What You Need To Know About Your Retirement

Most people know they want to retire someday but do not have a clear idea on how they will finance their retirement. This article looks at some of the factors you need to consider when thinking about your retirement from a financial perspective.

Retirement Planning has Changed
In the not-too-distant past, individual retirement accounts and 401(k) plans did not exist. The classic retirement model was based primarily on Social Security benefits and monthly employer pension checks. Furthermore, retirement savings did not have to last as long because people did not live as long as they do today. In addition to longer life expectancies, tomorrow’s retirees will lead a more active lifestyle. This means that retirement will be more costly for tomorrow’s retirees.

Let’s take a closer look on how the retirement landscape has changed.

Social Security. Social Security’s lack of viability seems to make news daily. The average annual Social Security retirement benefit was about $11,000 in 2004. Even if you receive this average annual Social Security retirement benefit, you probably want to have more than an annual $11,000 retirement income. To make matters worse, this average annual Social Security retirement benefit may decrease by the time you want to retire. This is because in the future, retirees will be receiving more Social Security retirement benefits than what active workers are paying into Social Security. As a result, your Social Security retirement benefit may be less than what you expect.
Traditional Pension Plans. Not too long ago, most workers were covered under an employer’s traditional defined benefit plan. Under these traditional pension plans, a retired worker would receive a monthly pension payment for the joint lives of the worker and his or her spouse, with a survivor benefit paid to the worker’s surviving spouse. The amount of the worker’s monthly pension payment was typically based on the number of years of service with the employer, multiplied by the worker’s average annual compensation over a specific number of years.

In contrast, most of today’s retirement plans are defined contribution plans. In contrast to the traditional pension plan, a defined contribution plan consists of contributions you make to your employer’s plan, as well as any employer contributions made to the plan on your behalf. Because a large part of your employer’s plan will consist of your own contributions, the amount of your retirement benefits will depend significantly on the amount of contributions made to the plan.

Start Saving Now
It is never too late and it is never too early to start saving for retirement. Consider the following four investors:

25-year-old Investor;
35-year-old Investor;
45-year-old Investor; and
55-year-old Investor.

Each Investor contributes $5,000 each year in their 401(k) plan for ten years. After ten years, none of the Investors make any additional contributions to their 401(k) plan. Assuming a 7% annual return, how much money will each Investor have at age 65?

The 25-year-old Investor will have $570,712 at age 65.
The 35-year-old Investor will have $283,428 at age 65.
The 45-year-old Investor will have $140,757 at age 65.
The 55-year-old Investor will have $ 69,904 at age 65.

This example shows it is never too early to start saving in a 401(k) plan.

Know Where the Free Money Is
When planning for retirement, you need to know the two primary sources of free money: the government and your employer.

Free Money from the Government. When you make a contribution to your 401(k) plan, the government gives you two gifts. First, assume you are in a 30% income tax bracket (combined state and federal). In this case, for every dollar you make as a 401(k) contribution, your paycheck will only be reduced by 70 cents. Second, your investments within a 401(k) plan grow tax-deferred. You do not pay taxes on the earnings on your contributions until you begin taking distributions at retirement. This leaves more of your money to compound through the years. Consider the Investors in the above example. If the same Investors make $5,000 in contributions annually for ten years in a taxable investment, and the earnings are taxed at 30% (that is, earnings are not tax-deferred), the Investors would have the following amounts at age 65:
- The 25-year-old Investor will have $278,663 at age 65.
- The 35-year-old Investor will have $169,858 at age 65.
- The 45-year-old Investor will have $103,536 at age 65.
- The 55-year-old Investor will have $ 63,110 at age 65.
As you can see, your nest egg will be considerably larger if it is allowed to grow tax-deferred until your retirement as shown in the “Start Saving Now” section of this article. Of course, when you begin taking withdrawals from your 401(k) plan during your retirement, you will have to pay income taxes on the amount of your withdrawals. Many workers, however, will be in a lower income tax bracket when they retire compared to their current income tax bracket. This makes the tax-deferral nature of 401(k) earnings a good deal for workers.
Free Money from Your Employer. Another common source of free money is your employer. It is common for an employer to make a matching contribution to your 401(k) plan based on the amount of contributions you make to the 401(k) plan. For example, an employer may provide a matching contribution of 50 cents for every dollar in contributions that you make up to 5% of your income. If you want to take full advantage of the employer matching contribution, you would have to contribute 5% of your salary into the 401(k) plan.

For example, if you are earning $40,000 a year, you would have to make at least $2,000 in 401(k) contributions ($40,000 x 5%). By making a contribution to a 401(k) plan in an amount equal to 5% of your salary, in addition to the $2,000 in contributions you make, the employer will make an additional $1,000 in a matching contribution on your behalf.

Following these retirement tips is a great starting point to thinking about your retirement. The next step is to develop a retirement strategy. To help get you started, you should read the article titled “Developing a Retirement Game Plan.”