With over 75 million Baby Boomers (ages 43-61) waiting in the wings, retirement planning has taken on a whole new meaning. The term “Golden Years” to describe retirement first appeared in the 1970’s. The ideal conditions for enjoying these years were to have $1,000,000 in the retirement nest egg, being an empty nester, no debt, and hopes for extensive travel. How well Americans have done preparing for retirement is a far cry from the “Golden Years” profile. Unfortunately, for many, retirement will be the “Rusty Years”.
The Fidelity Research Institute recently issued its’ 2007 Retirement Index study. It found that Boomers are on track to replace 62 percent of their pre-retirement income once retired. An industry rule-of-thumb is a 75-80 percent replacement ratio. The study also found that the median total household retirement savings of Boomers was only $45,000; a far cry from the $1,000,000 “Golden Years” scenario. The Spectrem Group, a consulting firm specializing in affluent and retirement markets, recently found that the number of U.S. households with a net worth of at least $1 million, excluding primary homes, has grown to 9 million. This represents only 6 percent of all American households. For many, the $1,000,000 nest egg will be an impossible dream.
Fidelity also found that Social Security will provide 33 percent of pre-retirees’ income during retirement. Today, more than 50 percent of those retirees age 65 or older depend almost exclusively on Social Security as their only source of income according to the Social Security Administration.
Many Boomers now find themselves sandwiched between aging parents and children who have moved back home increasing the financial burden on the already financially stressed Boomer. As a result, the Fidelity study found that 63 percent of Boomers plan on working at least part time in retirement. Some will even find it necessary to sell their homes to provide additional retirement income. Absent the sins of the past, how can one catch up? The answer may not be as difficult as one might expect. Save! Save! Save!
There are numerous retirement vehicles which provide tax incentives to those who are willing to save. These incentives may include tax deductions at the time of the contribution, tax-deferred build-up until withdrawal and in some cases tax-free build-up. Let’s discuss the features of the most common retirement vehicles.
Defined contribution retirement plans (401ks plan being the most common) are the centerpiece of the private-sector retirement system in the United States. More than 55 million Americans are covered by defined contribution plans, with assets now in excess of $2.2 trillion.
The 401k plan benefit has become the second most demanded employee benefit after health insurance. The typical 401k plan provides employees the ability to defer some or all of their salary into the plan. For 2007, the IRS allows employees under the age of 50 to defer $15,500 of salary into the 401k; employees age 50 or older can defer $20,500. The employee’s deferral reduces the employee’s taxable W-2 income by the amount of the deferral. What this means is the employee saves about 20% income tax on the amount of deferral. In other words for every dollar that the employee defers, the out of pocket cost to the employee is only 80 cents.
While not required by law, most 401k plans provide for a company match for all or some part of the employee deferral. A very common scenario might be that the plan will match 50% of the first 6% of salary deferral. This means that the 401k participant investment account receives a 9% annual contribution; 6% employee deferral and 3% employer match. Put another way, in the year of contribution, the employee receives a 50% return on their principal.
The other fairly common retirement savings vehicle is the Individual Retirement Account or IRA. While the 401k plan must be offered at the employer or company level, the IRA can be established by the individual. The good news is that one can often participate in their company sponsored 401k and still establish an IRA. For 2007, the IRA limits are $4,000 for individuals under age 50 and $5,000 for those age 50 or older. The individual must have “earned” income in the year of the IRA contribution. Most commonly, earned income includes salary, wages or self-employment income. For married couples, only one of the two needs to have earned income to allow both spouses to make the maximum contribution to IRAs. This is great for the stay-at-home spouse who has no earned income. In effect, that spouse can “borrow” earned income from the working spouse to maximize the IRA contribution.
The tax advantage of making an IRA contribution depends on the type of IRA vehicle used. There are three types of IRA’s, for purposes of this discussion we will discuss only two. The first is the Traditional IRA also known as a deductible IRA.
The tax treatment of this IRA corresponds to the 401k contribution. The taxpayer receives a tax deduction in the amount of the contribution. So long as the monies stay in the IRA, any income and capital appreciation grows tax-deferred. When a distribution is made, the taxpayer recognizes taxable ordinary income in the amount of the distribution.
The ROTH IRA reverses the tax treatment. Contributions made to the ROTH are not deductible; understandably, any distributions made are not includable in taxable income. This is true for both the amount originally contributed and any growth experienced during the holding period. Because of this extraordinary tax benefit, the ability to make a ROTH contribution is phased out for individuals with adjusted gross income (AGI) between $99,000 and $114,000; and AGI of $156,000 to $166,000 those married individuals filing jointly.
Which is better, the deductible IRA or the ROTH IRA? It depends. It takes approximately eleven years to negate the fact that the person making the ROTH did not get a tax deduction in the front end. But the ability to grow tax free forever is a very powerful advantage. If individuals do not contemplate dipping into their ROTHs for 10 years or more, it is almost always advantages to establish the ROTH.
There are many more retirement vehicles available than those discussed above. To name a few: SEP IRA, SIMPLE IRA, the 403(b) plan, and the Section 457 plan. The tax attributes are more or less the same. The difference lies mostly in the contribution limits, eligibility, and administrative requirements.
The time to start a retirement program is NOW! Let me give you some hypothetical growth scenarios of the cost of waiting. Let’s assume that an individual begins a retirement program at age 30. This individual hopes to retire at age 65 and anticipates that he/she can contribute $4,000 per year for 35 years. We assume that the investments selected will achieve an average annual rate of return of 8%. Of course this return is only an assumption as no one can guarantee a future rate of return and indeed the achieved rate can produce losses. At age 65, our individual will have added $140,000 but the hypothetical pool of assets will be worth $744,409.
Let’s now assume that the same individual does not start the savings program until age 40, just ten years later. The assumed rate of return is still 8%. He/she will have contributed $100,000 but the investments would be worth $315,818. Yes our hypothetical investor has put in $40,000 less of his/her own money by waiting ten years, but look at the difference in the size of the account - $428,591.
The best advice that I can give to a would-be investor is put your savings program on autopilot. That is why the 401k plan has become so popular. The selected employee deferral is automatically taken out of one’s paycheck before it can be spent. Furthermore, the amount goes in systematically over the course of the year. If an IRA is selected as the vehicle of choice, make it automatic as well. That is, arrange for a monthly automatic bank draft that will be sent to the investment custodian.
There is the mistaken belief that a savings program must include a large sum of money. That is absolute nonsense. Let’s assume that an individual can save $100 per month. But our investor continues the program for thirty years. Assuming an average annual rate of return of 8%, the modest $100/month will grow to $150,030. Increase the amount to $200 or $300 per month. Do the math.
I tell clients that you cannot borrow on your retirement. Few of us work for companies that provide the old pension plan. Unfortunately, you retirement nest egg will be determined largely by you and you efforts. Pay yourself first. Make a commitment to elevate your savings program to the same priority as your monthly mortgage. When the Golden Years arrive, you will not regret it.
Sal Geraci, CPA, CFP is located at the Freight Depot, 1200 Market Street, Chattanooga, Tennessee. His phone number is 423.826.1670. He is a Registered Representative offering securities through Cambridge Investment Research, Inc., a Broker/Dealer, Member NASD/SIPC. Mr. Geraci is also an Investment Advisor Representative of Evergreen Management, LLC, a Registered Investment Advisor.