Let’s be honest, retirement planning is not the most exciting topic in the world. Considering the number of acronyms and tax implications of different accounts and benefits options, it’s no wonder that many people wait much longer than they should start thinking about their retirement plan. Despite the fact that half of working adults agree it is smart to start retirement planning in their 20s, only 39% actually do so. Financial advisors often recommend that clients begin retirement savings as soon as possible, largely due to the fact that the impact of retirement savings accounts could dramatically change in the many years between individuals starting their professional careers and ending them. We’ve put together this guide of some of the most important considerations for your retirement plan as you seek out a plan to proactively prepare yourself for life after your working years.
Putting Together a Plan Before Getting Started
Even before you begin taking a look at which accounts best suit your retirement needs, you’ll need a more comprehensive understanding of what you’d like your life to look like in retirement. This part of the process will include answering questions related to where you’re at in your career in the present, at what age you’re planning to retire, what you’d like your life to look like in retirement, and how much you’ll need to accumulate in savings before you get there.
What Will Retirement Look Like For You?
One of the most exciting aspects of planning for retirement is that you’ll be planning for all the wonderful things you’d like to do and see once you no longer have extensive time or resource commitments relating to work and life keeping you from doing what it is you’d like to. Visualizing what retirement looks like for you is an important part of determining how much you’ll need to save before you reach the point of retirement.
Are you hoping to tour Europe and Asia, or are you just looking forward to staying home and catching up on your collection of novels? Maybe you have grandchildren that you’d like to spend special time and resources on, or maybe you want to keep working part-time once you “retire” because you love your job so much. In any case, be sure to put together a rough draft of the special things you’d like to accomplish in retirement so that you have a ballpark idea of how much it will cost.
What Age Are You Hoping to Retire?
It can be difficult to know exactly what age you’ll retire at, especially if you are some time away from that point in your life. Either way, determining the age you’d like to retire can give you a better idea of how much you’ll need to save each year in order to reach your retirement goal, and how much your current savings will grow between now and the future. Additionally, Social Security benefits and pension distributions will also depend on the age at which you retire, so you’ll want to have a solid understanding of the implications of retiring at different ages for each component that will apply to you in retirement. For example, qualifying individuals are able to begin social security benefit distributions at the age of 62, however, the amount you are eligible to receive is significantly increased if you wait to begin receiving your benefits until your designated “full retirement age” or the age of 70 at which point your benefits cannot grow anymore.
Conceptualizing Cost and Saving Required to Achieve Your Goals
After determining what you’d like your retirement to look like, and at what point you’d like to get there, you are able to have a more solid understanding of the costs you’ll incur once you’re in retirement. Understanding costs simply takes an estimation of what your monthly or yearly costs will be in retirement, to cover any general living costs you’ll incur in addition to any big plans or purchase you’ll be making in retirement. It’s a good idea for your budget estimate to be overly generous in order to account for the inevitable implications of inflation over time, as well as any additional unexpected or emergency costs that you’re unable to foresee such as emergency medical situations that may inevitably surface as you reach the later years of your life. Make sure to revisit these estimates time and again to account for any life or plan changes that may come up. As a rule of thumb, most financial advisors suggest that individuals planning for retirement should plan to receive 70-80% of their pre-retirement income in retirement in order to live comfortably.
After your costs are estimated, you’re able to deduce how much you’ll need to save before reaching the point of retirement. First, you should add your estimated social security and any pension payments based on when you plan to retire, and subtract this total from the amount that you’re estimating retirement to cost, in addition to any current savings you’ve accumulated. The difference of this calculation is your savings shortfall, which must be made up from savings plans including 401(k)s, IRAs, Roths, etc. Calculate how much you’ll need to contribute to each account each year in order to achieve your budgeted retirement goal, also taking into account concepts such as compounding interest which will grow your account at increasing rates as you gain interest on gained interest.
Investing Your Savings
Sometimes the most difficult part of retirement planning is understanding the implications of the many types of retirement accounts that are available to you. Whether employee-sponsored or not, each account behaves differently and will have different taxation qualities that could greatly impact whether the amount of income that you’ll receive in retirement.
As one of the most popular and beneficial forms of employer-sponsored retirement plans, 58 Million Americans have 401(k) retirement accounts in 2020. 401(k)s are a form of defined contribution retirement plan whereby both you and your employer make contributions to a retirement account. The amount that you contribute is a set percentage of your annual income that is automatically deducted from your paycheck and deposited into the account. Employers also have the option to “match” your contributions up to a certain percentage of the amount that you contribute to the account. Since this is essentially free money, it’s easy to understand why these types of retirement accounts are such an attractive option.
Individuals under the age of 50 are able to contribute up to $19,500 a year to the account, while those over the age of 50 are able to contribute up to $26,000 per year. Withdrawals from 401(k) accounts are discouraged until the age of 59.5, at which point you will not be taxed an additional amount on the money that you withdraw from the account. On the other end, at the age of 70.5, you are required to begin taking minimum distributions from the account or you’ll face up to a 50% tax penalty on your withdrawals. Your employer may offer you either a Traditional 401(k) or a Roth 401(k), which differ slightly on basis of when the money in the account is taxed.
The money in a traditional 401(k) is taxed once you begin taking distributions from the account, while the money in a Roth account is taxed when the money enters the account. Additionally, while you are able to begin distributions from Roth accounts at the age of 59.5, the account must have been opened for at least 5 years in order to dodge potential tax penalties. When or if you have a choice between the two types of accounts, Traditional accounts are better suited for those in the high-income earning years of their life who are expecting their tax rate to be lower at the point of retirement, while Roth accounts are better suited for those early on in their career who expect their tax rate to be higher when they enter retirement.
Individual Retirement Accounts, otherwise known as IRAs, are a retirement savings account option set up by individuals rather than employers. Since contributions to IRA accounts are limited to the contributions you make on your own, these accounts typically see less growth than 401(k) plans. One positive aspect of these accounts is that, since they aren’t employer-sponsored, you’re likely to have more choices in the investments that you select for the account.
IRAs have significantly lower contribution limits as compared to 401(k)s, allowing for a maximum contribution of $6,000 a year for those under the age of 50 and $7,000 per year for those over the age of 50. Similar to 401(k)s, you must wait until the age of 59.5 to make withdrawals from the account without tax penalty. Similarly, you’ll need to begin minimum distributions from your IRA at the age of 70.5 in order to avoid tax penalties.
IRAs are also offered in a variety of formats including Traditional and Roth accounts, which each have the same taxation implications as was discussed with 401(k)s. There is also the option of an employer-sponsored IRA account called a Simple IRA which allows for larger contribution limits than Traditional or Roth IRAs since both the employee and employer can make contributions to the account. SEP IRAs are another variation, which is best fit for self-employed individuals or business owners who are comfortable with their business making the contributions rather than choosing to make contributions to the account themselves.
Retirement savings accounts are not the only way to prepare for retirement. With the alternative of managing your own investments, you’ll be able to save for retirement in much the same way that you’d be able to with established accounts such as 401(k)s or IRAs. Another alternative is to invest in real estate. While you may have your own home you’re working toward paying off, it’s not uncommon for people to upgrade their homes, or move somewhere more attractive once they reach the point of retirement. Some individuals may make the choice to purchase and rent out homes to cover the cost of the mortgage, which can ultimately be another source of income and can help you to pay off a mortgage before you even reach the point of retirement. When making a decision about other investments, you’ll want to keep in mind the time and resources that you’ll be devoting to monitoring, upkeep, and management, which can ultimately be more time consuming than the retirement investment savings options we’ve discussed previously.
Bringing the Pieces Together
Putting a plan in place long before you retire is the key to successfully achieving all you have planned for yourself in retirement. Beginning with having a solid understanding of what you envision your retirement to look like is the first step in the process of budgeting for how much you’ll need and when you’ll be able to retire. This will also help you to understand how much you’ll have in retirement in context to how much you currently have saved, and how much you’ll need to save in between now and the point of retirement to achieve your goals.
Whether you’re hoping to move, travel, spend time with family, or pass along funds to your heirs once you pass away, having a solid retirement plan put in place is essential to ensuring that you won’t need to continue to work into the later years of your life. With so many moving parts, having a professional to help you work through the process of putting together your retirement plan has the added benefit of leaving no stone unturned. Advisors have a sound understanding of tax implications and other stipulations that could greatly impact the state of your retirement. Advisors can also help to manage your investments which can otherwise be a rather resource and time-consuming process. Contact an advisor today to help you get on track with your retirement plan goals.