Retirement Planning - The Basics
Are you ready to starting planning for the type of retirement you want? Here are some basic tools to help you get started.
Determine your retirement income needs
It's common to discuss desired annual retirement income as a percentage of your current income. The needed percentage could be anywhere from 60% to 90%, or even more. The appeal of this approach lies in its simplicity. The problem, however, is that it doesn't account for your specific situation. To determine your specific retirement income needs, you first should estimate your annual retirement expenses.
Use your current expenses as a starting point. Keep in mind that your expenses may change dramatically by the time you retire. If you're nearing retirement, the gap between your current expenses and your retirement expenses may be small. If retirement is many years away, the gap may be significant, and projecting your future expenses may be more difficult. Remember to take inflation into account. The average annual rate of inflation during the past 20 years has been approximately 3%. (Source: Consumer price index (CPI-U) data published annually by the U.S. Department of Labor.) Your annual expenses may fluctuate throughout retirement. For instance, if you own a home and are paying a mortgage, your expenses will drop if the mortgage is paid off by the time you retire. Other expenses, such as health-related expenses, may increase in your later retirement years.
Calculate the gap. Once you have estimated your retirement income needs, take stock of your estimated future assets and income. These may come from Social Security, a retirement plan at work, a part-time job and other sources. If estimates show that your future assets and income will fall short of what you need, the rest will have to come from additional personal retirement savings.
Figure out how much you'll need to save
By the time you retire, you'll need a nest egg that will provide you with enough income to fill the gap left by your other income sources. But exactly how much is enough? The following questions may help you find the answer:
At what age do you plan to retire? The younger you retire, the longer your retirement will be, and the more money you'll need to carry you through it.
What is your life expectancy? The longer you live, the more years of retirement you'll have to fund.
What rate of growth can you expect from your savings now and during retirement? Be conservative when projecting rates of return.
Do you expect to dip into your principal? If so, you may deplete your savings faster than if you just live off investment earnings. Build in a cushion to guard against these risks.
Build your retirement fund: Save, save, save
When you know roughly how much money you'll need, your next goal is to save that amount. First, you'll have to map out a savings plan that works for you. Assume a conservative rate of return (e.g., 5% to 6%), and then determine approximately how much you'll need to save every year between now and your retirement to reach your goal. The next step is to put your savings plan into action. It's never too early to get started ideally, begin saving in your 20s. To the extent possible, you may want to arrange to have certain amounts taken directly from your paycheck and automatically invested in accounts of your choice, such as a 401(k) plan through your employer. This arrangement reduces the risk of impulsive or unwise spending that will threaten your savings plan. If possible, save more than you think you'll need to provide a cushion.
Use the right savings tools
The following are among the most common retirement savings tools, but others are also available.
Employer-sponsored retirement plans that allow employee deferrals (like 401(k), 403(b), SIMPLE and 457(b) plans) are powerful savings tools. Your contributions come out of your salary as pretax contributions (reducing your current taxable income) and any investment earnings are tax-deferred until withdrawn. These plans often include employer-matching contributions and should be your first choice when it comes to saving for retirement. Both 401(k) and 403(b) plans also can allow after-tax Roth contributions. While Roth contributions don't offer an immediate tax benefit, qualified distributions from your Roth account are free from federal income taxes.
Traditional IRAs, like employer-sponsored retirement plans, feature tax-deferral of earnings. If you are eligible, traditional IRAs may enable you to lower your cur rent taxable income through deductible contributions. Withdrawals, however, are taxable as ordinary income unless you've made nondeductible contributions, in which case a portion of the withdrawals will not be taxable.
Roth IRAs don't permit tax-deductible contributions, but do allow you to make completely tax-free withdrawals under certain conditions.
You can typically choose from a wide range of investments to fund either type of IRA.
Annuities are generally funded with after-tax dollars, but their earnings are tax-deferred (you pay tax on the portion of distributions that represents earnings). There is generally no annual limit on contributions to an annuity. A typical annuity provides income payments beginning at some future time, usually retirement. The payments may last for your life, for the joint life of you and a beneficiary or for a specified number of years. (Guarantees are subject to the claims-paying ability of the issuing insurance company.)
Note: In addition to any income taxes owed, a 10% premature distribution penalty tax may apply to distributions made from employer-sponsored retirement plans, IRAs and annuities prior to age 59½ (prior to age 55 for employer-sponsored retirement plans in some circumstances).
Start investing early
There are several reasons why it is important to start investing for your retirement at an early age. First, the earlier you start investing in a retirement plan, the more money you will be able to contribute during the course of your working lifetime. With a longer time frame, you also will have a larger choice of investment options. Additionally, by starting early, your investments will have a longer period of time to compound. This means you will have the benefit of earning money year after year on the money your investments/savings generates each year.
Consider this example:
Sue starts saving at age 25. She invests $4,000 every year for ten years. Then, when she turns 35, she stops saving and does not invest another dollar. Based on a 10% return each year, which historically is reasonable growth for stocks (of course, remember that returns are not guaranteed), by 67, she will have $1.5 million in her account. That’s with only a $40,000 investment.
John, on the other hand, decided to wait. He didn’t start saving until age 35. He faithfully puts $4,000 into an investment account for the next 32 years (until age 67). That’s an investment of $132,000 on his part. At age 67, his investment account will have $889,000 in it, based on the same assumed 10% annual return.
Sue not only ends up investing dramatically less than John ($40,000 versus $132,000), she will end up with dramatically more money ($1.5 million vs. $889,000). That is the power of compounding!
It should be noted that these examples are for illustraive purposes and do not reflect any particular investment.
We can help you understand your investment options.
You need to understand the types of investments that are available and decide which ones are right for you. That’s where the expertise of Hocking Valley Financial Solutions can help. We will explain the options that are available to you, and will assist you in selecting investments that are appropriate for your goals, risk tolerance and time horizon.
Related Links:
- Retirement Planning - The Basics
- Traditional IRAs
- Roth IRAs
- Estate Planning
- Choosing a Financial Planner
- Long-term Care Insurance