I get asked that question frequently, and it’s an important question. Consider the person who is determined to set aside for retirement and disciplines him or herself to continue investing hard earned money all throughout their career. At the time they wish to retire, they discover that they had not accumulated enough, suffered an enormous (and unnecessary) loss, or that they are possibly facing a huge tax liability.
I’m certain this individual would much rather have discovered they were on “the wrong path” earlier than later. If you have a reasonable amount of time prior to your desired retirement (reasonable being ten years or more), good news! There’s time to plan effectively.
Let’s first look at the tax treatment of your future income for retirement. What do you have, or will have, set up thus far? Do you have an IRA? A 491(k), 493(b), 457, TSA or TSP? Are you scratching your head wondering what all those numbers and acronyms mean? All these retirement vehicles (some being company or Government sponsored plans), as well as Simple and SEP IRAs, are 100% taxable when accessed at retirement. While that may seem normal, it doesn’t have to be.
Picture yourself retired. Traditionally, your children are adults now, so you lose the Child Tax Credit. Your home may be paid off, or close to it, so you lose your mortgage interest to deduct on your Tax Return; the income you are going to draw is reported as Taxable Income. If you were to withdraw $4,000 a month from your IRA or 401(k), for example, that would be $48,000 reported as income for the year, which puts you in the 25% Federal Tax Bracket if you file Single, or 15% if filing Married-Joint.
The hypothetical tax liability for the Single in this scenario would be $7,793.75 and for the Married Couple $6,277.50. This also assumes no other sources of income. Other sources, such as Social Security, will also be reported, in part, as Taxable Income, increasing the tax burden.
You can see that, in retirement, Income taxes can potentially be one of your largest expenses. Now, given the chance, would you prefer to keep all of the income you draw for retirement, paying no taxes on that income? It’s possible, but now is the time to plan for that, not at retirement.
To achieve tax-free income later in life, I recommend the most under-utilized vehicle available to Income Earners- the Roth IRA. Money is placed in a Roth IRA after income taxes have been paid. You, the Investor, choose what investments you wish to hold within the Roth IRA. Then the magic happens. All of the growth over time, plus the money you’ve contributed, is accessible tax-free! Note that the intention is for funds to accumulate and be accessed at retirement. However, if needed, money can be accessed tax-free providing you have held those funds in the Roth IRA for at least five years.
There are limits and restrictions, of course. If the combined Adjusted Gross income of a couple filing “Married-Joint” is $183,000 or less (as of 2015), then each wage earner can contribute a maximum of $5,500 a year, being under age 50. Those who are 59 and older can contribute up to $6,500 a year (2015 allowable contributions).
Let’s look at the power of this tax-free income vehicle, if embraced early on in one’s career:
A 30-year-old wage earner who contributes monthly to their Roth IRA, whose investments net 8.5% in example, will have accumulated approximately $278,427 by age 50! At age 50, they are now able to contribute $6,500 a year. Doing that for just ten years, at age 60, this individual now has approximately $729,525 tax-free! And it gets better. Historically, the limits to the amount you can contribute to a Roth IRA have steadily increased, so chances are they may increase in the future, allowing you to contribute, and thus accumulate, much more!
So, when asked, “Which would you choose: Tax-Free income at Retirement or Taxable income?” Hopefully this article has helped form your answer.
Now, for those whose income exceeds the allowable limits ($118,000 for those filing Single in 2015), a close alternative would be a non-retirement account. After tax dollars are contributed (not be taxed again), only the growth would be reportable as income. If accessed by monthly withdrawals from an investment account holding stocks, mutual funds, Index funds or ETFs, a considerable amount of that income is tax-free because it is Principle – the money you placed into the account which was already taxed. I write about this type of plan in Against the Grain, Avoiding the Financial Pitfalls of Conventional Wisdom, available here: http://amzn.com/B005X9IYKQ
It’s understandable why the age of 65 has been synonymous with retirement. For decades men and women have pressed toward that mark in order to receive “Full Retirement Benefits” from Social Security. With that guaranteed monthly income for life now flowing in, many folks call it quits and can begin Retirement.
Let’s look at a simplified definition of retirement:
A point in time when an individual has sufficient financial
resources to pay for the costs of living without the need of
employment or running a business.
Does the average American dream of being 65 so that they may have the time to enjoy life?
What about those who are in their Forties and younger? Should they structure their financial goals to include the promise of a future Social Security benefit?
I would say “Nay!” and here’s why:
In 1940 there were roughly 159 workers pay into Social Security for every one person already drawing a benefit – that’s a healthy ratio. As of 2010 there were merely 2.9 workers paying into the system, for every one person drawing benefits- not a healthy ratio, and certainly not a sustainable trend!
The Problem of Perception
Too many today view Social Security as something that can finally allow for retirement. That is not the (original) intention that system. Social Security was introduced as a means of keeping a worker from starvation. So when you take benefit that is intended to put food on the table and raise its perception to the level retirement income , you have a big disconnect! Huge Disconnect!
I like the admonition, “Begin with the end in mind!” However, very few folks in the workplace do just that; it’s enough to focus on the pressing needs of this day.
If more individuals would pause for a moment and figuratively “Fast Forward” time in their minds and consider the fact that as long as they are taking in oxygen, they are going to need money. Where will that money come from? Your job? For your entire life? Well no one really wants that do they? At some point they either want to or HAVE to stop working and at such point they will need to pull money some resource or resources.
If you are planning on the Government taking care of that, you are going to be immensely disappointed (and broke).
Those “sources” to draw money from are up to us to build! It’s time to make planning (and discipline) for our future a higher priority than entertainment, keeping up with the Joneses, and any other pleasurable trappings that hinder us from taking the necessary steps Today, for our tomorrows.
Time is a crucial factor!
Just last week I had a conversation with 23 year old about financial planning. He stated that he was focused on saving up for a house and “wasn’t thinking about Retirement.” While that sentiment is common and understandable among people his age, it’s also a huge problem. The cost of waiting, putting off planning for retirement, is a cost we may never recover from.
A 20 year old could invest $100 a month, aggressively in a properly diversified portfolio, continue investing until age 65, and have accumulated over $1,500,000!
If our 23 year old friend waits until he is 35, he would need to invest not $100, but $300 a month just to hope to break $1 million!
The cost of waiting until you’re 40? (Anybody?) $600 a month in hopes of breaking a million dollars. The more one procrastinates, the more it costs. Just five more years of putting off investing and it requires $1,100 a month for a 45 year old to break a million dollars by age 65!
Time to Start
The costs of waiting are staggering. Do it for yourself, for your family- start putting aside for your future. Change your cable package, reduce your frequency of eating out, brew your coffee at home, pay off a debt; you can find ways to find the money to put aside for your future.
It’s up to you, not the Employer, not the Government.
The sooner you start, and the sooner you accumulate the wealth needed, the sooner you can retire. You are not bound by the “Age 65 rule!”
Some books to help get your thinking in the right direction:
“The Automatic Millionaire”- David Bach
“A Random Walk Down Wall St.” – Burton G Malkiel
- As the U.S. markets are enjoying growth and “High Points” the speculators and certain talking heads are beginning to promote their “plays”- get out of U.S. stocks while they are up and buy “Fixed income.” If you’ve been reading my e-mails and taking my coaching for any length of time, you will be able to recognize this as Speculating and Market Timing – and Market Timing not only does not work, but brings harm to one’s portfolio.Speculating with Fixed IncomeThose who would turn their focus to Fixed Income will often “chase returns”, looking for higher rates and yields. This is actually speculating. You see, in the search for higher returns, a speculator may look for Bonds with longer maturity dates. When you have a Bond with a longer maturity, you increase your risk (volatility) as the value is likely to fluctuate before it matures. For example, Long Term Gov Bonds are currently -11.48% (as of July 5, 2013)If not Long Term Bonds, some may choose Municipal Bonds or even Emerging Market Bonds (down -8.22% for same period) and Corporate Bonds; again increasing their risk as these vehicles are more volatile.Those who ran to Treasury Bills after the downturn of 2008 (up +25.8% at end of 2008), experienced great losses in that Asset Class if they held those in their Portfolios through 2009: -14.90%*The Purpose for Fixed IncomeIn a properly diversified portfolio, Fixed Income helps improve stability, acting as a “cushion” against the full impact of the Equities Markets. While providing the opportunity for some growth, growth is not the first priority, maintaining Capital is the first priority followed by growth. Remember, we don’t want to speculate and “chase” higher returns with Fixed Income (thus increasing volatility) , that’s the job of the Equities portion, which should be spread out globally.A Hypothetical that has allocated 50% to Fixed Income and 50% to Equities has reduced its volatility (Risk) by reducing the exposure to the Equities Market; and should not expect to participate in the full downturn of the market when compared to having 100% of one’s portfolio in the Equities Market. The other side of that coin is, when the Equities markets grow, you cannot expect to benefit fully (meaning 100% of the growth) as you have sheltered half of your portfolio from equities.Stay Involved With Your PortfolioEducation- Coaching, is a key component to the growth and success of your portfolio, and with it, your financial dreams and aspirations.Last month’s Coaching Session- “Mind Over Money”, was so impactful, many in attendance wished they had their friend or family member. Because this is such a helpful, relevant class, I am teaching it again this month.Please mark your calendar and make every effort to attend, Thursday August 22, 6:30PM at The Hampton Inn in Lancaster.
R.S.V.P is required for attendance. For Clients and prospective clients only- no Agents or Licensed Advisers or Brokers.
Call 661-942-2141 by Aug 14, 2013 to reserve a seat
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Let’s start with the positives of the 401(k) plan before we get into the Pitfalls.
Number One, once you set up the plan your contributions are automatic; you do not have to think. You can view this as “forced discipline.”
Number Two, there may be a Company match; you make a contribution and they match your contribution , typically 25 or 50 cents for one of your dollars, and some will match dollar for dollar.
OK, that’s about all the positives…..now let’s reveal some “Pitfalls.” :
While this sounds like a no-brainer, many employees are under the impression that they cannot lose their money that is in “The Company Plan.” Setting the obvious aside, let’s look at the reality that most workers focus on what they are good at in their job, yet now that they are putting money into this plan they must now know how to navigate the choppy waters of the Stock Market!
This arduous task quite often leads to unwise behavior such as emotional based decisions, hyper-trading (frequently switching fund choices), timing the market and speculating and gambling. All of these factors, according to Dalbar Research, are why individuals investors on average earned a meager 4.25% annually over the past 20 years, while the S&P 500 averaged 8.21%.
[Dalbar’s Quantitative Analysis of Investor Behavior Dec. 31, 2013]
When the 401(k) was first introduced in 1981, one of the intentions was to direct your attention away from the “disappearing Company Pension Plan” and focus on the growth opportunity of having your retirement funds in the Stock market.
One of several risks that resulted was that workers went from having a Defined benefit plan, in which they knew with certainty (dependent upon age, years of service, and averaged salary) what their future monthly retirement income would be, to having no idea at all what their future income will be.
So instead of knowing that you are working towards a future monthly income of $3,800, for example, you are now encouraged to put your own money in the Stock Market, possibly matched by a contribution of the Company’s money, and are expected to figure the rest out on your own.
As I write this, the majority of public companies’ 401(k) plans have absolutely no income provisions at all! Meaning that when you get to the point of retirement and have say, $400,000 in your 401(k) (Should you be so fortunate), what do you do with it? Take withdrawals? How much? How long it last? What if the market keeps going down? Obviously a drop in value like we saw in 2008 will have a devastating effect on the income that can be generated from your retirement account. $200,000 doesn’t go quite as far as the $400,000 that was once in the account.
(Adapted from the book, Against The Grain, Avoiding the Financial Pitfalls of Conventional Wisdom, by Tim Rosen available for Kindle through Amazon, and paperback at www.AgainstTheGrain-Book.com
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