When you start doing number crunching for retirement planning, you begin to realize that the outcome is dependent on many variables. In addition, other factors, such as how investment returns change over time, can have a significant impact, especially over the short term, on your retirement plans.
Over the past century, the rate of inflation has averaged about 3 percent per year. Growth-oriented investments, such as stocks, have returned about 9 percent per year historically. Bonds and other fixed-income investments have returned about 5 percent per year.
Those are long-term averages, which are all well and good, but suppose that a worker decided to retire around the year 2000, and, like most retirees early in their retirement, he still had a healthy chunk of his investments in stocks. Because the stock market experienced severe downturns both early and late in the 2000s, his standard of living and ability and comfort with taking withdrawals from his retirement funds may be impacted.
A Monte Carlo simulation runs many different scenarios and calculates the likelihood (percentage of the time) that you will accomplish your retirement goal. The T. Rowe Price retirement calculator we walk you through in this chapter does Monte Carlo simulations and tests about 1,000 market scenarios to see how your retirement plans will work out in many different market conditions.
If you find yourself with extra money, the good news is at least you don’t have to worry about making sure you can continue your current standard of living during retirement. In this situation, consider taking either of the following actions:
Enhance your retirement. Don’t be afraid to enjoy yourself. While you’re still healthy,
travel, eat out, take some classes, and do whatever else floats your boat (within reason, of course). Remember that come the end of your life, you can’t take your money with you.
Earmark a portion of your assets for your beneficiaries. You may want to leave something for your family members as well as other beneficiaries, such as your place of worship and charities. If so, you need to determine the approximate dollar amount for each of the
beneficiaries. Estate planning is so important that the chapters in Book 5 are devoted to it.
Of course, life can throw you unexpected curve balls that could cause you to incur higher- than-expected expenses. But if you’re always preparing for rainy day after rainy day, you may lead a miserly, unenjoyable retirement.
Making Plans for Nonfinancial Matters
Getting caught up in the climb up the career ladder, burning the midnight oil, and accumulating wealth and possessions is easy in a capitalist society. In your pursuit, losing sight of some areas
— the ones not about money — is also easy. These areas are just as important — if not more important — than your finances, which is why you should be working just as hard at planning them.
Personal connections
A lot of research shows that those individuals who have strong and healthy connections in their later years tend to be happier, enjoy better health, live longer, and live longer independently. As you’re preparing for retirement, make sure you spend time making and maintaining healthy
personal relationships. Doing so is an investment that pays dividends by improving the length and quality of your life.
If you have children of your own (and perhaps they give you grandchildren), you’ve got a built-in network of younger folks to keep you actively involved. If you don’t have any
children or grandchildren, or if you want more personal connections, you can forge
friendships with people younger than you through your activities, hobbies, fellowship, and so forth.
Personal health
Your health is much, much more important than your financial net worth. Just ask folks who have major medical problems — especially those they could have avoided — if they wish they had taken better care of their health. Although anyone can experience bad luck or bad genes when it comes to health, you can do a lot to stay healthy and enjoy enhanced longevity and the best possible quality of life.
Activities, hobbies, interests
For folks who have had full-time jobs, retiring and having no job to occupy their days sounds alluring. However, some retirees feel a lack of purpose and miss the satisfaction that comes from meeting the challenges of work. A fringe benefit of most people’s work is the human interaction that comes along with it.
When planning for your future, consider the following as good substitutes for work, because they provide challenges and foster friendships and connections with others:
Activities and hobbies: Exercising is a good choice to include in long-term plans; it provides vast health benefits and opportunities to meet new friends and hang out with old ones. If you’re not into exercising, perhaps you can look at different hobbies you like, such as collecting
something. You can meet interesting people and make new friends by going to auctions, garage sales, and such. People like to collect all sorts of things; just be careful you don’t spend too much money.
Part-time work: Working part time, especially when you have more flexibility in setting your hours, can be an excellent part of a retirement plan. It can provide enjoyments and a challenge
— not to mention some extra dough.
Volunteering: Giving something back to society pays many dividends. You can find a zillion volunteer opportunities. Your place of worship, organizations that support a cause you believe in (for example, fighting cancer or heart disease), and schools are super places to start
looking. Stumped for ideas? Try a service like VolunteerMatch (www.volunteermatch.org).
Chapter 7
Grasping Retirement Accounts and Their Rules
IN THIS CHAPTER
Reviewing the features of retirement accounts
Surveying the different types of accounts you can choose from Taking care of your 401(k) balances
Naming beneficiaries for your retirement accounts Becoming familiar with RMDs
One of the virtues and drawbacks of living in the United States is that you have plenty of choices
— sometimes too many. And that’s certainly the case with the numerous types of retirement
accounts and variety of investments; far more options exist here than in just about any other country in the world.
With so many choices, you may be confused about which option is best for you. Selecting the best is important because you can end up saving yourself more tax dollars and making more after-tax money in the long run. And whether you’re entering retirement or are still a decade (or more) away, you need to understand the nuances and rules of each type of account so you not only make good decisions but also comply with the myriad tax rules.
This chapter discusses the common types of retirement accounts to which you may contribute. It also discusses early withdrawal penalties, beneficiary decisions, transfer and rollover rules, and borrowing from or against retirement accounts.
Eyeing the Characteristics of Retirement Accounts
Before you can use retirement accounts to your benefit, you first need to know the 4-1-1 on these accounts, including the advantages to using them and the potential drawbacks. The following sections lay out these pros and cons. Keep this important information in mind as you consider the different types of retirement accounts available.
Focusing on the tax benefits
The main attraction of any retirement account is the tax savings it provides. You generally receive upfront tax breaks on your contributions up to a certain limit. For example, suppose that you’re able to contribute $1,000 per month ($12,000 per year) into a tax-deductible retirement savings
plan. Assuming that, between federal and state taxes, you’re paying about 35 percent in taxes on your last dollars of income, you should see your federal and state tax bills decrease by about
$4,200 ($12,000 × 0.35). This immediate savings is usually enough of an incentive to encourage folks to build wealth by funding retirement accounts.
Because the money contributed to the retirement account isn’t taxed at the federal or the state level in the year in which a contribution is made, your take-home pay shrinks by much less than the
$1,000-per-month contribution. Unfortunately, directing money into retirement accounts doesn’t allow you to avoid current Social Security and Medicare taxes on wages you earn during the year.
These upfront tax breaks are just part of the value derived from using retirement accounts.
You also can reap these other tax-related benefits when you invest in a retirement plan:
Your investment returns accumulate without taxation. After you contribute money into a retirement account, any accumulated investment returns aren’t taxed in the year earned. So, in addition to reducing your taxes when you make your contribution, you save from this tax- deferred compounding of your investment over time. In other words, all the taxes you would have owed over the years compound in your account and make your money grow faster. You pay tax on this retirement account money only when you make withdrawals.
When you invest, Uncle Sam ends up with less of your money. If you don’t invest money in a retirement account, you start with less dinero in your pocket because Uncle Sam and your state’s government immediately siphon off some taxes. The longer the money is invested, the more you profit by investing inside a retirement account.
Some people are concerned that if their tax rate in retirement is high, then funding retirement accounts could lead to higher taxes. Although this scenario is possible, it’s unlikely. Because of the tax-deferred compounding, you should come out ahead by funding your retirement accounts. In fact, your retirement tax rate could increase and you’d still come out ahead.
Income tax rates need to rise significantly from current levels to eliminate the tax-deferral benefits.
Even though income tax rates for some individuals may rise in the future, the benefits of tax- deferred contributions and investment income should outweigh the increased tax burden you may face when these funds are withdrawn. For example, say that your tax rate at the time of
contribution is 35 percent. Table 7-1 shows how high your tax rate would need to increase to wipe out all your tax-deferral benefits over the years.
TABLE 7-1 Retirement Tax Rates That Would Negate Tax-Deferral Benefits
Number of Years Contribution Compounds Tax Rate That Eliminates Benefits
10 50 percent
15 56 percent
20 61 percent
25 66 percent
30 70 percent
35 74 percent
40 77 percent
As you can see from the table, the longer your money is invested, the higher your tax rate would have to rise to wipe out the tax-deferred compounding benefits. After the money is in the account for 30 years, your tax rate would have to double (from 35 percent to 70 percent) to eliminate the tax-deferred compounding benefits.
If your employer matches your contributions or contributes additional money to your account, such as with a company-sponsored 401(k) plan, you’ll be even better off. Free employer money further enhances the upfront tax benefits by giving you more money working for you that is not subject to tax in the year the contributions are made. Even if you
unexpectedly need to withdraw your contribution, you should still come out ahead — the penalties for early withdrawal are only 10 percent and whatever penalty, if any, your state charges. You’ll also owe regular federal and state income tax on withdrawals.
Being aware of restrictions and penalties
Some people contribute little or no money to retirement accounts because of worries about having access to their funds. Although investing your money in a retirement account may limit your access to the money in the short term, overall the investment is a smart move for your retirement in the long run.
If you do have to withdraw your money from a retirement account prior to reaching 59ẵ, you may incur a tax penalty. The penalty is 10 percent in federal taxes plus whatever penalty your state assesses. This penalty tax is in addition to the regular income tax that’s due in the year you make the early withdrawal.
Some exceptions (called IRS Rule 72(t) exceptions) do allow you to withdraw retirement account money before age 59ẵ without penalty, though you’ll still owe income taxes. (All the exceptions are explained in detail in the free IRS Publication 590-B, “Distributions from Individual Retirement Arrangements”.) The most commonly used exceptions are these:
Five years of withdrawals: You may withdraw retirement account money early as long as you make withdrawals for at least five consecutive years or until age 59ẵ, whichever is later. The withdrawals must be substantially equal each year and be based on your life expectancy
according to Internal Revenue Service (IRS) assumptions and reasonable interest rates. IRS rulings provide details for computing the annual distributions.
Health problems: If you suffer a disability or incur significant medical expenses, you may be allowed to withdraw money early from your retirement account without penalty. See IRS publication 590 for more information.
Borrowing: Your employer’s retirement plan may allow you to borrow from your plan without incurring a penalty. This is generally not a great idea, especially if you seek the money for current spending, such as buying furniture, taking a vacation, and so on. It can make sense, for example, if you need some down payment money to buy a home. But be sure that you
understand the repayment rules and terms, because if you’re unable to repay the loan, the unpaid money is treated as a retirement account withdrawal and subject to current federal and state income taxes as well as penalties unless you withdrew the money after age 59ẵ.
You can read more about these and other exceptions at www.irs.gov/retirement-plans/plan- participant-employee/retirement-topics-tax-on-early-distributions.
The best solution for short-term money needs is to ensure that you maintain an emergency reserve of money (three to six months’ worth of living expenses) outside your retirement account. If you don’t have an emergency reserve account, you may be able to borrow money from other sources, such as a family member or through a line of credit or lower-interest credit card.
Identifying the Different Types of Retirement Accounts
Different employers and employment situations present unique retirement account options. This section explains the common retirement accounts you’ll confront and how they work.
Employer-sponsored retirement accounts
When you work for a company or organization, you may have access to an employer-sponsored retirement savings plan. In this case, the company provides access to an investment firm through which you can contribute money via payroll deductions. Plans have rules specifying, for example, how long after becoming an employee you must wait to begin participating in the plan, company matching contributions, and the overall limits of how much you may contribute to your account.
The good news with this type of plan is that your employer has done the legwork and maintenance for the plan. The potential bad news is that you’re at their mercy if they don’t have a good plan.
For-profit companies may offer 401(k) plans. Nonprofit organizations can offer 403(b) plans.
Government employees may have their own plans such as a 457 plan for state and local
government workers and the Thrift Savings Plan for federal government employees. These plans are similar in that contributions into them from your employment earnings aren’t taxed at either the federal or state level.
For tax year 2017, the annual contribution limits for these retirement accounts are the lesser of 20 percent of an employee’s salary to a maximum of $18,000. If you’re 50 or older, your contribution limit is $24,000.
Self-employed retirement savings plans
Another type of retirement plan is the self-employed retirement savings plan. One of the biggest benefits of earning self-employment income is the ability to establish a tax-sheltered retirement savings plan. These plans not only allow you to contribute more than you likely would be saving on a tax-deferred basis for an employer, but they also can be tailored to meet your specific needs.
As with other retirement savings plans, your contributions to self-employed savings plans are excluded from your reported income and are thus exempt from current federal and state income taxes. The earnings that accumulate on your savings over time also are exempt from current income taxes. You pay taxes on your contributions and earnings when you withdraw them, presumably in retirement, which is when you’re likely in a lower tax bracket.
A couple of different versions of self-employed retirement plans are available. The following list explains which plan may be right for you:
Keogh plan: This type of retirement plan is of potential interest to business owners who have employees that are covered by a plan, because you may be able to contribute more to your account relative to contributions for your employees’ accounts. Speak with a tax adviser or an investment management company for more information.
You must establish a Keogh plan by the end of the tax year (usually December 31), but you have until the filing of your federal tax return to make your actual contribution to the plan.
The drawback to a Keogh plan is that it requires slightly more paperwork than a SEP-IRA plan to set up and administer. However, the no-load mutual fund “prototype” plans simplify the administrative burden by providing fill-in-the-blank forms.
A Simplified Employee Pension Plan, Individual Retirement Account (SEP-IRA): This type of plan cuts through much of a Keogh plan’s red tape and is somewhat easier to set up and administer.
As with a Keogh plan, when you as the employer establish a SEP, you must offer this as a benefit to employees if you have them.
With both of these plans, you may contribute up to the lesser of 25 percent of your self-
employment income to a maximum of $54,000 for tax year 2017 ($55,000 for 2018). To determine the exact maximum amount that you may contribute from self-employed income, you need to have your completed Schedule C tax form so you know your business’s net income for the year. To find out more about setting up these types of accounts, see the nearby sidebar “Establishing and
transferring retirement accounts.”
Individual Retirement Accounts (IRAs)
What if you work for an employer that doesn’t offer a retirement savings plan? You can certainly lobby your employer to offer a plan, especially if it’s a nonprofit, because little cost is involved.
Absent that, you can consider contributing to an Individual Retirement Account, or IRA. You may contribute up to $5,500 in 2017 as long as you have at least this much employment (or alimony) income. Those folks who are age 50 and older may contribute up to $6,500 in 2017. The limits are adjusted for inflation annually (or not).
Whether you can deduct your IRA contribution from your annual taxes depends on whether you participate in another plan through your employer. Check with your employer about this.
If you can’t take the tax deduction for a regular IRA, consider the newer Roth IRAs, which allow for tax-free withdrawal of investment earnings in your later years. For tax year 2017, you may contribute up to maximum limits, which are the same as on a regular IRA, as long as your modified adjusted gross income doesn’t exceed $118,000 if you’re a single taxpayer or
$186,000 for married couples filing jointly.