When you hear the word retirement, what is the first word that comes to your head? Is it beach, travel, hobbies, or maybe just relax and do nothing? How about the words broke, I don’t know, or I’m screwed; do these words ever pop-up in your head? Probably not but maybe they do, and you don't know what to do about it. First, you must acknowledge that 1) your retirement savings is essential for your future, and 2) you must start saving even if it’s only a ten dollars a month, it doesn’t matter as long as you start. After reading this post, you are going to learn about, 1) types of retirement accounts, 2) how much you should have saved at every age for retirement, and 3) find out if you're on track to retire at your desired age.
Let's begin by reviewing five major retirement accounts. I think you will find after reading this post; these plans are easier to understand then you may think. Well, begin with one of the most common retirement accounts, called a 401(k).
401(k). Approximately 60 million Americans have one of these accounts provided through an employee's employer. A 401(k) account allows you the employee to contribute a portion of your pre-tax paycheck to this retirement account. This means you do not pay taxes on the money you contribute. Also, your investment gains will not be taxed until you retire. By combining these tax advantages, you will be able to grow your wealth faster. Check out the example below where we compare how a tax advantaged account like a 401(k) can significantly help grow your money versus a standard investment account.
Generally, if you are employed at a medium to a large company, you may already have a 401(k) and not be aware. After 90 days of employment, some firms automatically sign you up for an account and contribute 3% of your pre-tax income per paycheck. Give your HR department a call to learn more about retirement plans offered by your company.
Another advantage of a 401(k) is most employers will contribute a percentage of what you contribute to your own 401(k). THIS IS FREE MONEY!!! WE LOVE FREE MONEY!!! For example, my company will match the first $1,000 I contribute. At a minimum, I should contribute at least $1,000 a year so I can get another $1,000 a year for free from my company. The only string attached is most companies will make you wait a few years for the money to vest. This is merely an incentive to keep you at the firm because should you leave before your money fully vests you will not be able to keep it.
Contribution Limits. The IRS will allow you to contribute $18,500 a year towards your 401(k) tax-deferred. This number does change so for the latest figure; please visit the IRS website here. (2018 401(k) Contribution Limits). If you are over the age of 50, you can contribute an additional $6,000 in what the IRS calls a catch-up provision. Thus if you are over age 50 can you contribute $24,500 tax-deferred per year. Should you withdraw monies from your account before retirement, you may be subject to a 10% penalty plus federal, state and local income taxes. However, there are ways to withdraw funds from your account without facing any penalties or taxes, which we will discuss in a later post.
Napkin Note: Derived from a 401(k), is a 403(b) plan. This plan is for educators and those who work for non-profits. There is also the 457(b) plan which is designated for government employees. These plans are very similar to a 401(k) and will be described in detail in a later post.
Individual Retirement Account (“IRA”). If your employer does not offer you a 401(k) or if you have already contributed $18,500 in a calendar year and want to contribute more, you can open an IRA account with a brokerage firm. Similar to a 401(k), your contributions and investment gains grow tax-deferred. You will pay taxes on the monies once you retire. Some differences from a 401(k) are since an IRA it is not employer-sponsored, there is no matching program. To receive the tax benefit you will need to deduct the IRA contributions on your annual income tax return. An IRA is similar to a brokerage account, where you invest in stocks, ETFs, bonds, and other investments. But should you withdraw funds before retirement which the IRS defines as 59 ½, you will be subject to a 10% penalty and have to pay federal, state, and local income taxes.
Contribution Limits. You’re allowed to contribute up to $5,500 tax-deferred per year if you’re under age 50, and $6,500 per year if you’re over age 50. If you already have a 401(k), you will not be able to deduct the full IRS contribution once you earn more than $63,000 a year. Once you reach $73,000 a year in income, you will not be able to deduct any contributions (as a single tax filer). Even if you do not receive the deduction from the IRS, your investment gains still grow tax-deferred until you take a withdrawal.
Roth IRA. This type of retirement account is similar to the traditional IRA explained above. The two fundamental differences are the contributions are made after taxes are paid, and investment gains are never taxed. You can also withdraw funds before age 59 ½ with no penalty. With this said you might be leaning more towards a Roth IRA over a traditional IRA because you won’t have to pay taxes when you retire. But you need to consider the following: 1) your tax bracket may be significantly less than it is currently, since when retiring you will not be generating the same income as compared to your working years and, 2) no one knows what the tax law is going to be in 20, 30 or 40 years from now. Please consider these two factors and discuss which IRA is more appropriate with your financial adviser.
Contribution Limits. The contribution limits are the same as a traditional IRA.
SIMPLE IRA. SIMPLE stands for Savings Incentive Match PLan for Employees. This plan is designed for small business owners with less than 100 employees. Like a 401(k), contributions are made pre-tax, and investment gains grow tax-deferred. Small businesses favor this plan for their employees over a 401(k) because it is less complicated and most importantly less expensive. Employers can either match an employee’s contribution up to 3% or contribute 2% of an employee’s salary regardless if the employee contributes or not.
Contribution Limits. Employees can contribute up to $12,500 a year tax-deferred and an additional $3,000 a year once the employee is over the age of 50 as stated in the catch-up provision from the IRS.
SEP IRA. This type of retirement plan is designed for self-employed individuals with no employees. Just as in a 401(k), traditional IRA, and SIMPLE IRA, contributions are made pre-tax, and investment gains grow tax-deferred. A SEP IRA is subject to many of the same rules as a traditional IRA. Like all retirement accounts discussed you could invest in stock, ETF's, bonds mutual fund and other investments.
Contribution Limits. The tax-deferred contribution limits for this plan are enormous. In 2018 you can contribute $55,000 a year or 25% of your gross annual salary, whichever is less. There is a no catch up provision, but if you can save $55,000 a year for retirement for 30 years, I don't think you will need to do any catching up.
Please consult your financial advisor to make the best decision when choosing a retirement plan.
Fidelity has created a simple timeline for how much you should have saved by using your salary as a benchmark.
· By 30, you should have 1x your salary
· By 40, you should have 3x your salary
· By 50, you should have 6x your salary
· By 60, you should have 8x your salary
· By 67, you should have 10x your salary
Retirement calculators are a great way to see if you’re currently on track. Check out the retirement calculator at Merrill Edge here. Most investment firms have a retirement calculator, so search around and find one you like, but the results should be the same. I encourage you to play around and figure out where you are and what you need to do, to get on track. As always please leave your comments below or reach out to me with questions at email@example.com.