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.
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.