Tag: Financial Independence

An important part of saving for retirement is deciding whether to put money into a Roth retirement account (401(k) or IRA) or a traditional retirement account.

Choosing your retirement savings type wisely could help you avoid paying more taxes than necessary.

Think of yourself as a farmer

A Roth account holds “after-tax” money — or money you have already paid the income taxes on. Its qualified distributions are tax-free: you pay taxes on the seeds, but the harvest, which is hopefully much larger than the initial plating, is tax-free.

A traditional retirement account has pre-tax money: you don’t pay income taxes on the seeds (either by taking a tax deduction or deferring from your paycheck before taxes); you pay the income taxes on the harvest — when you withdraw the money.

When you are making the decision where to invest your retirement savings, consider the following four areas:

Is your tax bracket lower today than your tax bracket will be in retirement?

Anticipating tax rates can be difficult since no one knows how Congress may change tax rates in the future. If you believe you are earning less today than you will in the future (for example, you’re just starting in a career), then a Roth account may be the best option.

On the other hand, if your income is at its peak, a traditional account may be the best option.

Another option is to consider splitting your savings between traditional and Roth depending on your current asset mix (traditional vs. Roth vs. taxable).

Does your employer match your retirement contributions?

If yes, then your employer is already contributing to a traditional 401(k), so consider contributing to the Roth 401(k) to diversify your retirement account types.

Who are your beneficiaries?

If you are leaving money to charities, consider using a traditional retirement account since the charity is exempt from income taxes.

If your children are your beneficiaries, consider whether your children will be in a lower tax bracket after your death than you are now.

Some people choose to give their children the additional gift of prepaying the taxes and leaving the children tax-free money in a Roth account.

Will your required minimum distributions (RMDs) provide more money than you need?

If you already have money saved in a traditional retirement account, the government will require you to take minimum distributions at age 72.

On the other hand, a Roth IRA requires no distributions at a certain age, which means the money can continue to grow tax-free until you need it.

Diversifying your retirement savings between traditional and Roth accounts can be important because during your retirement you can choose to withdraw taxable money from your IRA or tax-free money from your Roth IRA.

Just like a farmer plants different types of seeds, you may want both traditional and Roth retirement funds to choose from when you are retired.

Regardless of your age or stage in life, certain financial goals have withstood the test of time and are good to put into practice and maintain for decades.

Here are 6 financial goals everyone should have at any age.

1. Live within your means

No matter what your age or income level, living within your means is key to long-term financial success.

Simply put, don’t spend more than you make or you won’t be able to accomplish the next goal.

2. Be(come) Debt free

What you’re really doing when you borrow money is spending ‘future dollars’ – money that you haven’t earned yet.

In essence, you’re borrowing from your future self. It’s the complete opposite of saving. Duh!

The trouble really comes when you borrow too much and don’t have enough future income to pay for it all.

Best practice to live debt free throughout your lifetime, but especially during retirement since most retirees have limited income.

3. Build and maintain good credit

Some things it actually makes sense to borrow for, like higher education or a home since these things usually cost more than what we have the ability to save for.

That’s why maintaining good credit is important for those purchases that are simply too difficult to afford in a cash payment.

Being able to lock in a low-interest rate on a large purchase will save you tens of thousands of dollars in the long run.

4. Have an emergency fund

An emergency fund is important because it will provide a cushion to support your living expenses during periods of transition, disability, or other unexpected events.

When calculating an appropriate emergency fund, be sure to use the expenses that wouldn’t go away in the event you couldn’t work such as insurance premiums and essential living costs.

In general, you’ll want to have an emergency reserve to cover three to six months of these expenses.

It’s also wise to keep a modest amount of physical cash on-hand (at least $1,000, or an amount consistent with the cash covered by your homeowner or renter insurance).

5. Maximize retirement savings for your income

While it would be nice to be able to put $19,000 per year into your 401(k) — the IRS’s limit for 2019 — for many people, it just isn’t feasible because they don’t earn enough. Instead, focus on maximizing retirement savings for your income level.

A good rule of thumb to follow is to start at 10% and slowly work your way up to 25% as you advance in your career and your income increases.

Saving at this level is a sure-fire way to significantly build retirement assets and it also helps you live well within your means.

6. Find value in your money

Finally, know why money is important to you and then align it with your values.

There is no sense spending your money in areas that don’t bring you joy.

If you work for a university or college, there is a good chance you have many different types of retirement plans to choose from.

403(b), 401(a), 457 Plans: what’s the difference and how can you optimize using them?

403(b) Plans

403(b) plans were created in the 1950s as a way for teachers and others who work for not-for-profit organizations to save for retirement. The name comes from the section of the tax code the plan was created under. 

Institutions normally offer a “match” or a flat rate that they will contribute to the plan on your behalf. You’re ordinarily required to put in a percentage of your own pay, through salary deferral, to receive employer contributions.

Features:

• The contribution limit for 2019 is $19,000 if under 50, with a $6,000 catch-up contribution if over 50 for $25,000.
• You are responsible for choosing the investments within your account.
• Most plans allow for loans. I don’t encourage using them, but if you exhaust all other options, it is available.

Pros:

• Most universities/colleges offer employer contributions.
• Traditional contributions lower your taxable income for that year.
• Many Plans also offer after-tax (Roth) contributions.

Cons:

• Many plans offer insurance-based products (annuities) as part of the core line up. These products often have high fees which can be detrimental to long-term financial success.
• The recommendations, service, and guidance from 403(b) vendors can be inadequate because they are often insurance salespeople who receive large commissions for selling insurance products within the 403(b).

457 Plans

457 plans are available to employees of state/local government agencies and certain tax-exempt organizations.

features:

• The contribution limit for 2019 is $19,000 if under 50, with a $6,000 catch-up contribution if over 50 for $25,000.
• Like 403(b)s, you are responsible for choosing the investments within your account.

Pros:

• If a 403(b) and 457 Plans are offered, you can max out BOTH.
• If you separate service, there is not a 10% premature withdrawal penalty. This can be especially beneficial if you want to retire in your early to mid-50s.

Cons:

• While premature withdrawal penalties don’t apply after separating service, required minimum distributions do apply.
• The 457 plan doesn’t have a match.
• If the 457 is considered non-governmental, your options for what to do with the funds down the road, such as rolling it into an IRA, can be limited.

401(a) Plans

A 401(a) plan is an employer-sponsored money-purchase retirement plan that allows dollar- or percentage-based contributions from the employer, the employee, or both.

Features:

• The employer can decide who is eligible to use the plan.
• These plans often have mandatory employee contributions.
• The contribution limit in 2019 is $56,000 (employee+employer).

Pros:

• It can allow for more tax-deferred investing, in addition to other plans.

Cons:

• These plans are not frequently offered.
• The plan gives employers more control over their employees’ investment choices.
• Contributions are sometimes mandatory and a portion of those contributions may be subject to a “mitigating rate” that is used to help fund past service liabilities of the organization’s defined benefit plan.

How to use them together

If you work for an employer that offers all three plans, you are in luck because you can contribute to all three plans at the same time!

A quirk in the IRS code allows you to personally defer $19,000 to the 403(b) plan, $19,000 to the 457 plan, and $19,000 to the 401(a) plan.

If you include employer contributions, a total of $131,000 can be contributed toward your retirement, before any catch-up contributions!

If you are fortunate to have an employer guaranteed retirement benefit in a post-pension era, it’s likely you have been offered the option of a lump-sum payment or monthly benefit.

You may like the peace of mind that comes with the payments since you are assured a monthly income for life, but the lump-sum option gives you the opportunity to invest your own retirement funds, can be withdrawn on your own schedule, and can be left to your heirs after your death.

Should you take the pension or accept the buyout? The answer to this question depends on a number of factors that we’ll explore below.

Pension and Lump-Sum Example

To help illustrate the point, let’s assume you are currently a 45-year-old female and your employer is offering to pay you $2,045 per month as a single life annuity starting at age 65 through the remainder of your lifetime (your official life expectancy is around age 88). Or they are offering to pay you $145,000 in a lump-sum today.

What the Math Says

The first step is to calculate the rate of return that would make the two options equal to each other. You’ll need to use an internal rate of return (IRR) calculator to do this.

I’ll spare you the mathematical details and skip straight to the good stuff. The calculation shows that the internal rate of return is 4.72% at life expectancy. This essentially means that $145,000 growing at 4.72% per year while withdrawing $2,045 per month starting at age 65 would last for 23 years, with nothing left over — the equivalent of the monthly pension.

The longer you live, the more pension payments there are and the higher your investment return would have to be to match the pension by investing the $145,000 lump sum. Conversely, if you don’t live very long, even a return of 0% or less would be better than taking the monthly pension.

As you can see in the chart above, the required rates of return to replicate what the pension provides is fairly modest in this scenario.

To secure the pension payments to age 100, you would need your lump-sum portfolio to generate an average annual growth rate of around 5.30% — which is certainly achievable with the right portfolio.

If it would take an 8% to 10% rate of return on the lump sum to give you a cash flow equal to the pension payments at your life expectancy, then the pension might be a better option.

On the other hand, if a low rate of return could provide that same cash flow, you might want to go with the lump sum.

You’ll have to determine if the rate of return in your particular situation is attainable given your tolerance for market risk and other investing factors. This is something a financial advisor can help you figure out.

Other Things to Consider

While the pension payments offer some nice longevity insurance if you live past life expectancy, you’ll also need to consider the impact of inflation on the $2,045 per month payments.

Using a simple inflation-adjustment calculation, the pension payments may only equate to $977 in today’s dollars 20 years from now with 3.76% inflation, and will quickly degrade from there. This simply means that your money won’t go as far to purchase goods and services.

You’ll also want to keep your beneficiaries in mind when deciding between the two options. With the pension, there may not be any money that passes to your chosen beneficiaries. The lump-sum offers a little more flexibility when it comes to how the money flows to your heirs.

Another thing to consider is the financial health of your employer. If you have any concerns about the longevity of the company — or their ability to manage the pension funds — you may put more weight into taking the lump-sum now.

Finally, you’ll need to do some self-reflection and determine if you have the discipline it takes to actually make the money last throughout your retirement.

If you’re the kind of person that will use the lump-sum to take a vacation, maybe taking the monthly payments makes the most sense from a behavioral standpoint.

The pension payments provide consistent cash flow that will help with budgeting decisions and eliminates the possibility of using up that portion of your wealth while you living.

There is no one-size-fits-all solution for everyone. The specific terms of the deal and your individual situation both play a role in whether you should accept the lump-sum or wait for a monthly pension check at retirement.

Before deciding which option is right for you, be sure to work with an advisor who will provide you with the facts you’ll need to make an informed decision.