Other Investments – Definitions Social Security: A United States federal program of social insurance and benefits developed in 1935. The Social Security program's benefits include retirement income, disability income, Medicare and Medicaid, and death and survivorship benefits. Social Security is one of the largest government programs in the world, paying out hundreds of billions of dollars per year. Based on the year someone was born, retirement benefits may begin as early as age 62 and as late as age 67. The amount of income received is based on the average wages earned over the worker's lifetime, with a maximum calculable amount of $106,800 as of 2009. Spouses are also eligible to receive Social Security benefits, even if they have limited or non-existent work histories. Social Security has faced serious solvency issues for many decades; today's payments are made from current payroll contributions by workers who may not have money available for them when they retire. Social security reform, whether through legislation, tax law changes, or privatization, has been a major political issue that draws strong opinions from different demographic segments. Pension: A type of retirement plan, usually tax exempt, wherein an employer makes contributions toward a pool of funds set aside for an employee's future benefit. The pool of funds is then invested on the employee's behalf, allowing the employee to receive benefits upon retirement. In a defined-contribution plan the employer makes predefined contributions for the employee, but the final amount of benefit received by the employee depends on the investment’s performance. In a defined-benefit plan, the employer guarantees that the employee will receive a definite amount of benefit upon retirement, regardless of the performance of the underlying investment pool. Defined-benefit plans have all but disappeared from private enterprise in the U.S. today, although they are still often offered in association with government careers.
Other Investments – Definitions (cont.) 401(k): A qualified plan established by employers to which eligible employees may make salary deferral (salary reduction) contributions on a post-tax and/or pretax basis. Employers may make matching or non-elective contributions to the plan on behalf of eligible employees and may also add a profit-sharing feature to the plan. Earnings accrue on a tax-deferred basis. If your employer will match you 401(k) contributions in any way, you should make contributions to your 401(k) your top priority as long as matching funds from your employer are in effect. It’s free money. Caps placed by the plan and/or IRS regulations usually limit the percentage of salary deferral contributions. For 2009, the IRS regulated contribution limit is $16,500, plus another $5,500 if you’re over the age of 50. There are also restrictions on how and when employees can withdraw these assets, and penalties may apply if the amount is withdrawn while an employee is under the retirement age as defined by the plan. 403(b): A retirement plan – much like a 401(k) – for certain employees of public schools, employees of certain tax-exempt organizations and certain ministers. Traditional IRA: An individual retirement account (IRA) that allows individuals to direct pre-tax income, up to specific annual limits, toward investments that can grow tax- deferred (no capital gains or dividend income is taxed). Individual taxpayers are allowed to contribute 100% of compensation up to a specified maximum dollar amount to their Traditional IRA. Contributions to the Traditional IRA may be tax-deductible depending on the taxpayer's income, tax-filing status and other factors. Roth IRA: An individual retirement plan that bears many similarities to the traditional IRA, but contributions are not tax deductible and qualified distributions are tax free. Similar to other retirement plan accounts, non-qualified distributions from a Roth IRA may be subject to a penalty upon withdrawal.
Traditional and Roth IRAs – Comparison The government won’t allow you to shelter too much money from taxes, although these limits are expected to increase in future years to account for inflation
Now, Let’s Do Some Scenarios The goal is to choose between a traditional IRA and a Roth IRA Assumptions: –No inflation –No wage increases, and your effective tax rate before retirement is 20% –No increases to the IRA contribution limits –Your IRA earns 8% annually, compounded monthly –If you pick a traditional IRA, You’ll be forced to withdraw a certain amount of money each year once you reach retirement age, increasing your effective tax rate to 28% during retirement. Say you’re earning $42,000 annually. The maximum amount you can contribute to an IRA is $6,000 annually (which you contribute as $500 each month). You’ll retire in 30 years. Answer the following questions: –Under a traditional IRA, how much money (including the IRA account and additional money saved) will you have in 30 years? Ask yourself: what’s the future value of the payments made into the traditional IRA over 30 years, and the value of the money you save in taxes. Then ask yourself what the post-tax worth of the IRA money really is (i.e. multiply your final IRA value by a certain percentage to account for the taxes you’ll pay when you withdraw your money...) –Under a Roth IRA, how much money will you have in 30 years? This is a bit easier – simply find the future value of the payments made into the IRA. No need to do any post tax calculation or to find the value of money saved in taxes through the 30 years. So, what would you pick?
Now, Let’s Change Things A Bit The goal is to choose between a traditional IRA and a Roth IRA Assumptions: –No inflation –No wage increases, and your effective tax rate before retirement is 25% –No increases to the IRA contribution limits –Your IRA earns 10% annually, compounded monthly –If you pick a traditional IRA, your forced distributions won’t increase your income taxes. In fact, your effective tax rate will fall to 20%. Say you’re earning $115,000 annually. The maximum amount you can contribute to an IRA is $6,000 annually (which you contribute as $500 each month). You’ll retire in 30 years. Answer the same questions: –Under a traditional IRA, how much money (including the IRA account and additional money saved) will you have in 30 years? –Under a Roth IRA, how much money will you have in 30 years? So, what would you pick? Notice how the gap shrinks in this scenario? Roths are cool, but they still need to be evaluated.
And Now, Let’s Plan Your Retirement How money do you think you’d need, in today’s dollars, to live comfortably without working? –An oft used rule of thumb is: you can withdraw 4% of your nest egg in retirement without going broke over time. So, if you want to withdraw $100,000/yr in retirement, you need a nest egg of ($100,000 /.04) = $2,500,000. That sounds good – let’s say you’ll need $2,500,000. Let’s also say you have 40 years until retirement Aaaaand... let’s say that inflation is expected to be 4% annually until you retire. Now how much money will you really need to retire comfortably? –First find the future value of $2,500,000 at 4% over 40 years. –Then find the monthly payments you need to make into retirement accounts to hit that number (you’re starting with nothing, and let’s assume you can average an 8% return). Depressed yet? Don’t be. Remember that you can adjust spending habits to reduce your required number, you may land a job that matches a portion of your retirement savings (401(k) plans, etc.), social security may actually survive, inflation may run lower, etc. There are a lot of variables. Of course, inflation could also be higher. Bottom line: pay yourself first in life. Save whatever you can, and don’t let those marketers get too much of your money. Also, don’t forget: IRA contribution limits don’t equate to a limit on your retirement savings – you can still take advantage of 401(k) plans and other savings accounts.
Finally: The Importance of Starting Early If the last foil wasn’t enough to convince you, let’s consider this scenario... –Say you start saving for retirement at the age of 35. Between all your retirement accounts, you manage to save $1,000 each month. You earn 8% each year on average. What’ll you have when you retire at age 65? –Now, say you slack off and don’t start saving until you’re 50. What’ll you have then? –And, what if you get off the dime when you’re young and start saving when you’re 20. Now what will you have? The truth is, you probably won’t be able to save huge amounts of money when you’re starting out in life, but every bit helps. Statistically speaking, the very first dollars you invest for retirement will be the ones that grow the most. If you fail to invest during the early years, you’ll be missing out on returns that you can never, ever recover. Some people believe missing ten years of early retirement savings means missing out only on these years of modest returns Don’t be fooled. This is the growth that is truly never recovered.
Section 11: Practice Problems 1.Is it more important to invest in a 401(k) or an IRA? Are you sure? Why? 2.Your income level makes you eligible for a Roth IRA. You invest $500/mo for 35 years, earning an average return of 9%. How much money do you end up with? Now, assume inflation averages 3.5% during those 35 years. What is your eventual nest egg worth in today’s dollars? 3.Your income level makes you ineligible for a Roth IRA, but you save $2,000/mo in a traditional IRA and a 401(k) for 35 years, earning an average return of 9.5%. How much money do you end up with? How much of it is truly yours if your effective tax rate in retirement is 25%? Now, assume inflation averages 4% during those 35 years. What is your eventual nest egg worth in today’s dollars?