There’s more to retirement than sitting on a nest egg, especially if you’re just getting into the game. Many people find it difficult or impossible to pay into a retirement account while raising a family or simply covering the cost of living. Others are distrustful of the markets, wary of incompetent financial advisers, or simply overwhelmed by the inexplicable complexity of retirement planning.
So what’s a person to do? The short answer is: take charge and stay informed. If the data tell us anything, it’s that financial literacy and proactive management of your money can help turn the tides in your favor.
A crisis is brewing
If you ask around, most people will say that there’s a retirement problem in the United States. In fact, surveys suggest that 92 percent of people believe there is a retirement crisis in America. Senator Tom Harkin, Chairman of the U.S. Senate Committee on Health, Education, Labor & Pensions, issued a report called “The Retirement Crisis and a Plan to Solve It.” While the federal government sometimes tries to address problems that don’t actually exist, Harkin’s report lays out a compelling case for the existence of a retirement crisis.
Highlighting just a few troubling facts, Harkin’s report points out that, in aggregate, Americans currently hold a $6.6 trillion retirement deficit. Only one of five people in the private sector workforce have a defined benefit pension plan, and half of Americans have less than $10,000 in savings.
What’s more, just 4 percent of employers are “very confident” that their employees will retire with sufficient assets. This is down from 30 percent in 2011. On the other side of the equation, only 14 percent of people believe they will have enough money to live comfortably in retirement.
Harkin’s report suggests that the retirement crisis is “directly attributable to the breakdown of the traditional “three-legged stool” of retirement security – pensions, savings, and Social Security.” All three of these legs have been eroded in some way by the financial crisis and global economic downturn. Institutions with defined benefit pension plans such as large corporations or municipal governments are having an increasingly difficult time meeting their obligations. Meanwhile, stagnant wages and a rising cost of living have made it more difficult for people to contribute to a 401K or an IRA.
And the fate of Social Security is by no means clear. Government spending cuts and what may be best described as decades of federal mismanagement have undermined the stability of the program. The program has always been meant to be a supplement to retirement income, not a substitution for saving, and some experts are forecasting that benefits will be reduced after 2041.
Harkin’s stool analogy provides a convenient way to think about retirement options. Unfortunately, as the report pointed out, one leg (a defined benefit pension plan) is a luxury that is not afforded to most Americans. Pensions aren’t perfect and even though they are fading from popularity because of their difficulty to manage (on the provider side), they are still a pillar of the American retirement system.
If you do not have a pension, then it is even more important to understand the two legs you have left. Of the two — personal savings and Social Security — most attention is called to savings, because it is the leg that people can actually affect. The fate of Social Security, on the other hand, is out of the hands of most people. While it is important to understand how Social Security payments could assist your retirement, it is critical not to rely on them. The leg that most people will depend on when it comes time to retire is the one they built themselves.
Conventional wisdom states that you should begin saving for retirement as soon as possible — and by all accounts, the conventional wisdom is right. There are many different ways to save, and some are definitely better than others. Hiding your cash beneath the floorboards is one method, but your treasure chest won’t grow in value over time down there. In fact, because of inflation, it will actually lose purchasing power. Putting money into a savings account at a bank is one option, but interest on most saving accounts also won’t outpace inflation.
Many people conflate the idea of investing and saving for retirement. Investments are things like stocks, mutual funds, bonds, and index funds. You can certainly try to build a retirement nest egg by investing directly in the stock market or in municipal bonds, but there’s a better way to go about growing your money. Chiefly, you can create a retirement account and fund it with pretty much any investment you like, and avoid pesky capital gains taxes.
Different plans have different pros and cons, but the major appeal is form of tax benefit. Here’s a quick breakdown of some common retirement accounts:
401Ks, 403Bs, Thrift Savings plans
These accounts are not all exactly the same thing, but they are pretty close. These are accounts that you typically open up in conjunction with an employer. Contributions are made directly from your paycheck and are tax deferred, meaning you won’t pay any taxes until you make a withdrawal. Your employers, depending on how awesome they are, may or may not match a portion of your contributions. Conventional wisdom suggests that if your employer matches contributions, you take full advantage of that free money.
One of the huge benefits of tax-deferred contributions is that it provides an incentive for young people to actually save. Early on in a career or while building a family it can be difficult to afford the cost of living while simultaneously putting away the 10 percent of each paycheck that many experts recommend. Tax-deferred contributions ease the short-term pain of contributions, giving Present You a pat on the back for looking after Future You.
Perhaps the biggest downside of a 401K is that the employer typically decides what investments go into the account. Companies have a long history of making bad investment choices and failing to diversify in a competent way, but most experts agree that any 401K is better than no 401K.
Traditional IRAs and Roth IRAs
In many cases, an individual investment account will be the vehicle that a person uses to grow their retirement nest egg. As with anything lorded over by the Internal Revenue Service, the full body of laws and regulations governing IRAs is a complicated tangle of specific conditions and exceptions that define any number of variables (you can find the current rules here).
Broadly, there are two types of IRAs: traditional, and Roth. Like any savings strategy, each account has its pros and cons. To get an idea of how the accounts work, and to highlight the differences between the two, we’ll walk through an example. Keep in mind this is highly simplified, and is only meant to be illustrative.
The primary difference between a traditional IRA and a Roth IRA is how they are taxed. When you fund a traditional IRA, you don’t pay any taxes — your contributions and investments are tax deferred. With a Roth IRA, your contributions are immediately taxed at your current income tax bracket.
As it stands, the maximum amount of money that someone can contribute per year to an IRA is $5,500. You can fund your account in a variety of ways, and buy and sell investments from within the account tax free (i.e. not incurring capital gains when selling stocks). In our example, we assume that because you are a savvy investor, once your account is funded you are able to double your account’s value over the course of several years, without any additional contributions.
At a glance, it’s easy to see that in the short term, the traditional IRA is the better choice. All things being equal, not paying taxes up front means that you have a larger investment to grow. This can have a powerful effect over time.
However, Roth IRAs have been growing in popularity for a reason, and chief among them is that because you pay taxes up front, you do not have to pay any taxes upon withdrawal (in this example, we assume a 25 percent tax rate). What’s more, there is no penalty for withdrawing the principal amount before the age of retirement. In a traditional IRA, if you try to withdraw money before you are 59.5 years old, you incur a 10 percent penalty on the amount you wish to withdraw, in addition to being taxed on that amount.
This means that if there is an emergency and you are forced to tap your account for money, the Roth IRA proves to be the better lifeline. (It’s important to point out that if you need to withdraw more than the principal from a Roth IRA, you will be taxes on earnings and pay a 10 percent penalty.)
Come the age of retirement, we assume that (because you are a savvy investor) you have once again doubled the value of your account (again, the amount is arbitrary, but consistent between accounts for illustrative purposes). Now you are ready to reap the rewards of your principal investment and careful investing, and cash out.
Remember that your investment in the traditional IRA was tax deferred, meaning that when you cash you, you will have to pay taxes on the entire amount. Meanwhile, your Roth IRA is already square with Uncle Sam, and you do not have to pay any taxes with pulling money out.
It’s important to point out that one of the key variables in this example is the tax rate you are charged with either investing initially or withdrawing funds from the account. Traditional IRAs benefit from the fact that most people are paying a lower effective tax rate when they near retirement than when they are at the height of their career and making contributions.