6 How Should I Fund Retirement?
Jillian had worried a lot throughout the latter part of her work life about having enough money to support herself in retirement. She had, of course, done more than worry. Jillian had worked steadily at a decent job that paid decent wages. Her employer had also matched her retirement contributions to the employer’s plan. And Jillian wasn’t planning on doing nothing in retirement. She was instead going to continue and expand a small bookkeeping business she had started on the side. So, when retirement finally arrived, Jillian discovered to her great relief that she had plenty of money to support herself. Indeed, she had enough to be generous with her nieces, nephews, and their children, more so than ever before.
Support
Your financial support in retirement is a big issue. Retirement is a peculiar social construct that depends on being able to financially support yourself without work. If you don’t have your own financial support, then you’ll need to continue to work. The government doesn’t fund retirement. You fund your retirement through your earnings or the earnings of your spouse, the Social Security taxes you pay on those earnings, and the credits that accumulate for paying those taxes. If you or your spouse don’t work, you don’t get Social Security retirement benefits. You don’t get a pension simply for your old age. Funding retirement may be the biggest question that we have when first thinking seriously about retirement. To put it another way, we don’t retire in large part because we must work to support ourselves with earned income. You think you’d work anyway? Then why not just work for free? So, roll up your sleeves, and work hard and long to fund your retirement, if that’s what it takes and a fully funded retirement is what you want.
Sources
Retirement funding generally sits on a three-legged stool of (1) savings in employer-sponsored retirement plans, (2) Social Security retirement benefits earned from work credits, and (3) retirement income from investments or part-time employment. Plan thoughtfully for all three sources. Make yours a stable stool. Two of those three legs of the stool involve employment. If you simply work for a long time at a reasonable rate of pay, you’ll get decent but not generous Social Security benefits, probably not enough to support your retirement. But if you also set aside the maximum allowed annual contributions in an employer’s tax-advantaged retirement plan for as long as you work, you’ll have a substantial nest egg out of which to amply supplement your Social Security. And if you also can arrange some extra retirement income from investments, annuities, payments on a business or other asset that you sold, or part-time employment in retirement, then you’re likely to have more than enough for retirement, indeed enough to share generously with family, church, charities, or others beyond securing your retirement.
Starting
The earlier that we think of funding retirement, the better. We have strong incentives to think early about saving for retirement: Congress has granted tax advantages to funding retirement through employer plans. Employers often offer those tax-advantaged retirement plans, even ones to which the employer will contribute funds on top of the employee’s contributions. Retirement may have been the farthest thing from your mind when you took your first substantial employment and your employer required you to decide whether to participate in the retirement plan. Funding retirement thus generally begins with paying taxes on earned income to qualify for Social Security while also setting aside a portion of that income to place directly in a tax-advantaged retirement plan. Whether you’ve thought about retirement savings a lot or not, you’ve probably already gotten a good start through your work. Plan to continue working and making maximum annual contributions to your employer’s tax-advantaged retirement plan, and you’ll have made a great start.
Taxes
Tax-advantaged plans can make especially good sense for retirement savings because of two features. One feature is that employer plans like the 401(k) for for-profit employers, 403(b) for tax-exempt and government employers, and SEP IRA for small business owners and self-employed individuals allow employees to contribute wages to the plans before paying income taxes on those wages. You can contribute more to your retirement savings at lower cost that way, although under current law you will pay income tax on your withdrawals in retirement. Another feature is that those employer plans and the Roth IRA and traditional IRA are generally exempt from capital gains tax on their increase in value and from income tax on their earnings, enabling those accounts to grow tax free. Retirement savings in tax-advantaged plans accumulating over a long term, without taxation on their growth, can have a huge advantage over ordinary savings subject to income tax on interest, and over ordinary investments subject to capital gains tax.
Savings
Making maximum annual contributions to the tax-advantaged retirement plan that your employer offers is indeed a great start. But in the best case, that won’t be all that you do. You should ideally be setting aside other savings to help along your retirement plans. Remember, you want a three-legged retirement stool, not just the two legs of your employment retirement plan and Social Security retirement benefits but also extra support in retirement from savings, annuities, investments, and their earnings, whatever extra that you are able to reasonably accumulate. Savings grow one of two ways: a little bit at a time or in big chunks. You may, for instance, receive a bonus from work, a refund from the IRS, an inheritance from the passing of a relative, or a lump sum from the sale of a business or other asset. If you can, sock that windfall sum away in an account that you earmark for retirement. But nothing guarantees that you’ll receive a windfall. So in addition, make a commitment to put a little extra away on whatever regular schedule that makes sense, whether out of each paycheck, once a month when paying bills, quarterly when paying self-employment taxes, or annually when filing your income tax return. Your extra savings outside of employer plans can be the cherry on top of your retirement support.
Income
Income during retirement can supplement your retirement-plan benefits and Social Security retirement benefits. Employment isn’t your only way to build a retirement nest egg. Plenty of retirees earned their retirement support by creating some other asset out of which to draw income. You may, for instance, own a business that you plan to sell at your retirement, to have income from payments on the business. You may alternatively have purchased rental properties that you plan on continuing to lease for retirement income, provided that you can manage the rentals. Investment income is another option. You may, for instance, have purchased an annuity with retirement savings, the payments from which you plan to supplement your retirement benefits. You may also own stock shares that pay dividends or may own certificates of deposit and other interest-earning accounts, all to supplement your retirement income. Other income sources could include draws from a trust, gifts from relatives, and inheritances. Include in your retirement budget whatever other sources of retirement income that you foresee and on which you can reasonably rely.
Earnings
Retirement doesn’t have to mean stopping all income-earning work. Income from part-time work could supplement your retirement budget. You may not even need to work for income but instead want to work part time during retirement to keep active, lend your day and week some structure, ensure your social interaction, or contribute to your profession or community. If you don’t mind working part time, you’re up to it, and you have employment available, then factor that income into your retirement budget. If on the other hand you need to work part time during retirement because your retirement benefits and savings are inadequate to support your retirement lifestyle, then by all means do so. Part-time work in retirement can be both necessary to a retirement budget and satisfying enough to work anyway, even if you didn’t need the income. At some point, though, if you’re working full time or nearly full time because you need the income or simply because you prefer to do so, then you’re not retired. That’s okay, too, if you must work or you want to work and you have the employment available.
Amount
You may also wonder how much in savings is enough for retirement. The answer depends on where you live, how you live, and who you ask. The cost of living varies a lot from locale to locale. Your lifestyle and its costs may also differ greatly from the average lifestyle and costs. And some financial advisors making these estimates are more conservative and cautious than others. Thus, beware going by a single figure or basic formula. That figure or formula may be way off from your actual needs. Saving far more than you need for retirement may be fine, except that you may be working longer and harder than you should, while sacrificing other things, to do so. Saving substantially less than you need for retirement could become a major problem for you. So, a better way to calculate the amount to save for retirement is to do a retirement budget, discussed in a later chapter. The budget will show you how much extra you need each month and year, if any, after your employment retirement plan and Social Security. Once you know the annual amount that you look to be short, you can multiply that amount times your lifespan at your retirement age, to calculate a total amount. A sound calculation benefits from a couple of other adjustments. See a financial advisor for the details, after reading the chapter below on budgets.
Investment
Investing your retirement savings wisely, and adjusting those investments wisely throughout your life, can make a big difference to funding your retirement adequately. You’ve already seen above that when you start your employment retirement plan early, including keeping it invested for growth, the growth can be as big as a multiple of the amount that you paid into the plan. The same is true for your extra retirement savings. Simply investing retirement savings in a market-indexed growth stock fund has earned annual returns of as much as seven percent, meaning that the money you set aside and invest for retirement would double about every ten years. That’s four times as much in twenty years and eight times as much in thirty years. Investing requires paying attention to both growth and risk. Don’t risk your retirement savings just for a little more growth. But don’t be so risk averse that your retirement savings don’t grow. Find a happy medium, which for many individuals funding retirement involves choosing a market-indexed growth stock fund. Market-indexed funds track the whole market, effectively diversifying risk out of any one or small cluster of stocks. See a financial advisor for your best investment choices. See the guide Help with Your Money for more investing guides and principles.
Statement
You should have a way of knowing where your retirement funds stand as you set them aside and invest them, relative to your retirement funding goals. Don’t fly blind. Instead, always have a good idea of where you stand on funding your retirement. Financial statements are a good way of doing so. Create a balance sheet that shows everything you own and everything you owe. Divide the sections of your balance sheet up, first into assets and debts. Then divide the assets section up into tangible assets like your home and motor vehicles, and intangible assets like your savings, checking, and retirement accounts. Then make a special section in your intangible assets for your retirement accounts. Every quarter (four times a year), update your balance sheet with where your retirement savings and investments, and other assets and debts, stand. At the beginning of every year, make and save a copy of your balance sheet for that year, and continue updating the new copy for the next year, so that you soon have a balance sheet for every prior year, showing where you’ve been and where you may be going.
Analysis
At the beginning of every year, take a closer look at your balance sheet to see whether your savings and investment strategies, and your household budgeting, are meeting your retirement funding goals. You should find your balance sheet reassuring, insofar as it tells you pretty much exactly where you stand on your retirement funding. You may find that your balance sheet relieves your anxiety over your retirement savings, especially if your balance sheet shows that you are right on track. On the other hand, you may find that your balance sheet shows that you are behind on saving for retirement, in which case you should look at making the necessary adjustments. You might, for instance, take on a second, part-time job for a little while, just to catch up on retirement funding. Or you might cut some discretionary expenses, just to catch up on retirement funding. In any case, use your balance sheet to analyze your retirement funding and savings and investment strategies. See the guide Help with Your Money for an example balance sheet and more explanation of its uses.
Reflection
On a scale from one to ten, how comfortable are you with where you stand on funding your retirement? Do you maintain and update a balance sheet to tell you where you stand? Do you analyze your balance sheet at least annually to make adjustments as necessary to ensure adequate retirement funding? Are you making the maximum allowed contribution to any employer retirement plans for which you qualify? Does your balance sheet reflect the balance of those retirement plans? Do you have your retirement accounts invested in a growth fund your financial advisor recommends? Do you anticipate any income from part-time employment during your retirement? If so, are you sure that you’ll be up to the work and that work will be available? Do you anticipate any unearned income during retirement?
Key Points
Plan to save the funds necessary to provide for retirement support.
Build your retirement funds from Social Security and employer plans.
Start early as you can on retirement funding, with work contributions.
Save extra retirement funds outside of employment retirement plans.
Tax-advantaged retirement plans can grow much more quickly.
Keep your retirement accounts invested in secure growth funds.
Maintain and update a balance sheet to tell you where you stand.
Analyze your balance sheet annually to ensure your funding progress.
Count income you may earn from part-time employment in retirement.
Count any other unearned income that you may receive in retirement.