Financial Planning for Retirement
Working your way through the puzzle of retirement savings options.
If you are like many people, you find it difficult to stretch your earnings and meet your financial obligations. Retirement savings may seem like the last place you can afford to put your money. Or perhaps you are a self-employed fitness professional and don’t have a convenient way to save through your employer.
If you are already saving for retirement, great! If not, it’s vital to start. Find out why saving is so important and learn the basics of the most common savings plans.
The old reality about retirement was that people worked until age 65 and planned for a 5- to 10-year retirement. In today’s reality, planning for a retirement of 30 years or more is the norm. Why? People are living longer because of advances in medications and medical care, more active lifestyles and improved awareness of the need for good nutrition.
Planning properly for retirement means taking into account the impact that inflation—even moderate inflation—will have on your savings and how it will affect your need for cash flow as you age. It is likely that you will lead an active life, even in retirement, so you will probably continue to spend money at the same level as you do in your primary money-earning years. While some of your costs will decline, expenses for other things— such as medications, travel and hobbies—will likely increase. You should also plan for long-term care costs. You may need to change careers or work part-time even in retirement to meet your needs.
The younger you start saving for retirement, the better. If you set aside money at a younger age, you avoid having to make retirement savings a huge part of your budget in middle age. Time and tax-deferred (sometimes tax-free) compounding of the earnings on your retirement assets can provide you with a financial windfall. However, it’s never too late to start saving.
How do you plan for retirement? You determine your needs, invest, and save money. The federal government has provided Social Security plus various tax- advantaged alternatives to provide you with incentives to save.
Common options in the United States are IRAs (Individual Retirement Accounts); 401(k) plans; SIMPLE (Savings Incentive Match Plan for Employees) and SEP (Simplified Employee Pension) programs; and defined-benefit and defined-contribution plans. The earnings on the money you put into these plans is not currently taxed, and the amounts you contribute are excluded from current taxation, so they act as a legal tax shelter. All postretirement withdrawals are taxed at your ordinary income tax rate in the year(s) of withdrawal. The Roth IRA, however, is an exception. You don’t get a tax deduction when you contribute money to this IRA, so everything that you take out is tax-free.
If you withdraw funds from retirement plans before age 591/2, you pay taxes and, in most cases, penalties as well. All plans except Roth IRAs require distributions to begin at age 701/2, regardless of need. Some plans require both annual filings with the Internal Revenue Service (IRS) and complex testing by your employer to ensure that they can be considered tax-deferred plans.
What are some options for retirement plans? One is Social Security, which the government administers. You and your employer contribute into Social Security during your working years, and then you receive payments from it during retirement. You can get reduced Social Security benefits at age 62 and full benefits starting from ages 65–67, depending on when you were born.
The bad news is that unless you plan to live at or near the poverty level, Social Security payments are not going to be enough. You do not know how the government might have changed Social Security by the time you retire. To be safe, don’t plan for it to be your primary source of retirement cash.
An IRA is a personal retirement savings plan available to anyone who receives taxable compensation during the year. If you are a salaried employee, you can deduct contributions to a traditional IRA from your taxes. (Self-employed workers may be able to deduct contributions as well, but there are complex limits if you use other tax-deferred retirement plans.) The money you ultimately withdraw is taxed as ordinary income. The maximum you can contribute to a traditional IRA is $3,000 for 2004 and $4,000 for 2005. You can add an additional $500 per year if you are 50 or older. If you are single and your income exceeds $55,000 in 2004 ($60,000 in 2005), you won’t be able to claim any deduction for a traditional IRA contribution. If you or your spouse is covered by an employer-sponsored plan, there is a complex phase-out calculation of how much you can deduct. If your combined income exceeds $75,000 in 2004 ($80,000 in 2005), you can’t deduct anything.
For a Roth IRA, you don’t receive a current tax deduction for a contribution, but money that you ultimately withdraw will be tax-free. If your income is over $110,000 ($160,000 if married and filing jointly), you are not allowed to make a contribution to a Roth IRA, whether or not you are covered by an employer-sponsored plan.
If you are an employee, you can participate in retirement plans sponsored by your employer. Here are some common options:
Salary Deferral 401(k) Plans. These plans permit you to defer a portion of your income into an account. The money in the account can then be placed into a menu of investment choices. For 2005 you can defer up to $14,000. If you are 50 or older, you can add up to an additional $4,000 in 2005. If your employer matches your deferral, it is as though you were getting free money! As a general rule, it’s best to defer at least the amount that your employer will match.
SIMPLE IRA Plans. SIMPLE IRA plans always come with an employer match. The maximum contribution you can make into such a plan is $10,000 in 2005. If you are 50 or older, you can contribute up to an additional $2,000 in 2005. Your employer may also offer a SIMPLE 401(k) plan. Unlike traditional 401(k) contributions, the money put into SIMPLE 401(k) plans must always be matched by employers.
Profit Sharing or Pension Plans. Employers can also establish a defined-contribution profit-sharing plan that permits you to put up to $42,000 into retirement investments on a pretax basis in 2005. Alternatively, employers can offer a defined-benefit pension plan that allows you to put sufficient money away to provide a retirement benefit of up to $170,000 in 2005. These two plans are quite complex. Don’t consider putting money in them unless you first consult with your tax professional, an attorney who is knowledgeable about retirement plans or a qualified actuarial firm.
There isn’t sufficient space in this article to discuss where you should invest the money that you defer for retirement (i.e., in stocks, bonds, money market accounts or elsewhere). Seek the advice of a financial planner who is a certified public accountant (CPA), particularly one with the Personal Financial Specialist (PFS) credential. CPAs with this credential have achieved a high level of education, licensing, continuing education requirements and ethical standards. If you prefer, work with other qualified investment professionals.
It’s never too late to start saving for retirement! The sooner you begin investing, the more secure your retirement will be—and that will certainly contribute to good health.
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Learn more about retirement savings plans at the following websites:
How can you save for retirement if you are self-employed? You can contribute to a traditional or Roth Individual Retirement Account (IRA). (See “Individual Retirement Accounts” on page 98 for more information.)
Alternatively, you may want to establish a Simplified Employee Pension (SEP). A SEP is a written arrangement that allows employers, including self-employed individuals, to make contributions
toward their own and their employees’ retirement plans without becoming involved in more complex arrangements. You can contribute up to $42,000 into your SEP in 2005, depending on your income. The advantage to a SEP is that you can stow more money into it than into a 401(k) or an IRA. For more information on SEP plans, see a certified public accountant (CPA).
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