Retirement

How do you plan for retirement? How do you know you are saving enough? An overview of the different types of retirement savings and how to use them to increase your income in retirement.

Retirement planning

The goal of retirement planning is to have enough income to live on after you stop working, and the earlier you start saving for retirement, the easier it is for you to save what you need because you will benefit from returns on your investments.

 To determine how much to save, you need to have a general goal in mind for how much you hope to spend annually in retirement, and you need to know what various sources of income you will have in retirement. You also should consider how much you hope to leave behind to your heirs, either through leftover money in a retirement account or through a life insurance policy. It is better to be more cautious when saving for retirement since you may have more expenses than you anticipate.

Once you have figured out your goal for the total amount you want to save, you can calculate what percentage of your income you need to put in a retirement account each month based on how many years you have left before retirement.

Setting a Monthly Retirement Savings Goal

You usually do not need to replace all your income in retirement because you might not have as many expenses as you do when you are working. Instead, you can determine the percentage of your income that you would be comfortable living on and plan to save that much.

For example, Casey has 40 years until retirement. Her goal is to replace 70% of her current income of $90,000 in retirement, which means she wants to take out $63000 per year from her retirement savings each year for living expenses. She wants to make sure she has this amount for 30 years. Casey needs about 3 million dollars, after considering inflation, since $63000 in the future will be worth less than it is now. She currently only has $1000. To meet her goal, she needs to set aside at least 15% of her income into a retirement account that will grow at an average annual rate of 5% per year.

Government Pensions and Social Security

Many countries offer a pension or social security program to retirees, and the percentage of the income these programs will replace depends on the country. In the United States, there is a 6.2% tax on most employees to fund Social Security. When you retire, you can claim a certain amount of Social Security benefits every month depending on your income and how long you contributed to Social Security. 

You must contribute to Social Security for at least 10 years to receive your Social Security benefit when you retire, and Social Security is usually not enough to replace most of your income. 

Even in countries with state pensions, such as the UK or France, you still may need to save some income for retirement to supplement your pension benefits.

Defined Benefit Pensions

A defined benefit pension means that you are entitled to a certain income every year after you retire based on how many years you contributed to the pension and your highest income. For most pensions, you must contribute to the pension for a certain number of years before your contributions are vested. Once you are vested in the program, you are guaranteed a benefit, but if you do not contribute to the system long enough to be vested, you may lose all the contributions you put into that system.

Some employers offer pensions that are separate from government pension programs. In the United States, receiving a pension may mean that you are contributing to the pension instead of Social Security, leading you to not be eligible for some or all of your Social Security benefits according to the Windfall Elimination Provision.

Employer-sponsored plans

One way to save for retirement as an individual is to invest in an employer-sponsored plan. In the U.S, these include 401k accounts for private companies and 403b or 457 accounts for public-sector employees.

You can sign up to have money automatically taken out of your paycheck and put into these retirement accounts. Your employer may also match a certain percentage of your income that you put into your account. These accounts are tax-advantaged, meaning that you do not need to pay income taxes on your contributions, although you do have to pay taxes on the money when you withdraw it from your savings in retirement. Tax-advantaged accounts are most beneficial to workers currently earning more than they would earn in retirement.

Some employers offer Roth accounts that allow you to contribute income that has already been taxed. When you withdraw money from a Roth account in retirement, you don’t pay taxes on it. Roth accounts are beneficial for workers currently earning less than they would be during retirement.

IRAs

An Individual Retirement Account (IRA) allows you to save money for retirement on your own if you are self-employed, do not have an employer-based plan, or do not like the investment options offered to you by your employer-based plan. If you contribute to a traditional IRA in the U.S., you can reduce the amount of taxable income you have by the amount of your contribution, lowering your overall income taxes on your current income. You can also contribute income that has already been taxed to a Roth IRA which allows you to save on taxes in retirement

There are limits to how much you can contribute to an IRA, which are lower than the maximum amounts you can contribute to an employer-sponsored plan. The current limits are $6,000 for people under 50, and $7000 for people over 50. So, while the advantages of having an IRA are that it is not linked to your employment or limited by your employer’s retirement plan’s options, you are not able to contribute as much to IRAs. However, it is possible to have both an IRA and an employer-sponsored account, such as a 401k.

How to invest for retirement

How you invest your retirement savings depends on your age and how many years you have until retirement. The general guideline is to keep more of your investments in stocks when you are younger and gradually increase the percentage of bonds you have in your portfolio. This allows you to reduce the risk of your investments as you get closer to retirement. 

To determine what percentage of your retirement portfolio should be stocks, you can use the 100 minus your age rule. This rule, based on the work of economist Harry Markowtiz, suggests that the percentage you should own in stocks should be your current age subtracted from 100. If you want to invest more aggressively, you can modify this rule to instead be your age subtracted from 120.

For example, Casey, who is 25 years old, should aim to invest at least 75% in stocks and 25% in bonds. At the most, she should have 95% in stocks and 5% in bonds if she is willing to take more risks with her investments.

What are Annuities?

Annuities are a type of investment usually sold by insurance companies which allow you to receive a fixed or variable payment over several years. Some people also choose to purchase annuities for retirement. You usually pay into an annuity over several years and are not allowed to access the payments until a specified date. Annuities  guarantee that you will have income in retirement, but they usually have higher fees than investment funds.

For example, Casey decides to purchase an annuity 10 years before she plans to retire to ensure she has a steady income stream. She pays $5000 each year into a 10-year annuity with a 6% interest rate. After 10 years, she will receive payouts of $490 per month for 10 years. This annuity won’t be enough to cover all of her retirement expenses, but it will supplement her other retirement income. 

Changing Employers and Using Retirement Savings Early

If you have an employer-sponsored retirement plan, you will be able to keep the money you contributed, even if you move jobs. Your retirement accounts will continue to accumulate investment returns that you will be able to access when you retire. However, there will still be fees on these accounts. You can choose to cash out the account or rollover the plan to a new employer or to an individual retirement account (IRA). 

Some people tap into their retirement savings before they are at the age when they can legally withdraw from them. This is usually not a good idea because you will have to pay a tax penalty on the withdrawal, unless you are using it for an allowable purpose, such as education or a down payment, and you are reducing your total retirement savings by lowering the amount you have invested now. You should leave your retirement accounts alone for as long as possible so they can keep growing until you retire.

Deciding When to Retire

When you retire depends on how much savings you currently have, among other factors. If you have a pension or Social Security, you may want to delay the start of your benefit payments, since most programs will give you higher monthly payments the longer you wait to start withdrawing them. At a certain point, usually around age 70, you will be required by law to withdraw a minimum amount each year from your retirement or to start your pension payments. 

Some people who wish to retire earlier follow strategies from the Financial Independence Retire Early (FIRE) movement. FIRE followers aim to retire in their 40’s or even their 30’s by maximizing their income, especially passive income such as income from investments, while reducing their expenses to the bare minimum. They usually invest most of their income in brokerage accounts that they can access earlier than retirement age and in traditional retirement accounts. The main goal of FIRE is to accumulate enough assets to live entirely on investment income rather than working a traditional job.

How to Budget in Retirement

Once you are retired, it may be tempting to withdraw all your savings at once and begin to spend them, but you are probably better off if you only spend what you really need and continue to invest most of your savings in less risky investments such as bonds. If you have a long retirement, this will allow you to keep growing some of your savings for the future.

Withdrawing just 4% per year from your retirement savings will allow you to keep the rest of the savings that are invested growing by at least enough to keep pace with inflation. That way you will avoid running out of money even if you end up living longer than you expect.

[1] “Retirement Calculator,” NerdWallet, accessed August 20, 2022, https://www.nerdwallet.com/investing/retirement-calculator

[2] “Social Security,” SSA, accessed August 20, 2022, https://www.ssa.gov/news/press/factsheets/HowAreSocialSecurity.htm#:~:text=Social%20Security%20is%20financed%20through,self%2Demployed%20pay%2012.4%20percent

[3] “Social Security,” SSA, accessed August 20, 2022, https://www.ssa.gov/benefits/retirement/learn.html

[4] Whether you’ll get pension payouts from a former employer when you retire depends on how long you held that job. The less time you spent with that employer, “What If I Leave My Company before I Retire?,” CNNMoney (Cable News Network), accessed August 20, 2022, https://money.cnn.com/retirement/guide/pensions_pensions.moneymag/index3.htm?iid=EL

[5] “Social Security,” SSA, accessed August 20, 2022, https://www.ssa.gov/benefits/retirement/learn.html

[6] Arthur Pinkasovitch, “Tax-Deferred vs. Tax-Exempt Retirement Accounts: What’s the Difference?,” Investopedia (Investopedia, July 20, 2022), https://www.investopedia.com/articles/taxes/11/tax-deferred-tax-exempt.asp

[7] “Retirement Topics – IRA Contribution Limits,” Internal Revenue Service, accessed August 20, 2022, https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-ira-contribution-limits

[8] Daniel Kurt, “Stock Allocation Rules,” Investopedia (Investopedia, July 11, 2022), https://www.investopedia.com/articles/investing/062714/100-minus-your-age-outdated.asp#:~:text=Balance%20by%20Age%3F-,The%20old%20rule%20about%20the%20best%20portfolio%20balance%20by%20age,as%20the%20investor%20gets%20older

[9] Mark P. Cussen, “The Pros and Cons of Annuities,” Investopedia (Investopedia, July 13, 2022), https://www.investopedia.com/articles/retirement/08/annuity-mutualfund.asp#:~:text=Annuities%20can%20provide%20a%20reliable,accept%20a%20lower%20monthly%20income

[10] Julia Kagan, “What Is the 4% Rule for Retirees?,” Investopedia (Investopedia, May 4, 2022), https://www.investopedia.com/terms/f/four-percent-rule.asp

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