Finance Friday: Retirement + Savings
This is the second entry in my Finance Friday series - I can't tell you how much FUN I've had connecting with many of you as C and I really take a serious stance on finances. So far, C and I have held steady with no online shopping (it's been way easier than we thought!) and we also met with our financial advisor, Maggie, who is also the advisor contributing to this series. In two weeks, I will share the action plan we aligned with Maggie on (no personal numbers of course) including how we're prioritizing and what our key goals are for the next five year. Until then, I can't recommend meeting with an advisor enough - it felt SO GOOD to get our full financial picture on the table in front of someone that wouldn't judge us and can actually support us in making big changes. In the meantime, I'm psyched to share Maggie's second post, answering all of your questions on retirement savings!
Wow! I can’t believe the positive responses I’ve received from this series. THANK YOU THANK YOU THANK YOU! When I left Wall Street to start my own practice there is always a level of self-doubt, but I knew that there was a way to make finance approachable, especially for women (I actually wrote about that here). So seeing all the positive responses, really provides extra fuel to my finance fire!
So as promised, today’s topic is retirement & savings!
As I wrote in my past blog post, I suggest splitting your savings into four buckets:
· Retirement: IRA, ROTH IRA, 401K, ROTH 401K, 403B, 457, etc.
· Long-term savings: non-qualified investment account
· Short-term savings: high-yielding money market savings account
· Fun-money: personal checking account
Retirement accounts are also known as “qualified accounts” because they qualify for special tax treatments. Typically, you have the ability to add money to pre-tax or after-tax to a retirement account. The major difference between the two is not if you pay taxes but when you pay taxes.
Pre-tax retirement accounts:
In a pre-tax account, you add in money before you pay taxes. In this type of account, your money grows tax-deferred until you are ready for retirement, at which time you will owe taxes on any money you take out of the account. This can help lower your taxes today while also saving for retirement!
For example, let’s say as a single person you earn $82,501 / year. This would put you in the 24% federal income tax bracket. If you save $10,000 in your pre-tax 401K per year, you would lower your taxable income to $72,501 ($82,501 - $10,000), which now puts you in the 22% federal income tax bracket. So not only are you saving $10,000 tax-deferred for retirement, but you’re also paying less in federal taxes that year!
When you save money in a pre-tax retirement account, you cannot withdrawal your money until you are at least 59 ½ years old without a penalty. Should you need to access this money earlier (not encouraged), you’d have to pay a 10% penalty and any taxes owed.
Once you are 70 ½ years old, you must start taking required minimum distributions (RMDs) by law. At this stage in your financial journey, it’s especially important that you speak with a financial advisor.* Not taking an RMD correctly can result in 50% penalty and any taxes owed! Furthermore, as advisors we help develop a retirement income stream to decrease the possibility of outliving your money in retirement.
*That said. I believe a financial advisor is necessary at any stage in life and most people wait too long. You should see an advisor as you accumulate money as well as in retirement. Just like you should see your doctor annually for a check-up not only when you’re sick!
Types of pre-tax accounts include:
a) Pre-tax 401K (corporations), 403B (nonprofits & schools), 457 (government):
These accounts are offered through employers. The annual limit for contribution pre-tax is $18,500 ($24,500 if you’re over 50 years old).
IMPORTANT: if your employer offers a match, you MUST take advantage of it, if not, you’re leaving free money on the table. To illustrate using our previous example:
Your employer says they’ll match 100% of your contribution up to 5%. You put in 5% of your $82,501 annual salary, which is: $4,125.05. Your employer ALSO adds $4,125.05 into your retirement account. So now you’ve doubled the money in your account without it even being invested! If you employer offered you a $4,125.05 raise, would you take it? Of course! How is an employer-match any different?
b) Traditional IRA (individual retirement account):
If your employer doesn’t offer a retirement account, have no fear, you still have options to save for retirement using an individual retirement account (IRA). I work with a lot of medical students and scientists working on their PhDs and this concern always comes up. As long as you are a legal US citizen or alien resident and you have earned income (rule of thumb: you file an IRS-W2 form) you can add money into an IRA. So if you have a work-study job, a server job, paid stipend to work in a laboratory, etc. you can save for retirement!
Traditional IRAs are pre-tax so the same tax treatment applies. A difference is that your annual contribution limit is lower at $5,500 ($6,500 if you’re over 50 years old) and your modified adjusted gross income (MAGI) has to be under a certain limit.
Also, if you are a stay-at-home parent, your working spouse can make a spousal contribution on your behalf. Not only does this build your retirement savings, but also this is tax deductible!
There are other types of IRAs, including SEP IRA and SIMPLE IRA, specifically for those that are self-employed. Feel free to email me at mjohndrow@farmingtonriverfg.com if you want to learn more.
One last point on pre-tax retirement accounts: employer sponsored accounts often offer the ability to take loans or hardship withdrawals against the account. Be cautious if you plan on doing this as you must pay the amount back in a certain period of time, plus interest. Traditional IRAs typically do not allow you to take loans, but you may take up to $10,000 without penalty for your first home purchase and some hardships, such as death and disability.
After-tax retirement accounts:
You also may have the option of contribution into a ROTH 401K, 403B, 457, and/or ROTH IRA. This money is after-tax. So, you do not receive the above-mentioned tax deduction, but your money grows tax free. Meaning—when you take the money out in retirement, you don’t pay taxes. Also, there is no required minimum distribution requirement!
“Which is right for me?”
I always get asked if someone should have a ROTH or a Traditional retirement account. Here’s what you should consider:
1. Assess do you expect to be earning more money in the future. For example, I typically tell medical residents that this period of time is likely their lowest earning potential. Therefore, they should invest in a ROTH before they move to a higher-paying position, since their income tax bracket will likely be at its lowest currently.
2. It’s always good to have both a ROTH and a Pre-Tax account in retirement. Typically retired individuals live off of their pre-tax account, making monthly withdrawals and paying taxes. But if you want to make a large purchase in retirement of several thousand dollars, that could be a hefty tax bill! Instead, those big payments can come out of your ROTH account, tax-free.
3. Having a “safety-net:” You can always withdrawal your ROTH contributions (not the growth from invetments) so if you find that you need to access some money prior to retirement (again, not encouraged), you always have this option.
Now that I covered the basic retirement accounts, I always get asked the following questions:
1. How much should I be contributing? You should really do a needs assessment with a financial advisor, but if you read my last post on budgeting & saving, rule of thumb is 10% of your income.
2. How do I allocate my investments? Great question! Often the default choice in a retirement plan is a target-date retirement fund. This investment is run by a fund manager who picks your investments (stocks and bonds) for you. A a target fund lumps everyone into one category, using the year you want to retire as the metric for how to invest. For example, say you want to retirement in 30 years, the fund manager will likely invest you in a majority of stocks, which take on more risk earlier in your career. Alternatively, if you have less than 5 years until retirement, the fund manager will likely invest you in all bonds or cash, which take on the least risk. This investment choices may not match your risk tolerance, which is the amount of risk you are comfortable with in your portfolio. I recommend doing a risk analysis and picking a diversified mix of investment choices available to you.
3. I don’t make that much money now, can I just contribute later in life? No! Remember last week’s post’s “bringing lunch from home & compound interest?” Let’s take that concept one step farther.
Let’s look at the investing choices of two hypothetical investors, Amy and John.
Amy started investing at age 25. She invests $3,600 per year for 15 years at an 8-percent interest rate and then stops (she STOPS contributing at 40 years old. Doesn’t put in an additional dime…. Not suggested by the way!)
Amy’s Investments
Investment with Compound Interest
At age 40
$104,500
At age 70
$1,050,000
John didn’t start investing until he was 40 (so, the same age as when Amy stopped investing). He invests $3,600 per year for 30 years (twice as long as Amy!) at an 8-percent interest rate.
John’s Investments
Investment with Compound Interest
At age 40
$0
At age 70
$450,000
John literally saves twice as many years as Amy (30 years vs. 15 years) and still ends up with half of what Amy had by age 70 years old ($450K vs. $1million). This example shows how important it is to start saving for retirement earlier rather than later, in order to take advantage of compound interest!
Amy & John example is for illustrative purposes only. The charts above do not represent the performance of any specific investment. This example assumes no withdrawals, expenses and tax consequences.
4. How do I start investing and saving? I always use a doctor analogy to help guide clients when they ask this question:
Self-directed accounts (Vangaurd, T.Rowe Price, Charles Schwab, etc.): this is like using WebMD or self-medicating when your sick. Sometimes, when you have a cold an over-the-counter prescription totally makes sense! Also, some people have gone to schools (medical, nursing, etc.) where they feel comfortable diagnosing themselves. Similarly, with these types of accounts you’ll add money and choose the investments yourself. Perhaps you have the time and enjoy doing investment research. This is the cheapest option.
Robo-advisors (Betterment, Ellevest): these types of accounts I equate to a walk-in-clinic. You know you don’t have anything too serious—i.e. a sinus infection—but know you need some z-pack antibiotic (anyone else have a husband prone to sinus infections?!). You don’t necessarily need a relationship with a doctor for this diagnosis, but you do need a test done by an MD to obtain your prescription. Similarly a robo-advisor will have a bit more guidance than self-directed accounts. Robo-advisors are still inexpensive, but typically more money than self-directed accounts. You don’t have much flexibility with investments here—you’re usually put into a model investment portfolio—and if you call you may or may not speak to a person on the line to help discuss your account, but it likely won’t always be the same person that you may develop a relationship with.
Financial advisors: working with a financial advisor is like having a general practioner that you completely trust. You don’t have to re-explain that the birthmark on your left arm is not cancerous and that you have a gluten-intolerance. Similarly, a financial advisor will know all of the in’s and out’s of your relationship and will make new, timely, and relevant suggestions each time you meet for you personal financial goals. It’s a long term relationship. But as they say, you get what you pay for. So you this is the most expensive option, but typically the one where you receive the most guidance.
I can truly continue providing more information on this topic—I’m so passionate about it! But I hope this was a good initial taste of the world of retirement and investment savings. Again, I encourage you to reach out to me if you want to learn more: mjohndrow@farmingtonriverfg.com
Three disclaimers:
1. I cannot answer your questions directly on the blog due to Compliance. Feel free to email me and I’ll answer any questions you may have. Perhaps Meg and I will do a roundup once this series is over to answer all the questions in an additional post.
2. Securities and advisory services offered through Commonwealth Financial Network, member FINRA/SIPC, a registered investment adviser.
3. All examples used in this blog post are hypothetical examples, and do not take into consideration the fees, expenses, and charges with investing, and are for illustrative purposes only. No specific investments were used in this example. Actual results will vary. Past performance does not guarantee future results.
