At some point, you might like to stop working for a living and enjoy life on your own terms. Unless you’ve won a lottery or have inherited a large sum of money, you’ll need retirement income and/or savings. For Americans, that typically means withdrawing or receiving payments from a mix of money paid into the Social Security System, retirement plans provided by an employer and optional retirement accounts such as IRAs whether regular or Roth. In a later retirement article, we’ll address in a simple way the mileposts along the way and what you might want to be doing to make the most of that “Third Age.”

In September, we published an article on RMDs. That’s mostly an issue for Boomers. For those of you living in the US, if you had tax deferred income during your work years, once you retire, the IRS wants their share. In this issue we’ll deal primarily with new entrants to the workforce. We’ll  examine tax deferred retirement accounts versus Roth accounts. We’ll also cover the importance of starting early. 

When you’re young and just getting started in life, you aren’t earning as much as you will later—yet you have plenty of things you need to spend money on. Things like an apartment and then a home. College loans may need paying off. You need clothes for work, a car, etc. Maybe you’re raising a family. You want to take that family on nice vacations. At the beginning, retirement is a distant dream. But you should still plan for and make financial contributions to that plan if you want to have a better shot at that dream.

When you’re middle-aged, at the peak of your earning years, you want to make the most of those earnings—to splurge a little. In this middle time, retirement is a little more real but not something you want to spend too much time thinking about. But that’s the time to really bump up the savings and catch up if you need to for earlier years. We’ll touch on that only briefly this time, but in more detail in a later retirement issue, after the next one.

No matter when you retire or what the source of these funds, some basic principles remain the same. We’ll mention them now and elaborate on them sequentially. NOTE: Whether you live in America or in many other countries, these principles may apply as well—the sources of income may differ and some expenses may be covered by your government that aren’t covered in the US.

To live relatively worry-free, you must maximize the amount paid in, thereby ensuring you get the most back. That means contributing to optional investments sooner than later—even if you do have other essential expenses. You should also increase those contributions as your income goes up. When you’re starting out—or in the first ten years of working, it will be challenging at best to estimate how much will you need for a secure and enjoyable retirement. We’ll talk more about that in the next financial and retirement issue.

Sources of Retirement Income

Social Security: For most Americans, Social Security is a fact of life. How much you get depends on a complicated formula applied to average earnings over your working years and adjusted up or down based on when you begin drawing benefits. You can easily calculate what that will be online and plan for retirement at the SSA.gov website. However, if you’ve been earning money for only a few years, any estimate will be relatively useless for planning. We will explore Social Security more fully in a later issue. For now, consider this nutshell:

• The earliest you can start getting benefits is at age 62, but the amount will be reduced by a percentage for every month before your full retirement age
• At age 67, full retirement benefits are paid for those born after 1960
• Retire at 68-70, with an increase in benefits of 8% annually until 70 (after that the benefits remain the same—other than COLAs)

Here is the main takeaway about Social Security: determine how much you can receive under the options that make sense to you. Then use this as the first item to be included in the total income available to you. Again, until you have several years of working income, you have no meaningful data with which to calculate.

But wait, will Social Security still be there when you retire or at a level that is sufficient? Even if you were born after 1970? Yes, it probably will—but maybe not with full benefits. All the more reason to maximize other sources of retirement income. We’ll say more about the future of Social Security in that later issue.

Employer Retirement Plans: Decades ago, many people worked for employers who offered defined benefit plans for retirement. The payout was typically based on a percentage an average of the three or five highest annual earnings. Most systems today, are now defined contribution plans. What you receive is dependent on the earnings in a 401-k or some other qualified retirement plan that the employer offers. (If none is provided by the employer, you can still create your own, an IRA). There still are some defined benefit plans, mostly in state and local governments. Also, since 1987, the federal government has had a defined benefit plan supplemented with Social Security and the Thrift Savings Plan (TSP). Whoever you work for and whatever plan options you may have, it’s critical for your retirement that you contribute as much as you can and do so wisely. NOTE: when you first begin working for an employer, among other decisions you must make and forms you must fill out, retirement plans are a critical element. Take the time to read them over thoroughly and don’t jump to a decision ill-informed. Ask for help from a trusted friend or relative who has been through it before and do your research. 

NOTE: if you change employers, you CAN leave the retirement fund with them OR you can transport it to your new employer in many cases–BUT you must be careful to do so via one fund administrator to another and NEVER receive the money yourself via check or otherwise. The result of actual or constructive receipt of retirement account proceeds can result in undesirable tax consequences.

IRAs: Formerly just two flavors—traditional IRA or Roth IRA. Then the IRS added the Roth 401-K—which somewhat merges the two but whose purpose is to enable a higher cap on annual contributions and hence a larger investment. It’s an alternative that can be offered by employers. Unlike the historic Roth, the Roth 401-k does come with an RMD requirement but not generally a requirement to pay taxes on the withdrawn earnings (yes, it’s complicated). Check with your human resources or retirement office about this.

The traditional IRA is a means to invest income from working without the normal deduction for taxes. Instead of paying as you go, you will pay taxes on that income you invest when you withdraw it—in retirement. You’ll also pay tax on any investment earnings (see the RMD article in the December Quarterly). NOTE: The regular 401-k offered by employers is ALSO a tax deferred vehicle.

The Roth IRA, on the other hand, is NOT a tax-deferred investment. You fund that investment with after tax income. Since you already paid tax on that money, you don’t pay again when you receive it NOR on any earnings. Not only that, but you never actually have to withdraw it. You can save it indefinitely, without an RMD requirement or even let your children inherit it!

So, which way to go—traditional tax deferred saving or Roth? For some time, financial advisers and employers urged workers take the tax deferred. They noted that this enables people to have more disposable income and that the investor might be in a lower tax bracket at the time of retirement. BUT That’s not necessarily true. Under the current tax laws the tax brackets are very large. [2018 update the brackets have changed, so the table below will differ–but the financial principles remain the same] Assuming you have a half way decent retirement plan or investment, your income very well keep you in the same bracket. Look at the chart below and you’ll see how big the brackets are. Bear in mind that some of the same retirement “experts” recommend you have somewhere between 75 and 85% of preretirement income, which diminishes the tax deferred strategy!  

Tax Bracket	Single Tax Payer	Married Filing  Jointly
15%	$9,276 to $37,650	$13,251 to $50,400
25%	$37,651 to $91,150	$50,401 to $130,150
28%	$91,151 to $190,150	$130,151 to $210,800

So we are dubious about that advice of expecting a lower tax bracket. In fact, for us, we are far away from either end of the bracket we reside in pre and post retirement. Had we known early in our employment, we would have put more in the Roth and less in the tax deferred account. More on that later in the conversion option. The bottom line for you? Hedge your bets and take both options—do some saving in tax-deferred accounts and some in Roth. Then stay tuned for changes in your income AND in the tax code.

But it’s not just tax deferred or Roth that you must decide on, you must also decide where within either option you will put your money. With 30 or 40 years until retirement, you cannot afford to be too conservative–investing predominantly in bond funds or especially not money market funds. Rather, you should be investing mostly in stock funds, which have more risk but more potential for growth. If you have an employer sponsored plan, you may have a limited selection from which to choose. If you’re on your own, you can do whatever you like. But if you don’t care to spend the time poring over financial advice to manage your own retirement savings, there are a multitude of simple options, like:

• Target date retirement funds–which set up a mix of various types of stock mutual funds, bonds, etc. which start out dominated by stocks and gradually get more conservative closer to the target date. For example, Vanguard currently has target date funds out to 2065 and T Rowe Price has funds out to 2060. If you’re constrained in your selection by an employer fund, go out as far as they have available and you’re comfortable with.
• Lifestyle funds, which have a fairly constant mix of  risk tolerance and growth, as opposed to one which evolves over time. They may often have somewhat higher administrative expenses and include more actively managed funds.
• Index funds, which have lower administrative costs than actively managed funds which entail choices by fund managers to buy and sell shares in one investment or another. But if you make this choice, you are getting into the task of managing a portfolio that balances growth and risk. Depends on your comfort level and the time you want to spend on this. 
• Whatever choice you make, don’t obsess over it, watching the values go up and down. If you must, check every few months and perhaps set up an annual or semiannual reallocation among the investment choices to match your preferred ratio. Stocks will go up and stocks will go down. Just be diversified. If you don’t know what that means or how to do it, just go for the target date fund and the managers will do it for you.

Maximizing the amount paid in

Don’t save what is left after spending, but spend what is left after saving. Warren Buffet

Pay yourself first. Do that by making it a deduction from your paycheck so it never touches your hand or goes into your bank account. If you must, have it go to a savings account. But you know that those don’t pay much these days. It’s best if you put it into whatever optional retirement system your employer offers or one that you create yourself.

But, how can you do that? What about your bills? Of course, you must account for basic necessities—food, shelter and clothing. You may also need transportation and insurance. So you exclude that before determining how much to pay yourself. The point is to be sensible about the optional portion of your expenses. You don’t need the biggest and best car. You don’t need the newest and most powerful computer, smartphone or other electronics. You don’t need to eat at the best restaurant or take the most wonderful vacation to an exotic location. You may want them, but you don’t need them.

How important is it to begin saving sooner than later? Immensely, even if only a small amount from a modest paycheck. A graph would be best, but let’s just show a table. Three people save for retirement. All invest in the same funds/plan with the average return Ibbotson expects historical market growth to be: an average of 8% annually.  Yes, there will big gains some years and losses others. Retire in a down market and you will suffer. Retire when it’s booming and lucky you. Still, the point is, that these savings are intended to add to the base of Social Security and other savings—not be your entire retirement income. But the point is, to maximize the savings to ensure you CAN retire at an age that will give you years to enjoy it without wondering how you will pay not just for travel and fun but essentials.

• Alexa starts 25 and saves continually until 65
• Dana starts at 25, saves for 20 years and lets the savings grow until retirement at 65.
• Don starts at 45 and saves until 65

Let’s assume both Dana and Alexa start saving the same amount, $2,500 annually and increase their contribution annually by 3%–based on higher income, etc. 

Don starts saving $7,720, which is the final amount that Dana at age 45. He also increases his contribution by 3% annually. You can guess that Alexa fares the best and Don the worst, but you’ll be surprised how much better Dana does than Don–while contributing far less money!

NOTE: The current limit on contributions to either a traditional IRA or Roth is $5,500. We make the assumption that the limit will increase over the next 20 years to permit a higher contribution.

	Don, saved 45-65	Dana, saved 25-45	Alexa, saved 25-65
1st year contribution	$7,720	$2,500	$2,500
Last year contribution	$20,483	$7,720	$8,155
Total contributed	$275,753	$71,691	$196, 658
Ending Balance	$624,728	$853,065	$1,139,859

So, now you know why it’s best to get started early! But don’t despair if you can’t, just get started as soon as you can–with the knowledge that you WILL have to make bigger contributions later to make up for lost time. We will cover that in the next issue, which is geared toward the middle-aged worker. Also, we will cover things like conversions from traditional to Roth. That will also be highlighted in the issue geared to workers near or in retirement.

NOTE: These numbers do not take inflation into account. The ending balance is in today’s dollars. What will inflation do to the purchasing power of those dollars in 40 years? To purchase an item in 2016 that cost $100 in 1976 would cost over $428! So don’t get too excited about how well off you might be if you follow even Alexa’s example. But remember, Dana and Don would due relatively less well.

Inflation is one argument for not being TOO conservative in your investment strategy while working. Also remember that once retired, you won’t be paying commuting costs, better clothes for work, eating out with coworkers, paying other deductions–like Social Security, etc. So you won’t need as much to live on either.

Another argument for not being too conservative is the reduction in earnings. An average of a 6% return, instead of the 8% assumed in the table, could reduce earnings by about 20% for Don and Dana, or nearly 40% for Alexa!

If you don’t maximize your investments early on, tax laws have certain “catch up” provisions which allow you to increase contributions from age 50 on. Also, if you do have other retirement income–from an employer plan apart from what we have discussed here and you have Social Security, you will have the option to be more aggressive in your investments–or not, depending on how much extra support (or wealth) you want to have in retirement.