When planning for retirement most people start with the basics: their budget, their retirement age, life expectancy and their expected retirement income. Usually the inflation rate assumption is more of an afterthought. We all know that our expenses generally go up each year when inflation is greater than 0%. What so many don’t understand is that higher inflation rates usually mean higher tax bills.
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Will My 401(k) Last for the Rest Of My Life?
If you’re starting to think about retirement, and your career has largely been in the private sector, your 401(k) balance could be the most important factor in determining whether you’re on track to retire or not.
Whether your 401(k) will cover your spending needs until the end of your life will depend on a lot of factors. It’s important to not just pin your hopes on a certain target for an account balance–a million dollars, two million dollars, whatever–and instead look at the whole picture. So let’s start with a few other questions that are just as important.
Are You Saving as Much as You Can in Your 401(k)?
There’s almost no way around it: You have to save money to make money. There is often a bit of a free lunch–call it a free appetizer–when it comes to 401(k)s, though: The amount your employer matches your own contributions. It could be a dollar-for-dollar match up to point, or some percentage of what you contribute yourself that increases over time. Either way, you definitely want to contribute at least this amount, or you’re leaving that free appetizer on the plate.
But that should really only be the beginning of any 401(k) savings plan. Fidelity advises saving 15% of pretax income. If you’re 30 or 40 years old and haven’t given the issue much thought until now, that number should serve as the minimum you should save.
Get into the habit of increasing your contribution percentage each year. Psychologically speaking, if you never see it hit your paycheck (because it’s going straight to your retirement account), you won’t miss it. Set an annual calendar reminder to increase that contribution, even by a half a percentage point. Between the contribution increases and salary increases, you should be able to put your contributions on a sharp upward trajectory.
What Else have You Got?
Once you have your plan for annually boosting 401(k) savings in place, consider what other sources of income you are counting on at retirement. Social Security is an obvious one. If you’re lucky you might have a pension of some sort. Brokerage accounts, rental property, or the planned sale of some asset like a business should all be taken into account as well–and will almost certainly affect how long you can expect your 401(k) will last.
Another reason not to simply come up with an arbitrary hit-your-number mark: Spending matters. At the risk of stating the obvious, your 401(k) and other investment assets will generally last longer if you plan to sip rather than gulp.
You’ll want to have a very solid grip on your plan’s MPG–that is, your projected spending in retirement–to get an accurate reading.
What Is It Costing You?
Even if you are diligent about saving to your 401(k), you probably haven’t considered what the plans might be costing you.
And why would you? The plan administrator’s fees–in addition to the fees paid to the fund companies themselves–are largely out of your control.
But it’s important–especially the further you are from retirement. Fees can really chip away at account balances over time. Consider a 401(k) returning about 7% annually. Here’s what happens if we modify the fees by half a percentage point and assume contributions of $18,000 per year.
Your main recourse here is to talk to your HR department and start asking questions. What are the fees of running the plan? How do they compare with fees offered by other plan administrators for companies of your size? Making sure the HR team has done their due diligence on this could mean tens of thousands of dollars to you.
You can also look at the fees charged by the funds themselves. Funds have expense ratios; actively managed funds generally have higher expense ratios than passively managed funds. To keep things really simple, consider a target-date retirement fund, which shifts its asset classes toward less risk the closer you get to retirement. (And if your plan does not offer a target date retirement fund, it should.)
Your 401(k) Is One Piece of a Larger Puzzle
A large 401(k) balance could have a big effect on when you can retire and your living standard when you do. But looking at it in the context of everything else we’ve talked about here is more important than an absolute dollar figure. Total savings, where you plan to invest your assets, the cost of those investments, and your spending habits are all complementary forces that will factor into a successful retirement plan.
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The Worst of the Free Financial Advisor: Episode #11–Julie Clow, Author of The Work Revolution, Freedom and Excellence for All
What a great show! We’re fired up about this interview…if you’re passionate about workplace improvement and efficiency, this is the interview for you.
Not familiar with podcasts and how they work? Here’s a link to the Apple page on podcasts: Apple – iTunes – Podcasts
Hoping to subscribe to our show so this goodness is waiting on iTunes every week? Try this link to subscribe: Worst of the Free Financial Advisor iTunes page.
<Open> Quick show agenda & OG not here.
<> Author Julie Clow interview
The book: The Work Revolution: Freedom & Excellence for All
<23:25> Fractional Sense w/ PK from DQYDJ.net. Topic: Risk Modeling
<27:44> Roundtable: Ford employees are being offered retirement packages soon…what should people retiring think about that they may have overlooked?
Around the Blogosphere:
Dr. Dean @ the Millionaire Nurse blog: Retirement Investing: We’ve Got It All Wrong!
Dominique @ Your Finances Simplified: A Guide to Broke Fancy: How To Fake It Until You Make It
Len @ Len Penzo dot Com: 100 Words On: Why I Hate Slow Drivers Who Cruise in the Left Lane
Carrie @ Careful Cents: May Debt Goal Update (Auto Loan): I’m Debt Free!
<57:38> Our Giveaway! One easy step to enter….
Worst of the Free Financial Advisor, Episode 7: Top 5 Annuity Traits
This week we’re talking about annuities!
Wait, don’t fall asleep yet, the episode hasn’t even started. Actually an annuity is an oft-misunderstood beast, so OG and I do our best to set the record straight.
Who knows, you might even enjoy learning a little about them!
PK from DQYDJ.net talks innumeracy. He calls his site “high on statistics and low on personality”….sure, PK. That’s what we have in common. No personality…. I still don’t know what innumeracy is…I think he’s swearing at us.
The roundtable team tackles an article by Sam from Financial Samurai on streams of income for retirement. How is your retirement vision? Is it close to Sam’s?
On the Sites (here are the articles mentioned in the segments):
Carrie Smith redesigned her site working with a friend at Careful Cents.
Dr. Dean talks coffee and tea at the Millionaire Nurse Blog.
Len Penzo made a list of 20 things he’s willing to spend more money for
Show Notes:
<Open> We begin the “I don’t want to say I told you so, but….” routine we often use when pretending we’re not bragging.
<14:30> Fractional Cents with PK from DQYDJ.NET
<21:00> Roundtable discusses Financial Samurai’s Achieving Financial Freedom One Income Slice at a Time
<51:50> Top 5 Annuity Traits
The show continues, but as usual, if you’re still listening after the Top 5, you’re here for our general hilarity, not because you’re looking for more tips.
Thanks again to all of our contributers and listeners. I think you’re gonna love this show!
Goal Setting and Pretty Retirement Charts – Our Cuppa Joe Discussion
Every Thursday we grab a cup o’ Joe and talk opinions on financial matters…..today we’ll chat about goal setting and workplace retirement plans.
My opinion: Do you know those 401k asset allocation charts in the front/back/middle of your workplace retirement plan booklet? They’re color coded circles of slick graphics, and are often found at the conclusion of a survey about the amount of risk you should take in your investments.
Those pie charts are nearly irrelevant when it comes to financial success.
Each day in a workplace somewhere in America you’ll find a fast-talking 401k-hocking yahoo teaching a group of people how to use these silly charts to determine how much risk they “want” to take.
How much risk you “want” to take?
“Want” and “financial success” rarely coexist when talking about money management. Most people want zero risk and huge returns. They also want Santa Claus to be a little more kind next year than last.
Is “how much risk do you want” really the question you should be asking with your 401k plan?
I have a better question.
Try this one on: How much risk do you need to take to reach your goal?
Isn’t that the question these surveys should be asking?
I know this doesn’t sound like rocket science, yet you’d think so if you’ve ever read workplace retirement plan guides. In many cases, risk tolerance charts and savings guidelines are presented as two entirely different discussions.
Huh?
Let’s be clear about what I’m discussing here. If you’re going to achieve financial success:
Find out how much you need to save.
Then learn what return you need on that savings.
If I had control of these workplace pie charts, here’s what I’d do
I’d gather everyone in the conference room and show the group how to determine the amount they need to save to reach financial success. I know that’ll differ for everyone, so it’ll be important to focus on goal calculators. With the boss’s permission, we’d follow this up with generous portions of alcohol. We’ll call it “Some of You Will Be Happy” Hour.
Second, I’d help everyone determine what return they need on that savings to achieve the retirement goal.
Sounds like I’m repeating myself, doesn’t it? I’m not.
Here’s where we finally insert the silly quiz
Third, the employees would be presented with the risk tolerance quiz. Everyone could see if the asset mix they (historically) would have needed to reach financial success matches their risk tolerance.
If so, more Happy Hour.
If it doesn’t: Houston, we have a problem.
The real problem
If you aren’t going to reach your goal, you have a choice to make: either save more money or raise your risk tolerance. One requires sweat, the other education.
Which path would you follow?
I believe that once we begin presenting 401k plans this way, instead of with some inane chart about your “risk tolerance” (lots of people very comfortably missing their goals out there), we’ll finally begin to realize that every goal can be met through a simple equation:
Savings x Return = Goal
How you approach one side will affect the other.
Okay, discussers, let’s go: Do you have a workplace retirement plan? Did it come with a silly risk tolerance chart…or did they present retirement in the brilliant manner I have above?
(photo credits: Nutty pie chart: Sebastien Paquet, Flickr; Teeter-totter: Rambergmedialigmages, FlickrEmergency Fund or Roth IRA?
If you’re teetering on the edge of a trip down investing lane–but aren’t sure that you’re ready to begin locking money away–a Roth IRA just might be like two tickets to paradise. Pack your bags, we’ll leave tonight.
I just made that up. I know it sounds familiar. Deal with it.
Unlike its nasty cousin, the “For Retirement Only With a Couple Exceptions” Traditional IRA, a Roth has some attractive properties for people who need money in a safe place but are thinking “I’d like to start slipping some cash into a retirement account.” Two tickets to paradise.
Of course, this paradise has some weeds, but what do you want? I never promised you a rose garden.
Just made that up, too. I know…it’s a gift. Thank you.
Paradise Ticket #1: Emergency Fund
While it still makes absolute sense to have “need it right now” money outside of a Roth IRA, here’s the magical property that makes this shelter a fine second tier cash reserve emergency fund: you’re allowed to take principal back out whenever you want. If you remove funds contributed during the current year, it’s as if you’d never made a contribution in the first place. If it’s beyond the first year, you may take out up to the amount you’ve contributed.
That’s awesomesaucewithacherryontop because if you need money quickly, there’s no reason why you can’t access the cash you contributed.
Before you fight me on this, let’s work through it logically:
– When you make a Roth IRA contribution, do you receive any immediate tax benefit? No.
– How can the government penalize you for something that you received no benefit from? They can’t.
You want proof? Okay, here’s the IRS applicable document, Publication 590, Individual Retirement Arrangements. Check out the chart on page 63 and then the ordering rules on page 64.
More proof? At the bottom of the page I’ve included links to two less well written articles than mine. No charge.
When will you get into trouble? If you try and take any interest the account has earned, you’ll pay penalties to receive this interest unless it’s been in the account for five years and you’re 59 1/2 (whichever is later) OR qualify for one of the few exceptions to the penalty (you’ll still pay tax on the money when you withdraw it).
Paradise Ticket #2: Retirement
If you don’t end up needing the money, because your car didn’t break down, junior didn’t need to be bailed out of jail (again), and the dog stayed out of your neighbor’s trash bins for a change, this money can be used for retirement. At some point, once you’ve completely secured the reserve, you can switch these funds into more appropriate investments for retirement.
Ultimately, of course, this is what a Roth IRA should be used for: retirement savings. By easing into the Roth IRA plan, you’ll build the account early so there’s plenty of money available when you’re ready to begin in earnest.
Like Steve McQueen you’ll have a fast Roth IRA machine and they’ll never catch you tonight.
The Downside
Oh, yeah, you weren’t thinking about having a Roth IRA as your only emergency fund, were you? A Roth IRA is, to put it bluntly, an absolutely rotten place for a first tier reserve.
Here’s just a sample of our problem:
– Remember when I said you can get money in a hurry? It’s not like the payday loan shop down the street or Louie on the corner. If your money is at an institution close by (like a neighborhood bank), you can probably take out funds now. If not, you’ll either have to wait for money to be transferred to a non-IRA account or until they can mail you a check. That’s not instant money. It’s “we’re going on an emergency trip to visit ailing Grandma in her cottage in the woods, and I paid for it with my credit card but don’t want to pay interest on the charge” money.
– If you take out all of your principal, you’ll only have some interest in the account. This money MUST stay in a Roth IRA for five years or until 59 1/2, which ever is later (as mentioned above). To take it out early, you’ll pay an IRS penalty. Although this may be a negligible amount on a small interest amount, it’ll make your tax return more complicated.
For these two reasons, I wouldn’t start a Roth IRA as your main emergency fund. Instead, only use it as second tier money.
What Type of Investment Should I Use, Joe?
It’s your cash reserve, silly. We don’t want to use anything that fluctuates at all. I know interest rates are poor, but if you’re only beginning, you’ll need the highest paying account the bank will allow while still keeping your money safe.
Don’t lock up the funds in a CD or you won’t be able to access the money, ruining why you used this strategy in the first place. It has to be a liquid account, like a savings account.
Once you have enough, transfer your money to a higher paying money market. Often this is between $500 and $2,000.
As soon as your cash reserve emergency fund is full, begin saving money into real retirement accounts that match your long term goals. Use a 401k for tax advantages today. Open a 529 plan for your children’s college.
Before long you’ll have so much cash they’ll be lining down the block just to watch what you’ve got.
So delicious.
How to Get Money In There Without Stealing It
The only way you’ll successfully save money is if you leave it outside of those pockets of yours. You know the ones. The I-can’t-hold-cash-for-longer-than-a-couple-minutes-without-spending-it pockets. Instead, make saving a bill.
Better yet, make it an automatic payment bill.
By setting up an automatic payment into your account you won’t have to remember to fund your account. Instead, money will flow directly from a checking or savings account into the Roth IRA, building it while you focus on other areas.
If possible, set up a separate direct deposit into your first tier reserve at your bank and then an automatic payment from the first tier reserve directly into the Roth IRA reserve account. That way, you’ll never have the money in your hot little hands.
If you want money in your hands AND to make Roth IRA contributions systematically, it’s going to be much harder, and there’s a good chance you’ll fail.
You can’t always get what you want. But if you set up an automatic payment plan you just might get what you need.
A Good Strategy
Once you’ve achieved your first tier reserve ($1,000 fast if you’re a fan of the bald dude on the radio, or other similar “quick cash” amount), split your automatic investment between your first tier reserve and a Roth IRA. This will help you ease into the investment world without the fear that the money is untouchable.
I’ve used this plan with nervous beginners to help calm them into rolling toward doing the right move: investing in their 401k where the money IS untouchable. It’s a good way to ease your mind.
…and before you know it you’ll be on your way to a million dollars. Then you could buy yourself a green dress.
But not a real green dress; that’s cruel.
No, I can’t stop.
Other Documents That Totally Agree With Me:
The Motley Fool: All About IRAs
My Money Blog: Can I Really Withdraw My Roth IRA Contributions at Any Time Without Tax or Penalty?
