Retirement Planning Guide
About the Retirement Planning Guide
In this guide, we cover the most important aspects of retirement planning: why it's imperative to begin planning as soon as possible; early retirement strategies; how to make sure income options are more than just Social Security; avoiding pitfalls; making use of tax-efficient accounts; how to offset the effects of inflation; reducing risk with asset allocation and diversification; and practical steps you can take to start building a solid retirement today. While this guide provides lots of specific information, we encourage you to seek the advice of a qualified financial advisor in order to receive information about your individual financial situation.
Why Planning for Retirement is so Critical Today
Almost everyone in the United States who has a received a paycheck is familiar with the FICA deduction. But few actually know what FICA stands for. FICA is the acronym for the Federal Insurance Contributions Act, which was signed into law by President Franklin D. Roosevelt in 1935. Initially established as social insurance to prevent aged Americans from living in poverty, it now includes Medicare (since the Johnson administration) and Supplemental Security Income (since the Nixon administration).
The FICA deduction is taken from an employee's paycheck and, along with the employer's matching amount, is deposited by the Social Security Administration into four trust funds: Old Age and Survivors Insurance, which is the Social Security trust; the Disability Trust that pays disability benefits; the Hospital Insurance trust that pays for inpatient hospital care; and the Supplementary Medical Insurance trust that pays for outpatient services and Medicare Part D prescription drug benefits.
7.8 million Americans over the age of 65 began collecting monthly Social Security checks in 1940. As the Baby Boomers (those born between 1946 and 1964) begin turning 65 in 2011, it is estimated that 71.5 million Americans will be over the age of 65 in 2030. How long can FICA payroll deductions support all of us?
To estimate your retirement needs, download this handy Retirement Budget Excel file.
While we've all heard the rumors that the Social Security and Medicare trust funds are going broke and won't be there when "we" retire, a more likely scenario is that both will be available to all Americans over the age of 65. The question is: what services will be available to whom and at what cost?
Today, retirement planning today is more crucial than ever. Market volatility, inflation concerns, unemployment, and a credit crunch are all working against us. Whether you're a Baby Boomer turning 65 or a 25-year old starting your first job out of college, it's time to make a plan to ensure that retirement will offer at least a baseline level of stability and comfort, but hopefully much more.
For anwsers to the common retirement planning questions, visit the Retirement Planning FAQ.
Retirement Income Options
Unlike income from a job, which is usually immediate, income in retirement comes from years of planning, saving, and prudent investing. It's probably one of the most difficult aspects of retirement for most people to adjust to. Income from a job is a "renewable resource." Provided you don't lose the job, as long as you work you receive income. But income in retirement works differently. The account from which the money comes from is depleted each month.
Congress established the Individual Retirement Account (IRA) in 1974 as part of the Employee Retirement Income Savings Act (ERISA). This allowed workers whose employers did not provide them with a pension to contribute money each year to a savings account that would grow tax-deferred. Over the years, the rules regarding IRAs have changed. For example, now all workers, regardless of whether they participate in an employer-sponsored plan, can contribute to an IRA. The Roth IRA, introduced in the late 1990s, allows workers to save money that is tax-exempt in retirement.
Pensions are still a source of retirement income for some, but they are largely being replaced by 401(k) plans. This switch from defined-benefit plans to defined-contribution plans has happened for two important reasons. First, people are simply living longer. A company that offered a pension to a retiree at 62 never expected to continue providing that employee with income until he or she was 85, 90 or even 95 years old. Second, the cost of the benefit has been rising faster than inflation over the past several decades. These two factors, along with increased competition from an ever-global workforce, have made pensions largely non-existent.
For those worried about depleting their nestegg after retirement and coming up short, annuities provide a great alternative retirement income source. Money that's used to buy an annuity is locked-in for a specific amount of time to provide the owner with a higher rate of return than CDs, government bonds, or money market account. . The payouts can be for as few as five years to a lifetime of guaranteed income. Fixed, variable, and indexed annuities can provide the security that bonds and stock dividends don't.
Stocks, bond, and mutual funds are the big three when it comes to retirement income options. Stocks are the growth-engine, bonds are the safety net, and mutual funds are often the best way to diversify. Regardless of age, an investor must always have a certain percentage of retirement savings in stocks. While the stock market can be volatile and investors can lose money in the short term, in the long run, most investors benefit far more by staying invested in the market.
Finally, cash, whether in the form of money market accounts or certificates of deposit, is necessary to protect assets. These accounts won't generate income in retirement, but they can keep pace with inflation and protect assets until a higher-yielding investment comes along.
For more details, visit the Retirement Income Options page.
Common Retirement Planning Pitfalls
We've all heard the advice: start saving as much as possible as soon as possible. But it's hard to save for retirement when we're young and just starting out. It's a lot more fun to spend the money now rather than save it. To avoid this pitfall, you need to develop a habit of over-participating in your employer-sponsored defined contribution program, like a 401(k). Deductions can be made less painful by setting up automatic withdrawals.
Avoiding the pitfall of passing up free money is another rule of retirement planning. Financial planners are usually shocked to learn that their clients don't take full advantage of an employer's match to a 401(k) account. If your employer offers a match, contribute at least the amount that will get you a 100% free match to your own contribution. For example, if your employer offers a match up to 6% of your salary, you too, should contribute at least 6%.
Not diversifying the portfolio is another retirement planning pitfall. For example, don't keep 75% of a portfolio in any one stock or market sector. When there's a downturn, a significant portion of the portfolio could be lost. In other words, don't own Exxon Mobil and Shell Oil at the same time.
Finally, everyone must save an adequate amount for healthcare expenses during retirement. While none of us can know what will happen in the future, one thing is clear: healthcare costs are rising dramatically. Medicare covers everyone over the age of 65 in the United States. But it doesn't cover everything, and fewer heath providers are accepting Medicare insurance because of the lower payments offered by the federal government. Medigap insurance, which is offered by private insurance companies, covers what Medicare doesn't, but it can be expensive for those on a fixed income. The best way to beat rising medical costs is to stay as healthy as possible. If you smoke, quit. Don't drink alcohol to excess, maintain a proper body weight, exercise regularly, and like your mother said, eat your fruits and vegetables. With these bases covered, make sure you get annual check-ups and don't skip doctor-recommended screenings.
For more details, visit the Retirement Planning Pitfalls page.
Retirement Savings Tips and How to Maximize Accounts
Save early, save often. There's really no other way to maximize the amount of money that will be available in all of your retirement accounts once you retire. Investing in stocks for the long run and bonds for income will provide a sound floor for the portfolio, but sometimes a little extra boost is needed for those who start saving late or for those who haven't made much money during their working years.
Adding a second or part-time job to a weekend schedule may not be an option for everyone, but for those who can, the money that's earned can go a long way toward providing a comfortable retirement. For those who have specialized skills, working as a consultant can sometimes be a great way to pick up extra cash without committing to a full-time position. For those who love to read, a part-time job in a bookstore could be an option.
Married couples who both work can sometimes live off one salary while banking the other. Or, the second salary can be used to pay off the mortgage or other debt. Nothing takes a bite out of retirement savings like debt. Credit card debt especially will be a huge drag on any retirement portfolio.
If you have office space or an extra room in the house now that the kids are off to college, it may make sense to rent it out. As long as local zoning laws allow for it, the extra money in rent each month could help to get the mortgage paid off or it could be saved for retirement.
For more details, visit the Retirement Savings Tips page.
Retirement Planning and Taxes
Taxes, inflation, and healthcare costs are the three big unknowns when it comes to calculating how much money needs to be saved for retirement. Traditional IRAs and employer-sponsored plans are somewhat tax-efficient. In exchange for the ability to defer taxes until a later time, a worker is allowed to deduct the amount he or she contributes to the plan. And, the taxes on all earnings within the account are deferred until the point at which the money is withdrawn after age 59 ½.
The premise behind these accounts is that the worker will be in a lower tax bracket after retirement than when he or she was working. But that's not always the case. With these traditional accounts, money must begin to be withdrawn by the April following the year the account owner turns 70 ½.
Roth IRAs can be much more tax-efficient. The contributions made to a Roth IRA are not tax deductible. But earnings still grow tax-deferred for as long as the money remains within the account. The two other differences between a traditional IRA and a Roth IRA are that distributions are paid out tax-free and mandatory distributions are not required at 70 ½. Is there anything better than receiving tax-free money?
For more details, visit the Retirement Tax Considerations page.
Incorporating Inflation into Retirement Savings Goals
Inflation is the sustained increase in the cost of goods and services. We're all familiar with inflation. We see it almost every year. It's clear when we go to the grocery store that not as many items are in the bag as last year given the same amount of money. Pricing on groceries, gasoline, restaurants, and rent always creeps up.
Inflation isn't always problematic. It occurs naturally over time as we assign a higher monetary value to goods and services. As long as income increases at least at the rate of inflation, there is no problem. But when inflation rises faster than earnings, the amount of goods and services that we can buy is reduced. And that's a big problem for retirees on a fixed income.
Living on a fixed income means that the same amount of money comes in each month regardless of a rise in prices. For example, a fixed income of $2,500 each month this year will buy $2,500 worth of goods and services. But if the inflation rate is 3% this year, those same goods and services will cost $2,898 in 5 years.
In order to offset the effects of inflation, all retirees need to keep at least a portion of their portfolios in growth assets like stocks. For those who have annuities, the cost of living adjustment (COLA) is a necessity, especially if the annuity has been purchased to provide lifetime income.
For more details, visit the Retirement and Inflation page.
The Importance of Asset Allocation and Diversification
Asset allocation is the way in which a portfolio is divided among different asset categories (classes)such as stocks, bonds, cash, and real estate. Diversification is about holding significantly different individual investments within a particular asset class. For example, if all your savings were held in Microsoft, Exxon Mobile, Walmart, MacDonalds, and Ford Motor Company stock, you would be allocated in one category, large-cap equities. But since these stocks are part of different market sectors, your portfolio would be considered well-diversified.
Asset allocation needs change over time, diversification doesn't. Depending on an investor's age, he or she will have a larger percentage of a portfolio in stocks. Those under the age of 50 should normally keep at least 70% of the portfolio in stocks, and 30% in bonds and other investments. Those in retirement should keep at least 40% of the portfolio in the market. Of course, asset allocation depends on an investor's level of risk tolerance and the overall value of all accounts. This is one area in particular that most people will benefit from speaking with a financial planner.
Asset diversification is like insurance. It protects against losing more value than necessary during a market downturn. For example, if Microsoft is down with rest of the "tech sector", Exxon Mobile might be up with the other stocks in the "oil sector". Mutual funds and exchange-traded funds (ETFs) also offer diversification by grouping stocks, bonds, or commodities together and trading them as a unit.
For more details, visit the Asset Allocation and Diversification page.
Building a Solid Retirement
As we've discussed, it's not easy saving for retirement. It takes hard work, patience and dedication. It may also take a bit of sacrifice to pass up spending now in order to save for the future. Whether you're just starting out or are nearing retirement, here are just a few additional tips to building a solid retirement.
Establish a five-year plan. Take a look at income, expenses, and goals for the next five years and lay out a plan. If you don't have a clear vision in mind about what you want, you will never take that first step to get it. And the first step is setting out some motivating goals.
Perform an annual budget review to see where expenses can be cut. Every little bit helps when it comes to saving for retirement. Speak with a financial planner to see if he or she has suggestions about how to safe additional money and move savings and checking accounts to a bank where there are no fees. Use coupons, join associations, and keep alert to other discounts you may be entitled to. Finally, protect your assets and income by being properly insured. Disability and long-term care insurance may be expensive given your individual situation, but they may be far less expensive than losing your livelihood.
For more details, visit the How to Build a Solid Retirement page.
Early Retirement Planning
For those who've been lucky enough to choose early retirement, it can mean a whole new chapter in life – the chapter that dreams are made of. Scrimping and saving, combined with a few solid growth investments and opportunities for residual income are what allow most of us to retire early.
For others, however, early retirement may mean they've been "downsized" or otherwise pushed into a situation they're not necessarily comfortable with financially. Either way, becoming debt-free should be the number one priority. High-interest debt, in particular credit card debt, will reduce a savings or retirement account faster than just about anything else.
The second priority might be to get a part-time job or develop another source of residual income. Even if you've been planning an early retirement, working at a part-time job allows people to stay connected and involved with business contacts and the community.
Finally, reducing expenses and maximizing savings opportunities will stretch an early-retired dollar even further. Joining an association like AARP for a nominal annual fee can provide substantial reductions in insurance and other services.
For more details, visit the Early Retirement page.
While we've covered the basics of retirement planning here, there is much more to securing a great retirement. To make sure you're on the right track, contact a licensed financial advisor. It only takes a few minutes, Start Now.
More Retirement Planning Guidance
- Retirement Income Options — Explore your retirement income investing options.
- Retirement Savings Tips — Tips for how to saving for retirement.
- Building a Solid Retirement — A practial guide to implementing your retirement plan.
- Early Retirement — What it takes to plan an early retirement.
- Inflation — Understanding how inflation affects retirement planning.
- Assest Allocation & Diversification — Learn how to manage investment risk.
- Retirement Pitfalls — Common retirement planning mistakes you'll want to avoid.
- Tax Considerations — How to minimize tax burden while saving for retirement.
- Retirement Planning FAQ — Frequently asked questions about retirement planning.