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, retirement today is more
than just a matter of accumulating enough money.
Increasing life expectancy has made retirement an
extended stage of life. People can expect to spend 15 to
35 years or more in retirement. That’s a long time. What
kind of retirement do you want to have? How should you
spend money during retirement? How can you prepare for
it and when should you start? |
 | This brochure, prepared by the Financial
Planning Association (FPA), addresses various stages of
retirement planning, from starting out in the workplace to
living after work, in order to help you achieve your dream of
a comfortable, fulfilling, financially secure
retirement.
Getting
started… Your 20s and early 30s
Working
on it…Your 30s through your 40s
The
home stretch…Your 50s and 60s
Retired
at
Last…
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 retirement 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 for retirement? Most likely, it will be through an
employer-sponsored retirement 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, and you can only put up to $3,000
annually into one through 2004 (up to $6,000 as a couple),
with additional increases after that. 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.
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.
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 qualified retirement
plan.
Working on it…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 for retirement. 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 towards retirement.
One of the classic
conflicts is saving for retirement versus 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, even if you plan to
retire early.
CAUTION: Try to avoid
tapping into your retirement 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.
The home stretch…Your 50s and 60s
Now is
the last opportunity to really sock away retirement funds. Try
to boost your retirement 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. 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 retirement 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).
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, both to reach
retirement and during retirement itself. 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 retirement 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 retirement will
cost—but watch out for rules of thumb. Arbitrarily figuring
you’ll need only 70 or 80 percent of your pre-retirement
income may prove too low, or too high. Expenses also can vary
during phases of retirement: typically high at first (all that
travel and fun), lower in the middle, then higher toward the
end as health declines.
Calculate what realistic
financial resources you’ll have to pay for your retirement.
Also, begin thinking about how you’ll roll over your
retirement assets in ways that either preserve their tax
deferral or reduce potential taxes.
Little
time to save?
What if you have saved little
toward retirement yet you want to retire soon? Your options
are more limited at this stage.
- Reduce expenses and invest the
savings
- Increase income through a second or
better-paying job
- Maximize retirement plan
contributions
- Invest more aggressively, but not
recklessly
- Postpone retirement or retire part-
time
- Make smart withdrawals from
retirement accounts once you retire
Retiring
Early?
Want to retire early—that is, before
“normal” retirement age? 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, in retirement.
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. Early retirement 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…
Retirement 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.
Retirees 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.
Retirees 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 retirement 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
retirement. 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 retirement turning out as you envisioned? Did
that “practice” you did just before retirement 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 for Retirement? Use our checklist to find
out.
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