Saving for Retirement
By Brett Newberry
Many people assume they can hold off saving for retirement and make up the difference later. Waiting too long to start saving can make it very difficult to catch up, and only a few years can make a big difference in how much you’ll accumulate.
It is important that you start saving as much as you can, as soon as you can. The earlier you start, the longer compounding can work for you. For example, a 20-year-old who saves $200 a month until age 65 and earns exactly 6% on saved funds annually would have accumulated around $550,000. But a 40-year-old contributing the same amount each month at the same earnings rate would have accumulated only $138,600 by age 65.
Chances are your employer offers a 401(k), 403(b), or similar retirement savings plan. You can contribute up to $17,000 in 2012. And if you’re 50 years old or older, you can make additional “catch-up” contributions of up to $5,500, for a total of $22,500 in 2012.
Since pretax contributions are excluded from your paycheck, you’ll enjoy an immediate tax savings when you contribute to one of these plans. Your employer’s plan may also allow you to make Roth contributions. There’s no immediate tax benefit (contributions are made with after-tax dollars), but qualified distributions are entirely free from federal income tax.
Even if you cannot contribute the maximum allowed, you should at least try to contribute as much as necessary to get any matching contributions that your employer offers. This is essentially “free money.” However, you may need to work up to six years before you’re fully vested in (that is, before you fully own) any employer matching contributions.
You can contribute up to $5,000 to an Individual Retirement Account (IRA) in 2012. You can also make catch-up contributions up to an additional $1,000 in 2012 to an IRA if you’re 50 or older. Your contributions to a traditional IRA may be deductible if neither you nor your spouse are covered by an employer retirement plan, or (if either of you are covered) your income falls within specified limits. Like pretax 401(k) contributions, deductible IRA contributions can result in an immediate tax savings, and as with 401(k) plans, withdrawals made prior to age 59½ may be subject to an additional 10% penalty tax unless an exception applies.
If your income is within prescribed limits, you can also make after-tax contributions to a Roth IRA. In this case, even the earnings are tax-free, if your distribution is “qualified.” Distributions are qualified if you satisfy a five-year holding requirement, and the distribution is made after you reach age 59½, become disabled, or die, or the funds are used to purchase your first home (up to $10,000 lifetime).
It’s common to discuss desired annual retirement income as a percentage of your current income. Depending on who you’re talking to, that percentage could be anywhere from 60 to 90 percent, or even more. The appeal of this approach lies in its simplicity, and the fact that there is a fairly common-sense analysis underlying it. Your current income sustains your present lifestyle; so, taking that income and reducing it by a specific percentage to reflect the fact that there will be certain expenses you’ll no longer be liable for (i.e. payroll taxes) will, theoretically, allow you to sustain your retired lifestyle.
The problem with this approach is that it does not account for your specific situation. If you intend to travel extensively in retirement, for example, you might easily need 100 percent (or more) of your current income to get by. It is fine to use a percentage of your current income as a benchmark, but it’s worth going through all of your current expenses in detail, and really thinking about how those expenses will change over time as you transition into retirement.
What if it looks like you will come up short? Don’t panic. There are probably steps that you can take to bridge the gap. Try to cut current expenses so you’ll have more money to save for retirement; shift your assets to investments that have the potential to substantially outpace inflation, but keep in mind that investments that offer higher potential returns may involve greater risk of loss; lower your expectations for retirement so you won’t need as much money; work part-time during retirement for extra income; and, consider delaying your retirement for a few years or longer.
Until next time,
The Business Doctor