Preparing for Retirement: The Basics [Retirement Part 1]
Understanding the basics of saving for retirement – which accounts, and why?
I know a lot of jokes about retired people… but none of them work!
All jokes aside, here is one of the most requested series by readers – navigating retirement savings! This week is the first of a multi-part series on retirement. Part 1 this week will serve mainly to introduce basics in addition to a comparison of different tax-advantaged retirement account options. Part 2 will go a bit deeper into projections and forecasts for the options from this week and investigate several scenarios with case studies.
Without further ado, let’s get into it!
The 7P’s
I had a middle school substitute teacher that walked in one morning and wrote this on the board - “Proper Planning and Preparation Prevents Piss Poor Performance”. I didn’t think twice about it at the time, but this adage has been a great guiding principle since I heard it. It’s especially true when it comes to saving for retirement.
The earlier you start to plan and begin saving and investing for retirement, the better financial situation you will encounter when that day actually comes! I’ll belabor this point to death if I have to, but the effects of compound interest and investing over time (especially for things like retirement) are HUGE.
Every year for the last 7 years, the Federal Reserve Board has conducted and analyzed a survey report covering the economic well-being of US households. In this year’s report, there were about 12,000 respondents nationwide. Here are some of the highlights regarding retirement.
From the survey, 25% of non-retirees reported that they had ZERO retirement savings, and fewer than 40% thought their retirement savings were on track.
The share of individuals reporting that they have retirement savings increases as the age demographic gets older (this is a good thing)
The share of individuals reporting that their self-assessed retirements savings preparedness is on track doesn’t exceed 51% even in the 60 and older demographic group.
Let’s let that sink in for a moment… about HALF of individuals that are approaching the “standard” age of retirement feel financially unprepared to retire, and 1 in 4 have ZERO dollars saved for retirement at all. While saving for retirement and being able to save at all may not be possible for all, I believe that we can all agree that the status of the country’s retirement planning and stability could be drastically improved.
What are my options?1
When you retire for one reason or another, there are a few different sources of income that you might have. One of the first ones that come to mind should be Social Security. Yes, the one you pay for every paycheck with the line item “Social Security Tax”. One of the biggest myths is that having a social security payout post-retirement is enough to cover all of your expenses. While that may be possible, even the Social Security Administration itself states that this is not the intended purpose of social security, and that it should be supplemented by other sources of income.
The full list of retirement plans laid out by the IRS can be found here but to cover the most breadth, I’ll be mainly covering the 401(k) and Individual Retirement Accounts in the traditional and Roth flavors!
Traditional 401(k)
The Traditional 401(k) in my opinion plays the “old-reliable” role on my roster. It’s a great foundation for retirement savings, and it’s offered by most employers. Your contributions to this account are pre-tax, which means it is withdrawn from your paycheck before it ever reaches your hands and is able to grow tax-free until the time at which it is withdrawn. The great thing about pre-tax contributions is that it will reduce your income that you must pay income tax on at the end of the year. If your employer pays you a salary of $60,000 and you contribute $10,000 to your 401(k) account that year, you will only be taxed on $50,000. You are taxed when you take money out of the 401(k) after retirement in the year which you receive the distribution.
Limitations
The contribution limits set by the IRS for the 401(k) remain unchanged from 2020 at $19,500, with an additional $6,500 allowed for those age 50 and older.
401(k)s tend to have limited investment options and higher fees than what you might find with an IRA. Due your due diligence to make sure you are allocated correctly! (More on this next week)
Company Match
Another great thing about the 401(k) is that many employers will match your contributions to the account up to a certain percentage. If your company offers this and you aren’t contributing anything at all (even when you can afford to), you’re essentially leaving free money on the table.
A standard company match benefit might be a match at 50% of your contributions up to 3% of your total income. When we do the math here on a $75,000 salary, you would have to contribute 6% of your income to be able to maximize the company’s 50% match of your contributions up to 4% of your total income. Your 6% contribution would be ($75,000*0.06) $4,500 a year, and the company’s match would be half of your contribution ($4,500/2) $2,250. You’re getting a FREE $2,250!
The company match portion does not count towards the IRS limit and should always factor into your equation when trying to figure out how much your compensation package is worth at your job.
Individual Retirement Accounts (IRA)
Traditional IRA
The traditional IRA is a more flexible retirement savings vehicle than the traditional 401(k) counterpart. They are flexible in the sense that once you open and maintain an IRA, you are able to invest with much more control than the traditional 401(k) in terms of stocks and bonds. Contributions are made pre-tax and taxes are paid when you start to claim money from it in the form of distributions.
While anybody can open and invest into a traditional IRA, these contributions are not always tax deductible like they are for the traditional 401(k). They depend on income limits set by the IRS so if you’re looking for a pre-tax deductible way to save for retirement, the traditional 401(k) may be better than the traditional IRA if reducing your taxable income is a top priority.
The contribution limits here set by the IRS are at $6,000 per year and $7,000 if you are age 50 and older. Additionally, the traditional IRA requires you to withdraw minimum distributions when you reach age 72.
Roth IRA
The Roth IRA is a retirement savings vehicle that you can think of as having the flexibility of the traditional IRA in terms of investment offerings but with an enforced income limit of $140,000 in tax year 2021 (no limit in the traditional IRA, but it’s not tax-deductible). You pay taxes on the contributions upfront, but any gains you make from it afterward are tax-free.
This is effective if you think taxes in the future will be much higher than the rate at which you are being taxed today. The Roth IRA does not require you to take minimum distributions like the traditional IRA does starting at age 72.
Roth 401(k)
The Roth 401(k) is employer sponsored and offers a combination of the traditional 401(k) and Roth IRA. Contributions are made post-tax and withdrawals are not taxed just like the Roth IRA. What’s great about this is that like the traditional 401(k), you can contribute up to the IRS limit of $19,500 and there is no income limitation to participate. The distributions from the Roth 401(k) are also required to begin withdrawing at age 72.
If your income is too high to participate in the Roth IRA and your employer sponsors the Roth 401(k), this is a great way to gain access to the functionality of a Roth IRA while removing the income limits.
Here’s a great tabular view of the comparison between a Roth 401(k), the Roth IRA, and the traditional 401(k).
Penalties
The last point that I will make in this week’s post is regarding penalties. For most of these accounts, withdrawing before the age of 59 and a half incurs a penalty (minus a few exceptions like first time home purchase, qualified education expenses, disability, etc.). Because planning for retirement for most in the Millennial generation is a long-term game, it may not be the best idea to contribute money to retirement accounts if you plan on needing that money in the short term.
As always, thanks for reading, and if you find my newsletter helpful, please give it a share! If you have any questions or want to follow up with me for a conversation, please comment down below, reply to the newsletter email, or DM via Instagram @millennial_wiz. See you next week for Part 2 of the Millennial Wiz RETIREMENT SERIES!
Disclaimers:
Please remember to do your own due diligence and realize that ALL investments have risks associated with them. This content is for purely educational purposes and should not be interpreted as tax advice. I present my research, but your investment decisions are purely your own! For tax and financial advice, please seek advice from licensed professionals.
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