When thinking about retirement, the most important thing is to start saving early. However, it’s also important to realize that saving is not enough on its own. You need to plan strategically for how you will fund your retirement years, which means considering all forms of income and how to maximize them.
When you pay into Social Security, you’ll receive a retirement benefit in an amount that depends on several factors. When you know about these factors early in your working life, you can plan around them and maximize your retirement income. And of course, even if you’re near retirement, it’s also important to understand how Social Security works, so you can pick the right time to start drawing your benefit.
What to Know about Social Security Benefits When You’re Starting Your Career
Your Social Security benefit is primarily determined by your earned income during your working years. In general, the more you earn, the higher your benefit will be. However, there is a maximum Social Security benefit. In 2019, this maximum is $2,861 per month. No one can receive more than that, but many people will end up receiving much less, mainly due to a couple of key factors. One of these key factors is their work history.
The federal government calculates the final benefit you receive based on your lifetime earnings, averaging your salary over the 35 years during which you earned the highest amount. The Average Wage Indexing Series is used to account for inflation in this calculation. However, it is critical to know that if you work fewer than 35 years, your salary is essentially considered “$0” each year that you’re short of 35. This will reduce your average salary calculation and therefore your benefit. It’s true that you only need to work for one decade to qualify for Social Security, but you’ll need to put in at least 35 years to reap the maximum benefit.
The second factor that can bring down your Social Security benefit is when you claim it. You’ll need to work until your full retirement age to get the maximum benefit. The full retirement age depends on when you were born. The government has increased the full retirement age from 65 to 67, although the increase is happening incrementally over a 22-year period that began in 2000. For people born in 1960 and later, the full retirement age is 67. Check the Social Security Administration’s chart to view your full retirement age.
That being said, you can claim your Social Security benefit at 62. However, that benefit will be lower than it would be if you waited until full retirement age. Basically, your benefit will be reduced a certain percentage for each month before your retirement age. If you were born in 1960 or later and your full retirement age is therefore 67, you can claim your benefit at age 62, but that benefit would be reduced by about 30%.
After your full retirement age, the Social Security benefit actually increases incrementally up to 70 years of age. Thus, if you want to maximize your Social Security benefits, don’t claim any until you are 70. Past 70, no further increases occur, so it’s time to cash out.
Understanding these rules early in your career can help you plan for the future effectively. However, it is important to understand that people often need to claim the benefit before reaching age 70—and that’s okay. In an ideal world, you would be able to hold off until 70, but life has a habit of getting in the way.
Similarly, it is important to maximize your earnings for 35 years, but within reason. If you take a year or two off, you may want to plan to work another year or two, so that you don’t have those zero-salary years included in your benefit calculation. The 35-year average also makes it possible to eliminate some low-earning years, such as those right after high school or college.
Your Income and Earnings in the Years Before and After Retirement
Two other important considerations have to do with the years leading up to and following retirement. One concerns penalties: people in early and full retirement have earning limits beyond which their benefit is affected. Currently, early retirees can earn $17,640 in gross wages or net earnings without penalty, but every $2 earned above this amount will result in a $1 reduction from your benefit. In the year leading up to your full retirement age, you can bring in $46,920 before you’re penalized. For every $3 earned above this amount, $1 will be subtracted from your benefit. Once you reach your full retirement age, your earnings will not affect your benefits.
The other important consideration is taxes. Up to 85 percent of your payout can be subject to federal taxes, depending on your filing status and overall income. If your combined income falls between $25,000 and $34,000 for single filers or $32,000 and $44,000 for joint filers, you’ll have to pay taxes on up to 50% of your Social Security income. Above these ranges, you’ll be taxed on 85 percent of your benefit.
Given all this, you may want to think about reducing your overall taxable income in retirement. By distributing funds evenly over the span of a few years without sudden increases, you can decrease your adjusted gross income, but this will require some planning.
How Married Couples Should Strategize for Social Security
Another important consideration is the strategies married couples should use when it comes to claiming Social Security benefits. In general, there are two primary strategies. You can claim your own benefit, or delay this claim and receive half of your spouse’s payout. Your marriage needs to be at least 10 years old to qualify for this strategy. This approach can be especially helpful if one spouse was a particularly high earner.
Generally, one spouse will begin receiving payout earlier, whether at 62 or full retirement age, while the other waits until age 70 to maximize their benefit. Typically, the spouse who earned more delays their claim.
One of the most difficult questions to answer in relation to retirement savings is how much money is enough, especially when one considers the risks involved in investing. Realistically, individuals need to think more about how much they can invest than how much they should invest. The two numbers may be radically different depending on personal situations.
People who consider saving for retirement important should make it a priority and enshrine it within their budgets. The first step is to get a sense of how much people will need in retirement and what that would look like in terms of monthly savings now, even if that number is not immediately feasible. Another approach is to ask how much the amount currently being saved will amount to in the future.
Some individuals figure out how much they must contribute now in order to live as they would like during retirement and translate that into their current investments. Whatever is left after making that deposit is how much individuals have to live on here and now. Of course, this strategy can leave individuals struggling to make ends meet.
Investors still face the question of how to determine the amount they will need in retirement. This is not an easy question to answer, but it is an important one. People who arbitrarily choose to save a certain amount for retirement each month may be in for a surprise when they get close to 65 and realize how little they actually have to live on after retiring.
Several free online calculators exist that can make the math much simpler. Individuals choose an investment strategy (from conservative to aggressive) and indicate how much they are currently saving to see what the monthly retirement income will be.
Thinking about How Much Money Is Really Needed during Retirement
Still, there is the question of how much monthly income is enough during retirement. Certainly, it is quite difficult for individuals to imagine how much they will need to achieve their goals. A good strategy when it comes to this question is to start broad and then get more specific over time. As individuals get closer to retirement, they will have a better sense of what they will need. When just starting to save, people can generalize much more.
Some financial professionals recommend that individuals set a goal of getting their take-home, after-taxes pay today. However, it is also important to adjust for inflation, which can be up to three percent per year, so it is best to round up rather than down. Once retirement is within 10 years, then it is time to get more specific with the numbers.
Budgets often change radically once individuals retire. Some expenses, such as transportation to work, will fall away, while new ones will arise. For example, individuals may need a travel budget for visiting grandchildren.
Individuals also need to think about longevity. In other words, it is not enough to ask how much they need each month. People also need to think about how long they will need the income. Average life expectancy now is about 90 years for men and 92 years for women.
However, current health concerns and familial patterns also need to be factored in. Some people will live significantly longer than that. Getting caught off guard can have undesirable consequences.
The Process of Finding the Right Balance in Retirement Savings
Once individuals have a rough idea of how much they need to save today using the strategies mentioned above and online calculators, then it is time to start thinking about how much can realistically get stashed away. While it can prove painful to increase savings and thus decrease spending money, individuals should also think about the benefits of saving.
The government, as well as many employers, incentivize saving for retirement. Employer retirement plan contributions are made before taxes. Depending on your tax bracket, putting $6,000 away for retirement in a year may only shrink your take-home income by about $4,500. When employers match contributions, that is basically an increase to salary, albeit a benefit that will not be seen until years down the road. Typically, individuals should save at least up to the employer match.
Most people worry that they are not saving enough for retirement, but there is also the risk of saving too much. Giving up today’s financial goals for the future is not always a wise decision. For example, prioritizing retirement savings over a down payment for a home does not always make sense. Individuals need to take stock of their goals and think about what they want for themselves both now and in the future.
Finding the right balance takes time and requires periodic reevaluation, so individuals should look at it as an ongoing process rather than a one-time assessment. Ultimately, saving for retirement is not all-or-nothing. Individuals can put away money for the future while also saving for a mortgage down payment, but they may not achieve the numbers they were hoping for as quickly as they would like. Sometimes, this is okay. Other times, individuals need to think about what is more important to them.
People have a wide range of different vehicles available to them when it comes to saving and investing for retirement. One of the more complex options that individuals tend to overlook is annuities. An annuity is an insurance product that can be used for steady, predictable income during retirement. Individuals invest in an annuity with an agreement about when payments for it will be received in the future. The income from an annuity may come monthly, quarterly, annually, and even in one lump sum depending on the agreement that is made. The size of each payment depends on several different factors, including the desired repayment period.
Through an annuity, investors can choose to receive payments for the remainder of their lives or only for a set period. The decision affects payout totals, as does the type of annuity. A fixed annuity provides guaranteed payments, while a variable annuity pays an amount that is dependent on the performance of underlying investments. The downside of annuities is the high expense, which is one reason why many people steer away from them. Ultimately, however, they can prove to be a great choice for many people provided that they do their research and ensure that the investment will work well with their individual situation.
How Exactly Does An Annuity Work?
While the idea behind annuities is simple, these contracts tend to be highly complex. In the most basic sense, an annuity is a contract with an insurance company to bear the risk of investment. You can pay for annuities in a lump sum or through a series of payments during what is called the accumulation phase. When the annuity begins to pay you back, this is called the payout phase. Payout can start immediately, or it can be delayed for years or decades. One example of an annuity that virtually every American depends on is Social Security. You transfer risk to the Social Security Administration, and in return you receive payments based on how much you paid into the system.
While the federal government guarantees Social Security, insurance companies back traditional annuities. A guaranteed payment is only as secure as the insurance company taking the payment. This fact also means that there is some risk involved in annuities. While the risk in variable annuities is inherent, even fixed annuities can prove problematic if an insurance company grows unstable. Individuals should make certain that they invest with respectable and dependable organizations in order to reduce this risk, especially since most individuals use annuities to provide guaranteed income in retirement.
What Are the Benefits of Annuities for Retirees?
Perhaps the greatest benefit of making annuities part of a retirement portfolio stems from research undertaken by Mark Warshawksy, Robert Veres, and John Ameriks. They found that annuities reduced portfolio failure rates across the board. In other words, annuities help to protect you against running out of money in retirement. While this means the most when viewed through the framework of longevity, it is worth pointing out that this vehicle had benefits across the spectrum. At the same time, this benefit is a double-edged sword, because the same researchers found that annuities can also limit the potential upside of investment by decreasing overall gains. Thus, while annuities provide some stability, they do so at a price, as the money could be invested in riskier vehicles with higher potential returns.
Another benefit of annuities has to do with legacy. Most people assume that annuities decrease legacy since payments are limited, but this is not the case. A study found that annuities actually help people to spend less of the asset during retirement, particularly if they live a long life. This fact translates to a greater legacy for the heirs. Part of the reason behind this is the liquidity of an annuity, which is not the same for other types of retirement investments. While no investment portfolio should have only annuities, knowing that a deposit of cash is coming on a specific date makes it less necessary to dip into other vehicles that take a long time to turn into cash.
Who Would Not Benefit from An Annuity?
Not everyone needs an annuity in their retirement portfolio. Most notably, people who are not concerned about running out of money during retirement would not benefit greatly from an annuity since the money could be used for an investment with a bigger payoff. Also, people who feel like they receive a sufficient fixed income from Social Security may not need to necessarily focus on adding to that fixed income. The other consideration is life expectancy. Individuals with serious health conditions will not get the most from an annuity, of which much of the value derives from longevity. However, people with these conditions who want to make sure a spouse is provided for may benefit immensely from annuities. At the end of the day, individuals also need to think about diversification. Without a lot of money to invest, annuities should not be high on the priority list. Even with a decent nest egg, no more than 25 percent of total savings should be placed in annuities, according to most financial professionals.
Going through a separation or divorce is hard enough on its own, but the situation grows even more complicated when it comes to money. One of the more confusing aspects of the financial ramifications of divorce pertains to retirement savings. Generally, spouses will need to split retirement assets, but the process behind this is not always clear. In some cases, one spouse will maintain an asset entirely. Understanding this process is key to handling the tax implications, as well as reformulating a strategic plan to get individuals where they want to be when it comes time to retire. The key determinant in how an asset is divided has to do with the type of account it is.
IRAs are handled differently than qualified plans, even when two former spouses agree to split both types of assets in the same way. Individuals divide an IRA using a “transfer incident to divorce” claim, while qualified plans, including a 401(k), require a QDRO, or Qualified Domestic Relations Order. Sometimes, courts will use one of these terms to cover both types of assets, but the paperwork must be in the proper order with the right designations to avoid additional headaches and hurdles down the road. With either assets, individuals need to remember to update their beneficiaries, although some divorce decrees require keeping a former spouse on the paperwork.
Key Points for IRA Asset Division
When dividing an IRA, it is important to treat the transaction as a transfer incident to divorce in order to avoid taxes. Without this declaration, both parties may end up losing money unnecessarily. The IRA custodian will classify the transaction as either a transfer or a rollover depending on the ultimate decision on the division of assets, as well as the wording of the official decree. After the transaction is completed, the recipient becomes the legal owner and that person will need to deal with any tax consequences arising from future distributions or the movement of funds. In other words, the former owner of the account does not face ramifications for how the new owner manages the funds, so long as the label “transfer incident to divorce” is used.
However, if the division is not properly labeled, the current owner will end up paying taxes and early withdrawal penalties on the entire amount received by the new owner. In order to avoid mislabeling, it is important to include both the division percentage breakdown and the dollar amount of assets being transferred. Furthermore, all sending and receiving IRA account numbers should be listed to avoid any confusion. Both sending and receiving IRA custodians need to agree with what the language indicates, in addition to the judge handling the case.
Special Situations with IRA Division
The courts must approve the division agreement or else the IRS will consider the amount sent to the recipient as ordinary income. Also, the recipient will not be able to place the funds in an IRA since it would not be an eligible transfer, and the tax deferral benefit is lost. Sometimes, recipients will demand compensation for that loss.
Another special situation occurs if the IRA being transferred was funded in part by nondeductible contributions. In this case, both parties will need to calculate the dollar amount of nondeductible contributions and report this on Form 8606 to the IRS. This form is very important, and calculations can prove tricky, so sometimes it makes sense to hire a professional for assistance. Otherwise, both people may pay unnecessary taxes down the line.
Considerations of Qualified Retirement Plans
When it comes to qualified retirement plans, particularly a 401(k), individuals need to understand the specific technicalities. Federal law provides a wide range of protections for these assets, but some notable exceptions involve seizure and attachment by creditors and lawsuits. Both divorce and separation proceedings make it possible for someone to ask for attachment of qualified plan assets through a QDRO. Such an order divides qualified retirement plan assets among formers spouses and/or children and dependents.
Like transfers incident to divorce, QDROs eliminate tax obligations, provided that they get correctly reported to both courts and IRA custodians. Through this order, the recipient has a wider variety of options. The funds can be transferred to a new or existing qualified plan, or they can be deposited into a traditional or Roth IRA. In the latter case, the money is taxed as a conversion but is not penalized. Any sort of transfer that does not fall under the QDRO umbrella will incur both taxes and penalties, so getting the right paperwork in order is extremely important.
The Takeaway Message
In the end, dividing retirement assets in a divorce can seem complicated, but it does not need to be provided that individuals do their homework and accurately report all information. The primary concern needs to be to get a transaction declared as a “transfer incident to divorce” or QDRO in order to avoid tax consequences. All custodians, as well as the courts, need to agree with these declarations. Lacking attention to detail in this matter could mean that the process becomes much more expensive and time-intensive than necessary.
Most people think about putting money away for retirement as “savings.” However, these accounts are really a form of investing today’s income in the hopes that it grows and provides a nice nest egg for the future. As with any investment, retirement accounts come with a certain amount of risk.
The amount of risk with which someone is comfortable depends on the person, as well as the situation. With retirement, individuals often try to reduce risk as they approach their sixties to protect the money that they have saved since there is less time for rebound.
Managing risk when it comes to retirement savings starts with understanding what risks exist. This is particularly true in light of the fact that more investment decisions are falling to the individual than ever before. Some of the key risks involved with retirement savings include:
Perhaps the most obvious (but still frequently overlooked) risk is inflation. Because of high inflation rates, the money that is put aside now will simply not be worth as much in terms of purchasing power in the future.
Since 1981, the inflation rate has been about 2.8 percent annually. That means people need to earn a return on investments of 2.8 percent just to break even when it comes to inflation.
Furthermore, inflation tends to be higher for retirees largely because of healthcare costs, which have actually grown at a rate that outpaces general inflation. Individuals should always think about inflation in terms of their low-risk investments, which may not even break even if they have a very low rate of return.
Sequence of Returns
The phrase “sequence of returns” refers to the state of the market during the time withdrawals are made. When retirees need to withdrawal from an investment account during a bear market, they will deplete their savings far more quickly than in a bull market.
This is exacerbated by the fact that depleting one’s savings limits the amount of money left to generate returns going forward. While most people focus on the average rate of return before retirement, afterward it is quintessential to consider the sequence of returns. Perhaps this consideration becomes most important when thinking about when to retire.
Ideally, individuals retire during positive market performance. This minimizes the need of liquidating investments to generate an income. When the liquidation happens, individuals may find themselves running out of money before predicted.
While the subject of longevity may seem morbid, it is a critically important consideration for people facing retirement. When it comes to retirement risk, longevity refers to how long individuals will actually live. Funding a retirement that lasts 20 years is significantly less challenging than making the same money last for 30 years.
While no one can predict exactly how long they will live, this consideration does have an impact on how fast individuals spend money once they have retired. Even individuals with a very solid foundation will have trouble generating enough income for 30 years. Yet people today are living longer than ever before, with many individuals living until their late nineties.
Current interest rates are considered fairly low. Retirees should recognize this fact because it means that they can generate only limited returns with “safe” investments, such as Treasury notes. While these notes once generated a return of more than 5 percent, or even 7 percent in the early 1990s, they now have a return of about 2 percent, which does not even cover inflation. As a result, individuals may have to save more than they initially thought when they started saving a few decades ago.
Another strategy is to move these investments into more aggressive accounts with the potential for greater yields, but this comes with the risk of losing considerably. While rates could increase, it leaves many people just starting to save relying on riskier options for the time being.
Healthcare costs continue to increase rapidly. People who do not plan for these expenses may find themselves going bankrupt when something happens. Before retirement, individuals need to think critically about their needs and prepare as best as they can. Looking at current health and genetics can say a lot about likely needs in the future. This will help direct people toward the best options for them.
Individuals also need to consider the level of care that they want. Private nursing homes cost much more than other options. To offset health costs, individuals can purchase long-term care insurance or supplemental policies for Medicare. However, it may also be prudent to save more than initially thought necessary for healthcare expenses, just in case.
Laws can change quickly, creating completely new tax situations. These risks are hard to predict, but they could really take a bit out of retirement plans. For example, taxes could skyrocket, which leaves individuals with traditional retirement accounts with much less money than they thought when they start to withdrawal funds.
On the other hand, people who prepare for this issue by investing primarily in Roth accounts may kick themselves if taxes are much lower when they start making withdrawals than they currently are. Many people try to mitigate this risk by investing in both traditional and Roth accounts so that they can be more strategic in how they withdraw down the road.
It is important to begin saving for retirement as early as possible. Fortunately, it is never too late to take control over retirement planning. Even in the decade leading up to retirement, there are important steps that individuals can take to maximize their savings. This is particularly true if they need to catch up in order to meet their goals.
Individuals in this situation should not feel alone. A survey conducted a few years ago found that three out of 10 individuals over 55 have no retirement savings at all. About 25 percent of responders had less than $50,000. These situations are serious, but all hope is not lost. The key last-minute steps to take when it comes to saving for retirement include:
Delay pulling on Social Security.
The age at which someone starts pulling on Social Security has a big impact on the monthly benefit. When individuals claim before their full retirement age, which is either 66 or 67 depending on birth year, the payments are reduced.
On the same token, payments increase by delaying retirement, at least up to the age of 70. Individuals who choose to retire at 70 will maximize their monthly benefit.
To see how much of an impact this will have in each individual’s particular situation, people can visit the Social Security website and track the payments that they would receive retiring between the ages of 62 and 70. People who are already behind on saving definitely need to make the most of this important benefit. The added effect is that this delay gives people even more time to save.
Diversify accounts to minimize taxes.
Once people retire and start to pull on their traditional 401(k)s and individual retirement accounts (IRAs), they will need to pay taxes on withdrawals. Furthermore, withdrawals become mandatory once individuals reach the age of 70 and a half.
These tax payments can significantly cut into the amount of money available for everyday living. People can help offset this issue by diversifying their retirement savings with a Roth 401(k) and/or a Roth IRA. Both of these accounts require that individuals invest after-tax money, but then no taxes are due upon withdrawal.
Diversification of accounts can help provide better planning for the future since individuals know more fully how much they will have to spend. With fluctuating tax rates, planning with traditional accounts becomes more difficult.
Downsize or consider a reverse mortgage.
One of the best strategies that individuals can undertake to increase retirement savings is downsizing their home, which in turn reduces cost of living. People often find this step necessary to survive in retirement anyway. Doing it early can mitigate some of the headaches that would otherwise come down the round.
However, individuals who wish to stay in their home can consider a reverse mortgage to help cover monthly bills. Such a loan is only available to people over the age of 62.
However, it does come with disadvantages that individuals need to consider. People will need to repay the loan to move. Additionally, they will not be able to leave the home to children unless they pay back the money. Also, these loans often involve a number of fees.
Reduce retirement savings fees.
Once people retire, they have the option to roll over the savings in a 401(k) into an IRA. If individuals have great investment options with the IRA and low fees, meaning less than one percent, then it makes sense to transfer money into that account. While this may not seem like a big deal at first, this move can easily translate into thousands of dollars of savings over the course of retirement.
The best part of this savings is that it requires only a one-time action on the part of the retiree and the savings will continue throughout retirement. These savings are quite significant when one considers how percentage fees compound.
However, individuals should make sure that they perform their due diligence before reinvesting the money. Any IRA should have adequate investment options for meeting realistic goals and charge low fees.
Create a strategic financial plan.
Ideally, individuals create a comprehensive financial plan for retirement savings early in life, but sometimes other factors get in the way. Even people who save diligently face emergency situations that require them to drain accounts.
When approaching retirement with less-than-ideal savings, it is more important than ever before to account accurately for monthly financial needs and figure out how to make the ends meet. Often, this means curbing spending right now to get as much into retirement plans as possible. Sometimes, individuals find that they will need to get a part-time job to cover their monthly expenses once they retire.
However, it is impossible to know these things without mapping out how much people’s financial requirements in retirement and their projected monthly expenses. Of course, much of this practice is prediction, but it also provides some needed guidance for future planning.