RETIREMENT CATCH-UP FOR LATE STARTERS |
Like many people, you may feel you're behind schedule in saving for retirement. With so many competing financial demands — daily living expenses, childcare, healthcare, and college costs — you may find it a challenge to put aside anything for the future.
But getting a late start doesn't mean you'll never reach your retirement goals. Fortunately, there are strategies to help you make up for lost time, including increasing the amount you're saving and choosing different ways to invest. You may also consider retiring later or working part-time to give your retirement accounts more time to grow.
Compounding can be an important ally whenever you invest. Compounding is what happens when your investment earnings are reinvested and in turn generate earnings. It means your account may increase in value faster than if you were accumulating earnings only on your principal, or contributions.
Also, as soon as you start investing specifically for retirement, you'll be able to benefit from the tax deferral offered by most retirement plans. With taxable investments, you owe tax each year on any dividends or interest the investment pays, but no tax on any increase in an investment's value until you sell and realize a profit. With tax-deferred accounts, you postpone paying income tax on earnings until you withdraw money from the account, so your investment compounds untaxed. In many cases, you can also defer taxes on your contributions to these accounts.
If you're like most people, you probably have an idea of how and when you'd like to retire. Perhaps you envision traveling around the world, mastering a new skill, or starting a business. Or maybe you want to volunteer in your community or just relax and read. Of course, both the age at which you expect to retire and the lifestyle you plan have an impact on how much you'll need to live comfortably. For instance, you'll need more income if you plan to travel or have expensive hobbies and less if you plan to work part-time.
To meet your retirement goals, you first need to figure out how much you'll need. The general rule is that you'll need about 75% to 85% of your pre-retirement income each year to maintain your standard of living. For example, if you earn $50,000 per year, you'll need $37,500 of income in the first year of retirement to replace 75% of your salary, or $42,500 of income to replace 85% of your salary.
In each of the following years you'll need more to compensate for the rate of inflation. For example, if inflation boosts the cost of living by 3% during the first year you're retired, you'll need $1,275 more the next year, or $43,775 — based on the 85% guideline — just to stay even.
Another factor you'll want to consider is your life expectancy. While you can't predict exactly how long you will live, you can make a ballpark estimate based on family history, your personal health habits, and actuarial tables, which provide the average number of years of life remaining for people who have reached a certain age.
As you're estimating your retirement needs, you'll want to factor in your expected healthcare expenses. The costs of doctor's visits, hospital stays, prescriptions, and health insurance premiums are rising at rates higher than inflation.
You'll probably have a number of income sources during retirement. If you qualify for Social Security because you paid into the system for at least ten years, or if you're married to someone who qualifies, you're eligible to begin collecting reduced benefits when you turn 62. If you wait until you reach full retirement age, which is 66 for people born between 1943 and 1954 and then increases gradually to 67 for people born in 1960 and later, you're eligible for a larger benefit.
Although Social Security, pensions and retirement plans, IRAs and other savings, and earnings from post-retirement employment is designed to provide a portion of your retirement income, it almost certainly won't be adequate to cover all of your needs. So you should plan on having additional income sources. These might include pensions, retirement savings plans, such as 403(b), and other personal investment and savings assets. How much income these sources will generate will depend mainly on how much you invest and the rate of return you achieve.
According to the Employee Benefits Research Institute (EBRI), income for people 65 or older comes largely from four sources: Social Security, asset income, earnings, and pensions and retirement plans.
For an immediate and personalized estimate of your Social Security benefits, you can use the Retirement Estimator on the Social Security Web site: www.socialsecurity.gov/estimator/
Because the Estimator draws on your actual Social Security earnings record, you don't have to manually key in years of earning information to get your estimate.
A retirement savings gap is the difference between current savings and what you'll need to reach your goals. Hopefully, your expected retirement income sources will be more than enough to support you in retirement. However, if it appears that you will have a shortfall, start taking action now to narrow that gap.
Here are some steps you can take:
An IRA, or individual retirement account, is a retirement savings account you set up and manage on your own or with professional help. The only requirement for putting money into an IRA is that you earn income — whether for full- or part-time work. And you can add to your IRA even if you're contributing to a retirement plan at work, such as a 401(k), 403(b), or a Keogh plan if you're self-employed.
You may have a choice among the three types of IRAs: traditional deductible, traditional nondeductible, and Roth IRAs. It pays to compare the benefits they offer and investigate which ones you qualify for. All offer tax advantages, but with a deductible IRA you can subtract your contribution before calculating your taxable income, and with the Roth IRA you can eventually make tax-free withdrawals after you turn 59 1/2, provided your account has been open at least five years.
There are limits on IRA contributions. In 2012, the most you can put into your account is $5,000, and you can't contribute more than you earn. One other advantage of a tax-free Roth IRA is that if you continue to earn after you turn 70 1/2, you can go on putting money into your account. That's not true with traditional IRAs, from which you must begin taking money out when you reach that age.
IRA contributions can make a difference in your long-term financial security. For example, let's say you invest $5,000 a year, or $416 a month, for 15 years in a hypothetical tax-deferred account providing an 6% annualized return. You would accumulate $121,585 before taxes, significantly more than your $74,880 contribution.
If you're over 50 and qualify for an IRA, you can also make an additional catch-up contribution of up to $1,000. You can add the catch-up contribution each year even if you've been contributing the maximum over the years.
If you've made the maximum contribution to any tax-deferred accounts for which you're eligible, and you're able to put aside more for retirement, you might consider investing in equities through a taxable investment account with a brokerage firm.
With a taxable account, you pay no income tax on paper profits — or increases in an investment's value while you own it — until you sell the investment and realize the profit. If you've held the investment for more than a year when you sell, in most cases you owe tax on any gain at the long-term capital gains rate — 15% if your income tax bracket is 25% or higher, and 0% if your income tax bracket is 10% or 15%. These rates are in effect through 2012.
Another way to help reach your retirement goals is to spend less — both now and during retirement. Even the small choices you make every day — for instance, taking your lunch into work four days a week — can help you set aside more money for your future goals.
By looking closely at your spending habits, you'll probably see ways to make cuts now to save more for the future. For instance, you might consider:
Saving even small amounts regularly can make a difference, as you can see by comparing the pretax value of the following three hypothetical investment accounts after 20 years. Each account earns 6% annually and compounds monthly:
Monthly investment |
$50 |
$100 |
$200 |
Value of account after 20 years |
$23,218 |
$46,435 |
$92,870 |
You might also consider modifying your lifestyle during retirement to decrease expenses. For instance, you might think about trading down to a smaller house, relocating to a place with a lower cost of living, or trimming your leisure costs.
As you decide how to invest your retirement assets, you'll need to weigh your tolerance for risk against your financial goals, since you need to achieve as much investment growth as possible in the time you have available. As a general rule, if you want your investment portfolio to grow in value over time, you should consider allocating at least a portion of your assets to stocks, stock exchange traded funds, stock mutual funds, and managed accounts that invest in stocks. While stocks may fluctuate in value sharply over the short term, over longer periods of time they have historically provided much stronger returns than other major asset classes, such as bonds and cash equivalents.
You may be able to offset some of the volatility and short-term risk of investing in stocks by allocating part of your portfolio to fixed-income investments, such as bonds. While bonds generally provide more modest rates of return than stocks, they pay regular income and may provide a stronger return in some periods. You might also consider asset classes whose returns aren't correlated with equity returns.
If you invest very conservatively — or don't invest at all — because you fear losing some of your principal, you run the risk of not meeting your goals. That's because the rate of return you'll realize will be so low that your investments won't outpace inflation.
While no one wants to delay retirement, postponing your plans for a few years can help you build up the balances in your investment accounts and avoid drawing on the assets you have. Putting off your plans for a few years may also increase the retirement plan benefits you're entitled to. And since you'll be spending fewer years in retirement, your projected retirement needs will be less.
If your spouse or partner isn't working, you might decide together that income from an additional job could help significantly. Finally, moonlighting at a second job or starting a home business before you retire can help you transition into retirement work, as well as provide access to retirement plans for the self-employed. Start thinking about the type of work you might enjoy doing later in life and research whether this will be possible. As with all aspects of retirement planning, the sooner you get started, the more likely you will be to realize your retirement dreams.