Adults are faced with many tough decisions. Your career, education and picking a partner (or none at all) are common examples. While you may consult with experts, family and friends, some decisions you must make for yourself. The consequences of those decisions may impact the rest of YOUR life.
“I’ll worry about retirement later” is a decision, and a bad one.
Whether your current income provides a fine lifestyle, or you are living from paycheck to paycheck, the lack of savings is likely to cause big problems down the road.
|“WHEN” you begin your retirement saving may be the most important retirement decision you will ever make!|
The Daily Pfennig recently quoted the late, well-renowned Richard Russell.
He referenced a study of two investors. One opened an IRA at age 19, contributing $2,000 annually for only seven years. The second investor began at age 26, contributing $2,000 annually until age 65. The assumed (unrealistic today) rate of return for both investors was 10% (7% interest plus growth).
Investor #1 made a profit of $930,641, a 66-fold return on his $14,000 investment.
Investor #2 made a profit of $894,703, a 11-fold return on his $80,000 investment.
Mr. Russell makes a dramatic point about compounding:
Compounding is the royal road to riches. Compounding is the safe road, the sure road, and fortunately, anybody can do it. …Of course, you need time …to allow the power of compounding to work for you. Remember, compounding only works through time.
But there are two catches in the compounding process. The first is obvious – compounding may involve sacrifice (you can’t spend it and still save it). (Emphasis mine) Second, compounding is boring – b-o-r-i-n-g …until the money starts to pour in. Then, believe me, compounding becomes …downright fascinating!
Both investors accumulated almost $1 million through discipline and prudent investing. Had the first investor stuck with his annual contribution for the entire 47 years he would have $1,743,880.
Young people are taking longer to reach adulthood. Many are in their late 20’s before finishing college and are saddled with student loan debt.
Major pension plans are being forced to revise their projections, even a 7% return is considered unrealistic today. Things can change; maybe the fed will raise interest rates back to 2007 levels. Don’t count on it!
Let’s look at some realistic possibilities in today’s world. The Securities and Exchange Commission (SEC) provides a handy compound interest calculator.
Assume Tom Thrift is 25 years old and commits to saving $2,000 ($166.66/month) a year, no matter what. Using our calculator, if he earned a 5% compounded rate, at age 65 he will have accumulated $241,590.
What happens if Tom decided to double his contribution in 20 years (age 45)? After 20 years he would have $66,129. Enter that amount in the calculator as initial investment. His monthly savings moves up to $333.32. At age 65, he now has $307,719.
Compare that to Pete Procrastinator, who has no savings and decides to “get serious” when he turns 50. If Pete saves $500/month for 15 years @ 5%, he will have $129,471 at age 65. Unless Pete is willing to save a whole lot more to catch up, it looks like downsizing and/or working longer is in Pete’s future.
|Regardless of your age, compounding still works magic. The sooner you begin a disciplined savings and investment program, the more money you will end up with. It’s just that simple!|
Using the tools available
The government offers various tax deferred plans to encourage people to save. The most common are the Simple IRA, Roth IRA and 401(k) programs. This IRS website provides the details. Self-employed, or government workers have similar plans available.
The government allows the investor to deduct their contributions to a Simple IRA or 401(k). When you withdraw money it’s considered taxable income. The Roth IRA is the reverse; you get no tax break when you make a contribution; however you can accumulate and withdraw money tax-free.
Be sure to consult with a competent tax advisor. Rules, regulations, tax and investment strategy comes in to play. There are penalties for early withdrawal, and not taking a Required Minimum Distribution (RMD) properly after age 70 ½. There are many rollover rules which allow employees to take their retirement plan from job to job, and/or roll over their 401(k) into an IRA when they retire.
401(k) plans became popular when most private sector employers phased out pension plans. The burden for retirement savings was transferred from the employer to the employee.
Some companies offer “employee matching,” up to a certain level. I know of one company that will match employee contributions up to $6,000 annually.
Employer matching is a no-brainer for everyone, including Pete Procrastinator. Using the same return of 5%, if Pete saved his $500/month and his employer matched it, in a 15-year period he would accumulate $258,943. His savings increased by $129,471, giving him a 10% return on his money.
|AS A MINIMUM, always save to the level of the matching provision – no exceptions! It’s free money and you earn 100% return immediately. What part of free money do people fail to understand?|
Many folks roll over their 401(k) into a self-directed IRA upon retirement. Up to that point, your investment choices are generally limited and handled by your employer.
It’s scary when the event takes place – it’s your responsibility to make your nest egg last for the duration.
As Richard Russell reminded us, “DON’T LOSE MONEY: This may sound naïve, but believe me it isn’t. If you want to be wealthy, you must not lose money, or I should say must not lose BIG money.”
Preservation of capital takes precedence over chasing risky returns.
Roth IRA versus Standard IRA
On the surface they appear similar. The Standard IRA allows you to deduct your contributions and you are taxed when you withdraw money. A Roth does not allow a tax deduction when you contribute; the withdrawals are tax free, and there is no Required Minimum Distribution (RMD).
Assume investor Tom Thrift is in the 25% tax bracket and saves $416.67/month in an IRA for 20 years, earning a 5% compounded rate of return. Each year his $5,000 contribution would be a deduction from his taxable income, saving him $1,250 in taxes. In 20 years he would accumulate $165,331, all of which is taxable when he withdraws money. If Tom takes it out and pays 25% in taxes, he will net $123,998.
The “theory” behind the Standard IRA is you are in a higher tax bracket while you are working. Once retired, your tax bracket would be lower. At age 70 ½ the government mandates a Required Minimum Distribution (RMD). The SEC provides this handy tool for the calculation.
If Tom decided to pay the 25% taxes each year and invest $3,750 into a Roth IRA he would accumulate $123,997 – so it appears to be a wash.
The hidden risk
For more detail, see my article; “Dump Your Business Partner – Now!”Many advisors recommend leaving money inside IRA’s and 401(k)’s as long as possible. My thoughts:
“I asked my CPA if he could guarantee that income tax rates would not increase; particularly the higher income brackets. Of course he said “No”. In essence, you have your life savings sitting in an investment account(s), and a business partner who can change the rules at any time and take a bigger cut – without your agreement or consent.”
Who knows what will the government do down the road? Once you have paid your taxes and rolled your money into a Roth IRA, you have dumped your business partner and removed considerable risk. If you can afford it, pay the taxes from funds held outside the Roth.
Subscriber Robert K. writes, “I would like to see you write about 401(k) withdrawals and in particular the tax consequences (pro/con) of withdrawals prior to age 70 ½.”
Robert, most answers are based on the premise that tax rates won’t change and the government won’t change the rules. It’s more than a simple math problem. What if the government decides to tax 100% of your social security? Are you willing to bet that taxes won’t go up? The real risk is unknown.
I like the Simple IRA and 401(k) because the early withdrawal penalties incentivize the saver to not touch their money. It may be beneficial to open a Roth IRA, even with a small amount. A Roth has no RMD, or tax consequences. Start your 5-year clock running now!
Check with your financial advisor, each case is different. You may want to begin rolling smaller amounts into the Roth immediately. Draw down your taxable accounts first while your Roth continues to grow.
I have friends who take an RMD and don’t need the money. They pay the taxes and roll it into a Roth and let it grow tax free – forever!
Don’t confuse hope with reality. Bottom line: start early, save more and get Uncle Sam’s hand out of your wallet as best you can!
Note: I’ve recently released my newest report, “10 Things You Need To Know, That Brokers Won’t Tell You About Dividend Paying Stocks!“. It’s free for qualified retirement investors. Click here to claim your copy today.