The ongoing recession has put a tight squeeze on family budgets for the past two years. With priorities changing every month based on inconsistent cash flow, how can anyone put away anything for retirement? It is easy to get distracted in these troubled times, but there is no time like the present to do a little financial planning and realize that savings, put away on a regular basis for the long-term, are the only way to provide for dignity and pleasure during our second adulthoods.
Retirement planning, to be effective, needs to start in the present tense. You must accept that earning potential declines on a steep curve as you put on the years. Our young-minded society has yet to accept that we may be useful when we advance in age. However, average lifetimes are also increasing. The cost of living for a nice affordable lifestyle has risen with inflation.
One constant in all of this has been Social Security, but Social Security payments may only constitute 40% of your necessary retirement income. The only way to fill the gap is with earnings from additional savings. You must commit yourself to start building a “nest egg” now. The “Law of Compounding Interest” will always be around, but you must have savings deposits for the “multiplier” effects in the table below to produce magic:
For example, $10,000 invested at 10% for 30 years will result in $174,000. Ordinary savings accounts do not pay these rates today, but returns in the stock market have been consistently around 10% over both medium and long-term periods since 1926. There are still two other important issues to consider, inflation and taxes. Inflation has been averaging 2.5% for the past decade. Combined federal and state tax rates may take another 45% away. However, all is not bad. Congress created Individual Retirement Accounts (IRA’s) and 401(k)’s to shelter your earnings from current tax impacts.
Financial planning starts with the family budget, and the top line of your budget right after your net income should be the amount you will save on a periodic basis. Start with a simple “tithing” figure. Set aside 10% of your net paycheck in a savings account or money fund. First, you need to build an “emergency fund”, roughly 3-6 months of net payroll. You never want to be forced to sell investments when the timing is wrong. An emergency fund can allow for work stoppage, auto repairs, or your child’s education needs. Once this preparatory work is completed, then on to the next topic.
Now that you are ready to save, let’s check your options. If your employer offers a 401(k) savings plan, take advantage of every aspect of that plan. Most employers will provide some form of matching the amount you invest. These funds are like extra pay. The company also pays all fees related to managing the funds, but your actual investment choices may be limited to selected mutual funds or ETF’s.
If you participate at work in a 401(k), or are covered by a qualified pension plan, then your ability to make contributions to a traditional IRA will be limited. If not, then contributions can reduce your Adjusted Gross Income and cut your current tax liability. The taxes will come later when you make withdrawals. You can also choose to participate in a Roth IRA. With the Roth IRA you give up your tax deduction, but withdrawals are allowed tax-free and earnings are still sheltered from tax. Your investment options are also not as confined as with a 401(k), but managing a diversified portfolio will require more research and active relationship with your broker.
Do you have credit card debt? The interest rates on these programs will far exceed your earnings potential on savings. Make an attempt to pay down these balances, and then you can begin making real contributions to your retirement program.
Financial planners in the government understand saving for retirement, and have provided businesses and individuals with tax-sheltered options to help you achieve your retirement goals. There are a number rules to follow, and it can get complicated, but since it is subsidized by taxes from general taxpayers, the rules are there to prevent abuse. Individual Retirement Accounts can make a significant difference in your future. Be sure to consult your tax professional for his advice so that choices will be in line with your personal financial situation.