This article is original content written by Manchester, CT Financial Advisor Thomas Scanlon, CFP®, CPA
Playing more golf, going to the beach or spending more time with your grandchildren is how some visualize their retirement. During your working career you went to work every day to get your paycheck. Assuming you are fully retired you won’t be going to work anymore. This means your alarm clock can retire along with you. How will you fund your retirement? How can you get a paycheck in retirement? Good questions. The key to funding your retirement is to know what it costs you a year to live. Then work at getting this number down. It’s important to be able to say I Did the Math. And remember, You Only Get a Mulligan in Golf.
When planning for your paycheck in retirement be cautious of the so called 4% safe withdrawal rule. This was a rule of thumb designed by former financial advisor Bill Bengen in 1994. It essentially said you could withdraw 4% of your investment portfolio annually and it would last you about 30 years. This assumes the portfolio was 60% equity and 40% fixed income. What’s changed? Interest rates for sure. The prime rate peaked in 1980 at 21.5%. The prime rate was 8.5% in 1994 when Mr. Bengen designed this rule of thumb. Today it is only 3.5%. That’s quite a decrease. This impacts this rule of thumb big time. 1)
1) 401(k) Plan
The 401(k) plan offered by your employer will likely become the cornerstone of your retirement plan. The primary reason the 401(k) plan is the key for a reasonable retirement for many is that there are far fewer opportunities to be eligible for a pension. Without a pension it’s clear You’re Gonna Need a Bigger Boat. Many employers have terminated their pension plans due to the cost of funding them. Essentially now the only employees that may be eligible for a pension are federal, state and municipal employees. Many large employers have replaced their pension plan with a 401(k) plan. It’s important to understand This is NOT Your Parents Retirement.
For 2019 employees can contribute up to $19,000 annually into their 401(k) plan. For employees aged 50 and older they can contribute an additional $6,000 in a so-called catch up contribution for a total of $25,000.
Some employers will offer a company match to the 401(k) plan. If your employer has a 401(k) plan and has a company match you need to participate in the plan and contribute at least the amount to get the company match. This is an employee fringe benefit you need to take advantage of. Payroll deducted contributions allow for an easy way to contribute to the plan. Having the contributions made on a tax-deferred basis is a huge benefit.
Even if your employer doesn’t offer a match to the 401(k) plan take a hard look at the plan. If the investment options are decent and the costs are reasonable it may make sense to contribute to the plan.
Younger employees should inquire if their employer offers a Roth 401(k) plan. The contribution limits on the Roth 401(k) plan are the same as the 401(k) plan mentioned above. Keep in mind that these limits are the total amount that can be contributed. The contributions can be split between the two plans if your employer offers both.
The difference with the Roth 401(k) plan is that unlike the 401(k) plan the Roth 401(k) plan contributions are put in after tax. The advantage is that when the employee contributions to the Roth 401(k) plan are withdrawn in retirement they are tax-free. Any employer match contributions made to the Roth 401(k) plan however will be taxable income just like they are with the traditional 401(k) plan. That’s why younger employees should strongly consider the Roth 401(k) plan. As they are just getting started in their career their income should be more modest than later in their career. Paying the taxes upfront in a lower tax bracket would be beneficial. Having decades of tax-free growth would be awesome.
2) IRA and Roth IRA
For most folks funding the 401(k) plan might not be enough to provide the retirement plan you were looking for. You will need to save money outside your 401(k) plan. Two excellent tools to save for retirement are IRA’s and Roth IRA’s.
Eligible individuals can contribute up to $6,000 into an IRA or Roth IRA annually. Taxpayers age 50 and older can make another $1,000 in a catch up contribution for a total of $7,000. For eligible taxpayers these are maximums allowed into an IRA or Roth IRA or some combination of the two.
To be eligible for an IRA you need to have earned income for at least the amount of the contributions. Earned income is from working as an employee or from being self-employed. Higher income taxpayers however may not be able to have a tax deductible IRA. For a married couple filing a joint income tax return in 2019 if either of them is an active participant in a qualified retirement plan than you can have a tax deductible IRA if your modified adjusted gross income is below $103,000. There is no tax deductible IRA if your modified adjusted gross income is over $123,000. A partial deductible IRA is allowed for incomes between these amounts.
Like the IRA you need to have earned income of at least the amount of the contribution to fund a Roth IRA. There is also a limit on your income to be eligible to fund a Roth IRA. For a married couple filing a joint income tax return if your modified adjusted gross income is under $193,000 you can fully fun the Roth IRA’s. If your modified adjusted gross income is over $203,000 you are not allowed to fund a Roth IRA. For modified adjusted gross income between these amounts a partial contribution is allowed.
The difference with the Roth IRA is that it is not income tax deductible. However, on the back end when qualifying distributions are made they are income tax-free. To have your Roth IRA distributions you just need to meet two simple criteria. The Roth IRA account needs to have been open for at least five years and you need to be over age 59 ½ when taking your distribution. That’s it!
In retirement if you are collecting a pension, well, first of all congratulations. This should set up your ability to get a paycheck in retirement much easier. Your pension will be taxable as ordinary income. The distributions from your 401(k) plan and IRA will also be taxable. Up to 85% of your social security benefits are also taxable. This is part of what makes the Roth IRA so appealing. The ability to have an income stream that is not taxable in retirement is sweet. It’s important to understand The Difference Between a Roth IRA and an IRA.
3) Social Security
The social security system certainly has its funding issues. Pre-retirees need to be cautious when planning to take their social security benefit.
Individuals can claim social security benefits early, at full retirement age or after full retirement age. Your full retirement age depends on when you were born. For example for people born from 1943-1954 their full retirement age is 66. Folks born from 1955-1959 full retirement age is age 66 plus a number of months depending on the year you were born. For people born in 1960 and later their full retirement age is 67. 2)
It might look tempting to take your social security benefits as soon as you can which is age 62. Be very careful here. You will be in for a big haircut. Depending on your age and your full retirement date the discount that is assessed against you for taking your benefit at age 62 is between 25% – 30%. Yikes! That’s a huge discount.
At the other end of the spectrum you get a paid premium if you delay receiving your social security benefits. If you wait until age 70 to collect your benefits you will receive 132% of what you were entitled to at your full retirement age.
Everyone needs to establish and maintain a cash reserve fund first. This is even before you start investing in your 401(k) plan. The popular media commonly mention you need to maintain six months of living expenses in your cash reserve. Our experience is that most folks don’t have anywhere near this amount. Put away what you can and add to this fund over time. If six months seems unrealistic shoot for three months. Your career matters here also. If you are employed where there is reasonable job security you may be able to manage with a smaller reserve. If you are self-employed or if you are married and only one spouse is working you would want to work towards having more in your cash reserve.
As was mentioned earlier funding the 401(k) plan alone may not get you the retirement plan you were looking for. Funding IRA’s and Roth IRA’s will surely help. You should also however be saving money outside of retirement accounts. Save, until it hurts, a lot.
5) Low / No Debt
One number that affects what it costs you a year to live is your debt service. This could be a mortgage, car loan, student loan or just credit cards. Ideally when you retire you won’t have any debts. It helps to be able to say I’m Debt Free. I know, interest rates are very low and you get the tax write off for the mortgage interest you pay. It’s still likely a better deal to not have any debt. First, in retirement your income will likely be less from when you were working. This should mean a lower income tax bracket. Second, taxpayers can take the standard deduction or itemize their deductions whichever is greater. So you only get to take advantage of the mortgage interest deduction if you itemize your deductions. The standard deduction for a married couple filing a joint return in 2018 is $24,000. The main itemized deductions are mortgage interest deduction, state income tax and property tax and donations. According to the Tax Foundation approximately 69% of taxpayers take the standard deduction. 3)
Raymond James and its advisors do not offer tax or legal advice. You should discuss any tax or legal matters with the appropriate professional. The foregoing information has been obtained from sources considered to be reliable, but we do not that it is accurate or complete, it is not a statement of all available data necessary for making an investment decision and it does not constituent a recommendation. Any opinions are those of Thomas F. Scanlon and not necessarily those of Raymond James.