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.
While many Americans look forward to their retirement years, saving for this time period can bring a lot of stress. A majority of workers participating in a 2017 AARP survey said they felt that they did not have enough saved for the various expenses, both expected and unexpected, that come with retirement. Part of this problem may relate to the hidden fees associated with retirement accounts, especially 401(k)s.
Often, people do not even know they are paying fees on their 401k, or have little choice in paying them, as their plan is selected by their employer. According to financial expert Robert Hiltonsmith, these fees can cost the average two-earner family more than $150,000 over a lifetime, an amount that accounts for nearly a third of all investment returns.
Understanding the Incredible Impact of Fees on Retirement Savings
Most people saving for retirement do not understand the impact that fees can have on their accounts. In fact, paying a single percent less in fees for an investment over the course of a lifetime can translate to enough money for an additional 10 years of retirement.
Consider three people who all invest $100,000 and achieve a rate of return of 8 percent. One person invests in an account with 1-percent fees and eventually achieves a total of $761,000. Another puts their $100k into an account with 2-percent fees. During the same time interval, this account will only grow to $574,000. The third person invests in an account with 3-percent fees. This account ends with $432,000. These figures demonstrate how seemingly small increases in fees can cut into overall savings.
In 2015 a law professor at Yale published a study concluding that a surprising number of 401(k) plans focus on high-fee funds, and ultimately recommended that employees pay close attention to the fees they pay.
Instead of putting money into plans with high fees, employees may be better off investing in a retirement account outside of their employers’ that will conserve a much higher percentage of their investment for the future. Pew Charitable Trusts has also researched this issue, noting that fees lower the amount of money available for compounding and thus have a reverberating effect on growth through the life of the investment. Unfortunately, many people think that fees are an inevitable part of saving for retirement, but this is not the case.
Pushing through the Confusing Language of Fee Disclosures
Often, 401(k) plans bury the nature and number of fees in pages upon pages of statements and then use undecipherable names to describe them. Since 2012, retirement plan companies have been required to declare the amount and purpose of fees, but that does not mean they do not try to confuse the average investor. Even savvy investors may feel lost in a 30-page disclosure document designed to discourage people from asking questions. Phrases like “asset maintenance fee” and “required revenue fee” seem legitimate, but they actually just refer to revenue sharing and commissions.
To determine if you are paying too much in fees, you will first need to know what an appropriate amount is. In general, fees should be less than 1 percent, but many finance professionals note that they have seen fees as high as 3.25 percent. Some plan managers will try to justify a higher rate by saying that a small company needs to pay higher fees until they grow larger—this is not the case. Ideally, it should be under 1 percent, regardless of the size of the company.
Viewing Employers as a Key Partner in Fee Negotiations
The regulatory changes that took place in 2012 made employers responsible for the plans they select for employees on a fiduciary level. Employers have a duty to select plans solely for the benefit of their employees and are required to review fee disclosure documents within 90 days of receiving them. During this time period, it is possible to make changes to the plan. Company owners and managers can actually face rather significant fines if they do not review the disclosure since it is considered disregard for the welfare of employees both now and in the future. In other words, employees are not alone when it comes to negotiating for better fee structures and should view their employers as partners in this struggle.
Employees should advocate for a joint disclosure assessment with their managers to make sure that the plan is the best for the future. When people take the time to learn what the fees mean and how they may be unnecessary, they can argue for a fairer structure and ultimately put everyone in a better position for retirement.
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.