When should someone start planning for retirement? Fidelity Investments recommends most young people try to save two times their annual salary by the time they turn 35. Unfortunately, retirement is so far off in the minds of most young people that they find their retirement account is completely empty at the age of 30.
What can you do to make sure you are prepared when you are ready to retire? Here are some programs to take advantage of that will help you save for that day.
Social Security is a wide-ranging social welfare system in the United States, paid for by payroll taxes, often referred to as FICA (Federal Insurance contributions Act). Employers deduct money from their employees’ paychecks through payroll deductions, match that dollar amount, and send that money to the government. The largest Social Security payout is through old-age pensions, but Social Security is also paid to disabled workers and to spouses and children of deceased, disabled, or retired workers.
All workers in the United States who have paid into Social Security are eligible to receive a monthly pension payment from the Social Security Administration after they retire. Workers need to work at least 40 years to receive full benefits, and their specific benefit amount is determined by how much they have paid in over the course of their working life. You don’t have to do anything special to be eligible to receive an old-age pension from Social Security other than pay your normal payroll taxes. Your employer will make those payroll deductions for you. However, if you are self-employed, you are responsible yourself for paying these taxes. Every year when you file your income taxes, you are responsible for reporting and paying your self-employment tax (SECA tax). The main difference between FICA taxes and Self-employment taxes is that when you are self-employed you are both the employer and the employee, so the amount of tax you pay is double.
The Social Security system was first created during the Great Depression, when over 50% of all retired people lived below the federal poverty line. While you will get a bigger pension if you paid more in to the system over your career, Social Security is still designed primarily as a “safety net,” designed to help the poorest retirees. This government-provided monthly income is a small supplement to help prevent retired people from having no means to afford a basic living standard. Even today, Social Security payments are credited with lifting 20% of all retired people out of poverty.
How does it fit into my retirement plan?
You should not be relying on social security payments to make up the bulk of your retirement income. Remember, Social Security is a safety net – there if you need it to help maintain a modest standard of living. But if everything goes well and you are actively planning for your retirement years, Social Security should only be a small percentage of your retirement income.
In recent years, the most popular way to prepare for retirement has been to actively plan for retirement by saving and investing to build up wealth so that when you retire, you have that savings to live on. There are several tools available to help you with that savings and investing plan.
Cash Savings are the savings you keep in a savings or checking account. In the past, this was the primary means that people used to save for retirement – keeping liquid assets that could be used to live off in their old age. Cash savings is no longer often recommended as a reliable way to prepare for retirement, since other alternatives with strong advantages have arisen.
You DO need to have money in a savings account. A rule of thumb is to keep enough money there to pay for 6 months’ worth of your regular living expenses. One major drawback to keeping money in a savings account is that the interest you earn on that money is very low, and if the economy is experiencing inflation, the value of the money in your savings account is decreasing. Another problem with cash savings is taxes. If you earn more than $10 in interest on a savings account, you need to report that on your income taxes as income earned.
Traditional IRA Accounts
In 1975, the government passed legislation allowing citizens to make contributions to Individual Retirement Accounts, commonly known as IRAs. Citizens are encouraged to invest in their futures by opening an IRA and making regular contributions. With a traditional IRA, the government lets you take a certain amount of your income and deposit it directly into a retirement account. This contribution amount is not taxed, so you are really reducing the amount of taxable income that you have to pay income taxes on. There are limitations on the amount of money you can contribute to your IRA each year, but this tool can help you build wealth slowly and steadily.
A dedicated IRA account is better than a savings account because it can be invested in stocks, bonds, mutual funds, certificates of deposit, real estate, or other investment instruments. This gives an IRA another major advantage over cash savings – you can help your retirement savings grow through investment. The added value to your IRA, like dividends, interest, and profits from stock trading, is also not taxed while it is in the account. When you retire and begin withdrawing from your IRA, you do need to pay taxes on your withdrawals.
One disadvantage of an IRA is that the money is “locked in”. Remember that an IRA is for your retirement years, so you cannot withdraw money early from your IRA without having to pay a penalty. One exception is for buying a house. If you are a first time homeowner, you are allowed to withdraw $10,000 for a down payment (or for construction costs) without having to pay the penalty, but you will be responsible for paying income taxes on that $10,000. Another disadvantage is risk. If you have a large amount of your IRA invested in stocks, it is possible to lose a large amount of your savings if your investments fall in value.
Once you have your savings in a dedicated IRA account, it can also be invested in stocks, bonds, mutual funds, certificates of deposit, real estate, or other investment instruments. This gives an IRA another major advantage over cash savings – you can help your retirement savings grow through investment. The added value to your IRA (like dividends, interest, and profits from stock trading) is also not taxed while it is in the account. When you retire and begin withdrawing from your IRA, you do need to pay tax on what you take out.
A disadvantage of an IRA is that the money is “locked in”. You cannot take money out of your IRA without taking a huge tax penalty, so it cannot be used to buy a house, for example. If you have a large amount of your IRA invested in stocks, it is also possible to lose a large amount of your savings if your investments fall in value.
Roth IRA Accounts
Roth IRA accounts operate very similarly to Traditional IRAs, but the major difference is when you pay taxes on the money.
With a Traditional IRA, deposits you make into the account are tax-free. You pay taxes on that income when you withdraw the money from your account during retirement. With a Roth IRA, the opposite is true. You pay the full income tax when you make the contribution, but you do not pay any tax when you withdraw the money. This means that if you think tax rates will go up by the time you retire, you will probably choose to open a Roth IRA and pay taxes now while interest rates are lower. But if you think tax rates will go down, you will probably choose to open a Traditional IRA and pay taxes later.
One major advantage of a Roth IRA account is that you can make qualified withdrawals at any time, tax and penalty free. This applies ONLY to the money you contributed, not to the gains you have earned.
Employer Retirement Help
Many professional jobs offer some sort of retirement assistance to their employees. This is almost exclusively the case with salaried positions that have an employment contract, or union jobs that have collective bargaining agreements.
Once you retire, you can receive money from your pension plan account. At one time, employer pensions made up the majority of retirement income for the elderly. Employees were more likely to work for the same employer for many years, so it made sense to invest in this type of a personal retirement plan. Employer pension checks are issued every month. The amount is generally much lower than a normal paycheck. The amount you receive is determined by how long you worked for an employer and how much you were earning.
Employer pensions have an advantage similar to the Social Security program. If you choose to participate, automatic payments can be transferred from your paychecks into your pension account. Then just keep working until you retire. At that time, you will receive checks from both your pension account and from Social Security. This money should provide enough for you to live on, even though it’s less than you had while employed.
There is one big risk with employer pension funds—the employer could go bankrupt, and that could impact your monthly payments. Private-sector employers with pension funds have insurance through the Pension Benefit Guaranty Corporation. The employer pays a monthly premium for each employee contributing to the pension plan, so if this employer goes bankrupt, the government would protect the employees’ basic pension benefits, requiring the employer to continue paying pensions. Religious churches can opt out of the PBGC, so this leaves their pension programs possibly unprotected. Government pensions could also suffer setbacks. You’ve likely heard that the Social Security fund could run dry by the time you retire. The same thing could happen for state-sponsored retirement plans, impacting thousands of government employees. Even decreases in the fund could impact individuals, as many retirees in Detroit were shocked to discover in 2015 when the city was forced to cut its pension payments.
401(k) accounts were created almost by accident. In 1978, Congress passed the Revenue Act. It included a provision that allowed people to defer paying taxes on income until a later date. A tax consultant named Ted Banna realized that this obscure tax code, called 401(k), could be used to create simple retirement accounts. 401(k) accounts are created through an employer. The employee contributes through a payroll deduction and the employer makes, their own contribution, often matching how much you contribute. This means that your employer is paying in to your retirement account while you are still working. The money is still yours, so even if the company declares bankruptcy later, you don’t have to worry about your account being affected like you would through an employer-sponsored pension plan.
The main advantage of a 401(k) account is that you don’t pay the income tax on your contributions right away. You can wait and pay taxes when you withdraw the money in retirement. This makes it similar to a traditional IRA. With a 401(k), you don’t pay additional taxes on the capital gains and interest (which you do with the traditional IRA). If you prefer to pay taxes now rather than later, there are also Roth 401(k) accounts which let you pay the tax immediately.
Which Method Do I Use?
Before the 1970’s, most people’s retirement plan included relying on their company pension and Social Security, plus any other savings they might have accumulated. It was common for retirees to sell their house and move into something smaller, using the profit as their main retirement savings.
Since 1980, however, fewer and fewer employers are offering a pension package, leaving it up to individuals to build their own retirement accounts and portfolios. This is not necessarily a bad thing. While choosing a retirement account is more complicated than just working and getting a check when you retire, the tax benefits and potential for investment and growth means that if you plan well, you can retire with even more comfort than you experienced while working.
The exact retirement plan you choose will vary greatly based on what programs your employer offers, but the main idea to keep in mind is to always be saving!
- In your own words, explain what the term retirement means.
- What is a 401K and how did it get its name?
- What is Social Security and why do people pay into it?
- Why is it important for you to start a retirement earlier?
- Along with Employer pensions, why should people also be looking at private pensions aswell?
- In your own words, explain what a Roth is and what the difference is between a Traditional and a Roth IRA.