows the entire principal amount in the account to earn during a person’s working years, rather than to be reduced through income tax payments. More money will be earning a return and therefore more earnings will accrue for retirement.
Taxable withdrawals from tax-deferred savings accounts during the retirement years can affect portfolio depreciation. If you need to withdraw a given amount to support your lifestyle and that amount is taxable, you will need to withdraw a larger amount than you need in order to pay taxes on the withdrawal. Continually withdrawing taxable amounts will reduce the size of your portfolio faster over time than by making tax-exempt withdrawals.
Individual Retirement Accounts (IRAs)
Under current 2006 law, regular (traditional) Individual Retirement Accounts allow investors to save up to $4,000 per year or $5,000 if they have turned at least fifty by the end of the contribution year. A portion and possibly all of the contribution may be deductible from your taxable income.
Deductibility is based on income—the higher the income, the lower the deduction—and whether you or your spouse participate in an employer-sponsored retirement plan. Both spouses can make IRA contributions, but a separate account for each must be established. IRAs are owned individually. There is no co-mingling of funds allowed by the tax law between IRA accounts of a married couple. Withdrawals prior to age 59½ exact a penalty tax, calculated under current law to be 10 percent of the taxable amount withdrawn in a particular year, unless an exception applies.
One exception to this withdrawal rule exists if you are withdrawing a substantially equivalent amount each year (at least annually) over your life expectancy or the joint life expectancy of you and a beneficiary. If this exception is followed, there is no penalty for early withdrawal of IRA funds.2 Once withdrawals begin—and they must begin on or before 1 April of the year following the year the taxpayer reaches age 70½—the amount withdrawn each year must be calculated according to a formula prescribed in the law.
Traditional IRA withdrawals are subject to income tax. All earnings are taxable as are deductible contributions. The following example illustrates:
Suppose your IRA account balance was $450,000, built over the years from three sources:
Deductible contributions of $100,000,
After-tax (taxable) nondeductible contributions (the tax was paid before you made the contribution) of $250,000, and
Tax-deferred earnings of $100,000.
Income tax has never been paid on the first ($100,000) and third ($100,000) sources. As you withdraw money from the IRA after you turn 59½, the law requires that you pay ordinary income tax on 1 and 3 (tax on $200,000).
Nondeductible contributions to your second IRA source ($250,000) allow part of any IRA distribution from that account to be excludable from income tax according to a taxable/non-taxable formula.3
IRA accounts can be invested generally in cash and marketable securities such as stocks, bonds, and mutual funds, but not in collectibles with the exception of some minted precious metal coins.4 Annuities from insurance companies are also eligible IRA investments but life insurance is not. Banks and brokerage firms are the main purveyors of IRAs and often define the investment options available as certain mutual funds, or provide the investor self-directed IRA investment options. Only some IRA custodians allow real estate (excluding a real estate investment trust—REIT—or through some other readily marketable vehicle) partnerships and operating businesses as IRA investments.
Roth Individual Retirement Accounts (Roth IRAs)
Roth IRAs differ from regular IRAs in three important respects:
- Roth IRA contributions are never tax deductible.
- There is no minimum withdrawal requirement each year after attaining age 70½ as there is with regular IRAs.
- Earnings are tax free, so no income tax is due upon withdrawal of the funds as long as the owner is at least 59½ and the account is at least five years old.
All other IRA provisions are generally the same with Roth IRAs as with regular IRAs. It is possible to convert a traditional IRA to a Roth IRA but the tax on any untaxed portion of the traditional IRA balance must be paid in the process. There are also specific income requirements of the IRA owner to consider.5
401(k) Plans
These plans are employer-sponsored and are eligible for employer contributions that match the employee contributions to an extent defined by the sponsor. Under 2006 law, $15,000 per year can be contributed by the employee to these plans ($20,000 if the employee has turned fifty by the end of the contribution year). Some employers match employee contributions to a certain extent.
The same minimum withdrawal rules that apply to IRAs also apply to 401(k) plans. Deposited funds can be withdrawn, depending on the terms of the plan, after age 59½ or termination of employment. Distributions from a 401(k) plan, other than “required minimum distributions” for orderly withdrawal, can be rolled over into a new 401(k) account or IRA. Co-mingling 401(k) balances is discouraged as it does not allow the preservation of benefits associated with “pure” IRAs.
Beginning in 2006, participants in 401(k) plans will be able to designate certain plan contributions as Roth contributions. Roth contributions are after-tax contributions that will grow tax deferred and never be subject to further income tax beyond what has already been paid. Unlike Roth IRAs, there are minimum withdrawal requirements after age 70½, but these can be avoided by rolling the Roth 401(k) into a Roth IRA.
403(b) Plans
403(b), or Tax Sheltered Annuity, plans are similar to 401(k) plans except sponsors are employers who are tax-exempt organizations. Examples of tax-exempt organizations are school districts, colleges/universities, religious organizations, and charities. If you work for any of these, you may have a 403(b) plan instead of a 401(k) plan. There are some differences between these two types of plans, but they function similarly.
Small Business Owner Plans
For small business owners, there are other retirement plan possibilities that qualify for special tax treatment under the Internal Revenue Code. Some of these plans are SIMPLE, KEOGH, SEP, and 412(i). If you are a small business owner or otherwise self-employed, it is useful to explore the different options available.
The key to retirement savings is discipline and regularity. Assuming your earnings keep pace with inflation, setting aside a fixed percentage of your earnings for savings is a much better plan than saving a fixed amount each year; as your salary increases exceed inflation, you have the opportunity to save larger amounts.
Monitoring Your Retirement Plan
It is important to regularly measure the amount saved by comparing the saved amount to a projected need. The purpose is to deter mine if your retirement funding is on target. If you are underfunded, you must make up the difference before retirement, postpone the date of your retirement, or accept a lower level of income upon retirement. Monitoring consists of comparing your retirement savings balance with a calculated progress balance. For example, if you had projected that you needed to save $500,000 by the time you retire and you have been able to save $10,000 per year for ten years, a comparison of the current savings balance with the balance needed to meet your goal is very helpful.
Seeing this comparison will help you decide whether or not you need to increase the rate of your savings. Saving $10,000 at the end of each year for ten years has produced $100,000 of contributions. In addition, your savings has accrued $25,779 in earnings over ten years (using a 5 percent compounded earnings rate, after tax). Your total account balance today is $125,779 after you have paid the income tax on the earnings. If you have twenty more years until your retirement, keeping the same savings pace of $10,000 per year while earning the same 5 percent after-tax return will make your goal. In fact, you will exceed your goal, accumulating more than $664,000.
On the other hand, if you have only ten years until retirement, chances are that you will not make your goal without increasing the amount you save each year or increasing the earnings rate. Assuming this account is taxable and you are able to net a 6 percent return per year after taxes instead of 5 percent, your account balance in ten years would only be $357,059. By increasing your savings each year to $15,000 from $10,000 and using a 6 percent return after taxes, your account balance would still only be $422,963. To meet your $500,000 goal in ten years, you would need to save $20,845 per year, earning 6 percent after income taxes have been paid each year. This kind of fine tuning is helpful if you monitor your account balance and compare it to your goal at retirement.
INVESTMENT RETURNS
Average investment returns have been used for the calculations throughout this article. However, the key to saving for a comfortable retirement is not only calculating the amount needed and monitoring your progress, but achieving consistent investment returns.
Investment returns are not distributed evenly over years. In fact, the sequence of returns achieved can have a dramatic impact on your money lasting through your retirement years. Higher returns received in the early years of retirement withdrawals, when there are higher overall invested balances, will achieve better portfolio performance over time than if lower returns are received in the early years. At the end of the day, it is not average returns that are successful in helping you reach your retirement goals, but consistent returns.
A method that has been proven to produce more consistent returns over time involves selection of a portfolio that adequately diversifies your risk, using various asset classes with measured correlations to each other.
CONCLUSION
Building a financial plan is important for your economic well-being in retirement, but saving just for savings’ sake is like driving without a map or shooting without a target. By carefully planning and providing for your needs, then monitoring your progress as life changes occur, your savings will become meaningful and useful as you reach retirement and other financial goals.
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Article written by Robert M. Haynie
Photography by Bradley Slade
ABOUT THE AUTHOR
In 2002, Robert M. Haynie was recognized by Worth magazine as one of the top 250 financial advisors in America, and in 2005 he was named one of America’s best financial planners by Consumers’ Research Council of America. Employed by Merrill Lynch in Seattle, Haynie is a Certified Financial Planner®, Certified Public Accountant/Personal Financial Specialist, and Certified Investment Management Analyst (CIMA®).
Haynie is past president of the Puget Sound Chapter of the BYU Management Society, past board member of the University of Washington Gift and Estate Planning Council, and member of the Investment Management Consultants Association and the Personal Financial Planning Division of the American Institute of Certified Public Accountants.
For seven years, Haynie shared his expertise as a presenter at BYU’s Education Week. He earned his MAcc from BYU in 1978. The contents of this article represent solely the views of the author and do not necessarily reflect the opinions of Merrill Lynch
NOTES:
- Except with Roth IRAs—see Roth IRA discussion.
- See Ernst & Young Tax Guide 2006, p. 279–280.
- See Ernst & Young Tax Guide 2006, p. 276.
- See Internal Revenue Code, Section 408(m)(3).
- See Ernst & Young Tax Guide 2006, p. 273.
This brief summary of planning ideas is for discussion purposes only. It does not contain legal, tax, investment, or insurance advice and cannot be relied upon for implementation and/or protection from penalties. Always consult with your independent attorney, tax advisor, investment manager, and insurance agent for final recommendations before changing or implementing any financial, tax, or estate planning strategy.