While historically people could count on Social Security and pension plans to provide a comfortable income during retirement, people today need to save and invest as they prepare for life after work. Luckily, there are wide variety of retirement plans available. However, understanding which vehicle is the best option can be confusing. Learning more about the specific advantages and disadvantages of various plans can help people figure out what they need for their particular retirement needs and goals. One way to categorize retirement plans is to consider those sponsored by employers versus individual retirement accounts.
Retirement Plans Sponsored by Employers
A great way to start saving is through employer-sponsored plans. The most basic employer-sponsored retirement account is the defined-contribution plan, typically a 401(k). A defined-contribution plan involves payroll deductions that go directly to an individual account within the company plan. Ideally, your company will match your contributions, which means that your employer will also put money into the account, up to a certain amount and based on how much you elect to contribute.
Employer-sponsored accounts are generally easy to set up, since the contributions are usually deducted directly from your pay each pay period. They’re also easy to maintain, because the plan administrator handles most of the statements and disclosure. In addition, 401(k) contribution limits are typically higher than those for individual retirement accounts—not to mention the fact that any employer matching is free money. Furthermore, contributions to 401(k) plans reduce your taxable income now. However, you’ll pay taxes on withdrawals from traditional 401(k) accounts during retirement.
In contrast, with a Roth 401(k), your payroll contributions are made after taxes, so your withdrawals during retirement are tax-free. A Roth 401(k) also has no income restrictions, unlike a Roth individual retirement account. Which you choose (traditional vs Roth 401(k)) basically depends on whether you think you’ll be in a higher income tax bracket during your retirement. Roth 401(k)s are often recommended for younger investors, who tend to fall in lower income tax brackets, but there may be good reasons for older investors to consider Roth 401(k)s as well. A financial advisor can help you make the best decision.
There are some drawbacks to defined-contribution plans, the most obvious of which is greater restrictions on investment choices. With an individual plan, you have much more control over where your money is invested. In addition, employer-sponsored plans often come with high management and administrative fees, which can take a significant chunk out of your savings. New employees should also make note of any waiting period before they can make contributions, as this is common. You may also have to wait until you’ve been with your company for a certain period of time (say, a year) before your employer will match your contributions.
Individual Retirement Accounts
The other main option when it comes to saving for retirement is the individual retirement account (IRA), which can be set up through banks, brokerage firms, and other financial institutions. These accounts hold various investments, from stocks and bonds to cash and mutual funds, reserved for retirement. Several different types of IRAs exist, each with its own tax and contribution rules, so it’s important to look through all the options. As with a 401(k) plan, you can select a traditional or Roth IRA, with Roth contributions made with after-tax income, in order to avoid taxation upon withdrawal during retirement. You can contribute to both a Roth and traditional IRA in the same year, provided that you qualify for both.
The main advantage of IRAs is the fact that you’re in the driver’s seat and make all the decisions, whether that means personally or choosing a professional to do so. Furthermore, an IRA comes with a very wide range of investment choices, so it becomes easier to diversify. However, there are some downsides, too. IRAs in general have lower annual contribution limits, although these limits increase once you turn 50. Contribution limits depend on your modified adjusted gross income. Furthermore, even traditional IRA contributions are not always tax-deductible. (Roth IRA contributions are never tax deductible.) The deductibility limits for traditional IRAs depend on your income, as well as your tax filing status and access to workplace retirement plans.
General Guidelines for Deciding on Retirement Contributions
The exact savings strategy you should use will depend on your individual circumstances, but some general guidelines can help you determine your contributions. For the most part, you should first take advantage of any workplace retirement plan that comes with employer matching. Outside of the 401(k), these plans might include 457(b)s, 403(b)s, and defined-benefit plans, which work much like a pension.
Once you’ve maxed out your 401(k) contributions, or at least the matching available from your employer, it might be time to consider an IRA. Additionally, people who do not have a retirement plan through their company should focus on an IRA. Here, the most important decision is whether a traditional or Roth IRA is more appropriate. Determining this will involve making some predictions about your tax status in retirement. People who will fall into a lower tax bracket in retirement will benefit the most from a traditional IRA. Furthermore, people who are self-employed or who own a small business should recognize that specialized accounts exist for them, including the solo 401(k) and specialized IRAs.
One of the most common questions people ask their financial advisors is, when should I start saving for retirement? Virtually across the board, financial advisors will say that you should start as early as possible—ideally when you’re in your 20s and have just launched your career.
Of course, there’s no reason to despair if you didn’t start a retirement fund right out of college. Not everyone in their 20s has the foresight to start saving for something decades in the future, especially since many employers do not offer a savings-matching program. If you started saving for retirement later in life, the situation certainly isn’t hopeless, but it is a bit more urgent. You’ll need to save more and be more focused to meet the same goals, since you’ll have less time to achieve them.
However, if you start early, you’ll enjoy a wide range of benefits, including the increased flexibility that compounding interest provides. You’ll also be able to take more chances with your investments, because you’ll have more time to recover from losses. Another major benefit of starting early is that it instills good habits early on.
When you start to plan for retirement in your 20s, you’ll learn several lessons that will serve you well for the rest of your financial future. These include:
Learning the value of compounding.
If you’re in your 20s, you have a lot of time before you retire and can use this to your advantage. Making money grow over the course of 40 years is much easier than achieving the same thing in half that time. Even when your money just sits there, over time it can double, triple, or quadruple. The best way to understand the value of compounding is to think about the math behind it.
As a hypothetical situation, imagine you save $6,000 toward retirement each year until the age of 65 at a 7-percent rate of return. If you start saving at age 45, you will have about $246,000 in the account when you reach retirement age. If you begin saving at 35, the account would have about $567,000. However, starting at the age of 25 means you’ll amass nearly $1,198,000. In other words, starting at 25 nearly quintuples the final amount saved, compared to starting at 45. This happens even though you would only contribute an additional $120,000, or $6,000 annually, for the 20 years between age 25 and 45. This math underscores that your savings depend not only on how much you contribute, but also on how long you’ve been contributing.
Understanding how to maximize employee benefits.
Employers often provide some sort of retirement benefit for full-time employees. Most commonly, you’ll have access to a 401(k) plan through your company. Understanding these accounts and how they work sooner, rather than later, will make it easier to use them strategically down the line, when choosing the right investments becomes extremely important. When you start contributing to your 401(k) early, you’ll have some time to play with the account without serious consequences.
A 401(k) typically rises and falls with the stock market and continues to grow over time. Money for the account is taken directly out of your paycheck, so you never see it. If you’re lucky, your employer will match your contributions to the account at some percentage—this can be a major boon and add up quickly. Plus, this matching is essentially free money, so it makes sense to take advantage of it. Some employers will offer profit-sharing instead, which means that a portion of the company’s profits is put into your 401(k) account, reducing your tax liability.
Keeping meticulous records and budgets.
People save money when they spend less than they bring in. The concept is simple, of course, but it’s a lesson many of us learn the hard way. However, saving for retirement will encourage you to become more discerning with your money, and you’ll soon learn to keep track of exactly where it goes. This skill will become more important over time, especially when it’s time to save for a down payment on a house or pay off a big debt. Ideally, people in their 20s should strive to live on about 85 percent of their income and save or invest the rest.
Keeping track of spending has become simultaneously more and less difficult. It’s easier than ever to buy things today; sometimes it only takes a few taps on a screen or one click of a button. Because of this, impulse spending can be hard to avoid.
At the same time, technology does a lot of the recordkeeping for us. Most of us no longer have to spend time adding and subtracting columns of numbers to balance a checkbook. In addition, smartphone apps can help track your spending; basic spreadsheets on your desktop computer are also effective. Whatever method you use, keeping track of spending can help you stay out of debt or pay off a large debt that must be wiped out before you can begin saving for retirement in earnest.
The Bottom Line: When it comes to saving for retirement, there really is no such thing as too soon. People who start saving early will set themselves up for success down the line by learning critical lessons about finance and investing. In addition, starting to save early, even if only a small amount, leads to significant gains because of compounding interest. If you think you can’t save, re-examine your finances to see if you can cut back on spending in some places. Putting aside even a little bit of money each month will help you establish a lifelong habit that will pay off enormously in the end.
Choosing a retirement plan can be one of the most important decisions you make as you map out your financial future. Especially now, when Social Security again appears to be in jeopardy while defined benefit plans are already on their way out, a need for reliable options for working people is pertinent as ever. Unfortunately, too many employees put off thoughts of retirement as unfeasible or premature. Lack of planning often leads to hasty decision-making when the time comes to make vital choices about life after work.
That’s why default options are extremely useful for employers to introduce. Simply put, their implementation demonstrates a commitment to the well-being of the workforce that can pay off greatly in the long run. Lifetime Income Default Options offer their recipients a fixed rate of income during the years after retirement, with the option to opt out of the program rather than the need to opt in. Since many people underestimate how long they will live after they retire (and therefore don’t plan on having as much money), this option, helps provide a long-term safety net.
The major dilemma of retirement planning, income level vs. liquidity, is a choice not to be taken lightly. Some people may not be aware of it, but these lifetime income options offer a sort of compromise. To begin, their money is placed into a diversified fund that readjusts along with the market, so income level stays steady while their savings are accrued, then at a preset time (usually at age 48) allocations to a deferred annuity begin, with full conversion achieved about a decade later. This gradual approach helps to neutralize changes coming from interest rate adjustments, typically a driving force in annuity price changes.
The strategy assures employees that they will receive a baseline amount of income in retirement. If they choose, they can adjust their level of savings as they see fit. This saves them from getting locked into a strict amount and gives them the flexibility to spend the amount of money they feel most comfortable with.
These plans have already generated a great deal of interest that only looks to gain more momentum as the word spreads. It’s important not to let stagnation or complacency with existing, less than adequate plans get in the way of your employees’ needs. These plans offer a reliable way for your employees to retire with greater financial stability, and can encourage greater savings pre-retirement. In the end, what’s important is that people are able to use the tools at their disposal for a comfortable and prosperous retirement. A plan that offers employees flexibility while helping to provide for long-term financial safety is a win for them, and a win for you as a leader.
For many, having $1 million saved for retirement sounds like plenty, but when you break down the numbers, what once seemed like a fortune might seem like just passable or maybe even too little to maintain the lifestyle you have or fund the one you want.
Obviously, there’s no single answer for whether $1 million is enough to keep someone afloat during retirement—ostensibly, a frequent first-class jetsetter is going to need much more than that while someone opting for only simple pleasures may be satisfied with less.
If you’re a baby boomer and come out shy of the million dollar mark, know that you’re very much not alone. According to a survey from GoBankingRates, only 22% of individuals ages 55-64 and older have $300,000 or more set aside for the future and about 29% of those over 65 have nothing saved at all.
In fact, most Americans (81%) don’t actually know how much they’ll need to retire. But thanks to some general guidelines and user-friendly retirement calculators, it’s easy enough to estimate your target savings and see whether $1 million will allow you to afford the post-work life of your dreams. But how?
One rule of thumb is to plan on replacing 70-90% of your current income with savings and social security once you leave the workforce. That means if you make the American median annual household income of $55,775, then you should anticipate needing $39,042.50-$50,197.50 per year during retirement. However in an article for AARP, Dan Yu of EisnerAmper Wealth Advisors said that for the first 10 years of retirement, you are more likely to be spending 100% of your current income.
Another way of looking at it is by first calculating the bare minimum of how much you’ll need per year and then working backwards to see how much you need to save. Investopedia recommends using the 4% sustainable withdrawal rate, what they describe as “the amount you can withdraw through thick and thin and still expect your portfolio to last at least 30 years,” as a means of calculation. That means if you have $1 million saved, then your yearly budget will be around $40,000. If your retirement aspirations lean more towards golf resorts than improving your home garden, even with the additional $16,000 or so per year that you’ll receive through social security, $1 million will clearly not sustain you for long.
There’s also the added variable of your expected lifespan. While it may seem bleak to confront your own mortality, you need to calculate your yearly saving and spending with a time frame in mind. According to the CDC, the average life expectancy in the United States back in 2014 was 78.8 years old. But given that more Americans are living past 90, and a 65 year old upper middle class couple has a 43% chance that one or both partners will live a full 30 years more, you may end up stretching your savings for longer than you could have ever imagined.
Where you plan on living also has a massive impact on how far $1 million will get you. While a retiree in Sherman, Texas could lead a nice cushy life for 30 work-free years with a retirement account of just $408,116, a retiree in New York City would need more than 5 times that. SmartAsset calculated that the average retiree in NYC needs $2,250,845 in savings, allocating $47,000 per year for housing alone. Even a nest egg in Brooklyn isn’t much better—that too requires more than $1 million. Perhaps for that reason, New York City isn’t on Forbes list of best places to retire in 2017.
Even with the most careful planning, there are always going to be a few financial surprises along the way that may set you back more than a few pennies worth. Whether they’re negative like medical emergencies and subsequent health expenses or positive, like travel fare to a destination wedding, they’re still taking a bite out of your bank account that may not have been in your original budget. For this reason, it’s important to use the above guidelines and calculation tools as a rough estimate, and be on the safe side by saving more than you think you’ll need.
As the adage goes, “a life without regrets is a life not lived,” but it is also “better to regret what you have done than what you haven’t.” The three biggest regrets of retired baby boomers center on the things they have not done and teach the next generation to make more informed choices.
- Not Saving for Retirement Earlier
A rare absolute rule of finance is that people should start saving for retirement as early as possible, with the best time to start being in one’s twenties. Life expectancies are growing and show no signs of slowing down, so more money is needed to be stretched out for a longer period of time. Starting to save and invest as soon as one enters the full-time workforce can make a dramatic difference in the amount of money that accumulates by the time a person is ready to retire.
Many baby boomers failed to start saving on time and properly because they did not understand just how much money would be needed for their retirement. Some also did not know that receiving social security benefits or taking money out of retirement accounts before it is needed can have tax consequences that can substantially lower savings. Finally, many people tend to forget to adjust for inflation when considering whether they are satisfied with the rate of return on their investments.
- Not Working Less and Traveling More
A study of 2,000 baby boomers commissioned by British Airways revealed that one out of five boomers regrets not doing more traveling around the world. The survey data also indicate that only 9% of American workers get more than nine vacations days per year and that only 37% of Americans took all of their vacation days in 2015, suggesting that working too much may be an issue whose scope extends far beyond just the baby boomer generation.
A 10-year research project conducted by Karl Pillemer, Professor of Human Development at Cornell University, into the lives of 1,200 people aged 65 and older also revealed that lack of travel during one’s youth is a common regret. He writes, “To sum up what I learned in a sentence: When your traveling days are over, you will wish you had taken one more trip.”
- Not Working More
It might sound surprising given the decades of work they’ve done, but more than two-thirds of middle-income baby boomer retirees wish they had worked longer, and not for expected reasons. One might assume that people would want to continue working to keep earning their salaries, but for many baby boomers, wanting to keep working is about the work. People who are passionate about their careers and enjoy their work want to keep doing it. For this reason, many baby boomers return to the workforce on a part-time basis or as consultants. A number of baby boomers also enjoy working during their later years because they find that it keeps them mentally sharp, physically fit, and gives them a sense of purpose.
According to the Investment Company Institute, 401K plan assets reached $4.8 trillion dollars at the end of the first quarter in 2016. That’s nearly 20% of total retirement assets in America (which was at $24.1 trillion).
For 401K plan holders heading into retirement, changing jobs, or leaving a company, a big question looms: what should be done with this type of retirement savings account? Essentially, investors have to choose whether or not to roll the money over into a new account.
Options for rolling the 401K over include putting the cash into a self-directed IRA or transferring it to a new employer’s 401K plan. If workers decide against a rollover, the other options are to leave the account alone or cash out. Before making a decision, investors should look at the pros and cons and choose based on their unique situation.
Rollover Options and Advantages
There are significant advantages to rolling the 401K over to a new employer’s plan or IRA. Most investment professionals advise choosing an IRA, but it’s important for workers to also examine the quality of the new company’s 401K plan (if going to another job).
Pros of the Rollover into a Traditional IRA
Dr. Don Taylor, a retirement advisor and contributor at Bankrate, says that the rollover to a traditional individual retirement account from a former company’s 401K plan can provide “wider investment choices and potentially reduced annual fees and other expenses.” This flexibility makes the IRA an attractive selection, as investors can choose among mutual funds, stocks, bonds, and exchange-traded funds.
Like with a traditional 401K employer plan, money can continue to grow tax-deferred in a traditional IRA. That way, investors won’t have to worry about capital gains and dividend taxes each year.
This also allows workers to shop for plans with lower fees, and, if desired, select an IRA with more access to investing tools and management guidance. The IRA can also be withdrawn without penalty for specific purposes, like college tuition or a first-time home purchase (up to $10,000).
Pros of the Rollover into a Roth IRA
Unlike traditional IRAs, Roth IRA contributions are made after income is taxed—with the benefit that earnings are not taxed when withdrawn later. Because contributions are made after income taxation, investors have the ability to withdraw those contributions (not earnings) from the account without fees.
The Roth IRA does not have minimum required distributions after reaching age 70½, unlike 401Ks and Traditional IRAs. This makes it a potentially lucrative investment vehicle into old age and a good option for those looking to set up future generations.
Since the Roth IRA rollover requires a tax payment before transfer, Dr. Don Taylor attests that a Roth IRA rollover makes sense only if investors can come up with the tax fees from a source other than the 401K funds and “expect to be in a lower tax bracket now than when (they) start tapping retirement funds.” This makes paying the taxes now financially beneficial in the long run.
Pros of the Rollover into the New Employer’s 401K Plan
Most employers offer new employees the chance to roll over their old company’s plan. Getting all retirement plans into one place can make saving much more convenient and cheaper.
Investors should compare fees between the two company’s plans, and only roll over their old 401K’s cash if the new employer’s plan has lower fees and/or better investment options. The new company’s plan may even have lower fees than IRA accounts do.
For those that do choose to transfer to the new company’s fund, understand those earnings will continue to grow tax-deferred, and while those funds can be withdrawn after 59½ years old without penalty, workers may have the option to delay required minimum distributions (RMDs) beyond 70½ years old (if still employed at that company).
Traditional benefits of the old 401K still apply at the new company too. Investors are given more protection under federal law, as 401K assets are better protected from claims from creditors than IRA assets are. Many 401K plans provide investors the benefit of being able to borrow against the plan as well.
Options for Those Choosing Against the Rollover
While rolling the account over is traditionally the best choice, everyone’s personal situation is different. In some circumstances, one of the following two options may be the most ideal—or necessary—choice.
Leave the 401K Alone
The first and most common choice is simply to leave the 401K account with the old employer and let earnings continue to rise tax-free. For investors that like their current plan, aren’t paying a lot in fees, and are happy with its performance, this may be the best—and easiest—choice. Prior to doing this, do compare fee charges with other fund options, like the new business’ 401K plan and traditional and Roth IRAs.
In addition to having the benefits mentioned above for 401K plans, there is also a specific benefit for not touching the 401K. For those that leave their employer between the ages of 55 and 59½, they can enjoy penalty-free withdrawals before reaching 59½ (the typical starting withdrawal age).
Before doing this, ex-employees should check to see if their employers allow the money to stay in their old account. Most companies require at least a balance of $5,000
A final choice is the cashout. Most investors don’t suggest this route, as paying taxes on the withdrawal alone could easily cut into 35% of the total amount (depending on the tax bracket). A withdrawal penalty of 10% would also be assessed if younger than 59½.
Additionally, savings would no longer grow tax-deferred, which means investors robbing their future selves. For example, take the case of a worker making $75,000 per year who has a traditional 401K with $50,000 in assets. This worker decides to withdraw it all after quitting the company. In this case, 25% of that amount would be taxed and a 10% penalty would be implemented, leaving the worker with 35% less, or just $32,500. If this money was simply just left in the 401K and continued to grow at a decent rate for one or two decades, this easily turns into a six-figure mistake.
The cash-out option is mostly seen as a last resort for those experiencing a legit financial emergency and can’t access cash from other sources, such as lenders, savings accounts, and family. Only do it if absolutely necessary. Nearly every time, borrowing from other sources makes more financial sense than cashing out retirement savings.
Making the Best Decision with the 401K
While the traditional IRA is commonly seen as the best rollover option for 401K plans with an old employer, everyone’s personal situation is different. Ideally, workers should always research and choose retirement savings plans with low fees and high returns. They should make choices that set them up for long-term financial success.
Thus, it’s advised to also analyze the financial advantages and disadvantages of rolling over to the Roth IRA, transferring to another company’s 401K plan, and leaving the money with the old 401K. Once workers have a clear picture of what makes the most financial sense, they can go through with the decision—and watch their nest egg grow to its highest potential.