In my experience assisting individuals and families in their retirement planing, I found that my clients are very enthusiastic to discuss the “sexy” side of finance and “hip” investments decisions that have turned to rags or riches. However, when probed about current savings in, let’s say, an employer sponsored tax deferred retirement savings plan, few understood the options. Add on a couple of questions about pending government retirement income benefits and our conversation has gone from the lively banter that keeps our eyes peeled to CNBC to the dry lecture about income taxation from our 11th grade Civics teacher. That’s right. No one wants to talk about the boring benefits that everyone has equal access to. However, I urge anyone planning for a retirement to reacquaint themselves with these important keystones of retirement income.
I was surprised to read on the internet that almost 50 percent of retirees wish they had spent more time in their pre-retirement years learning and taking advantage of their employer-sponsored retirement plan. In most countries, you may choose to carve out a portion of your income today, place it in a “incubator” where it may grow (at least at the rate of inflation), and when you hit a retirement mark as defined by your employer and the government, you may access this account as a source of taxable income to fund your retirement needs. Since this type of account involves the government “giving up” taxes today, be sure to keep your eyes open for any changes in legislation that may affect your opportunities in your employer’s plan.
For example, in the United States, the federal law allowed for individuals over 50 years old to defer $20,000 in 2006. That is quite a significant amount to not pay taxes on today. If I were in the highest US tax bracket, my post tax take home amount from this money would only be $10,600! I would have to find a significantly lucrative (and very risky) post tax investment to get as good of a return in the first year! Although you will have to pay taxes on this pretax investment when it is withdrawn from a retirement “wrapper” account, at retirement you will potentially have more control over your tax rate as you may choose which stream of income to take from where and when. One interesting point, this tax law changed in 2001 and significantly increased that amount that individuals may contribute to a employer and as well as removed the percentage of income limitations.
Prior to 2001 in the U.S., individuals could contribute 20% of earned income or $10,500 in an employer plan (401K). The government passed the Economic Growth Tax Relief and Reconciliation Act of 2001 and, among other things, significantly increased the amount that individuals may contributed to their 401K. Additionally, since older workers will have “less time” to save according to the new system, the law provides for “catch-up provisions” for those over 50. The Internal Revenue Service announced on October 18, 2006, that the limits for 2007 employer -sponsored elective deferrals will be $15,500 and the catch-up provision will be $5000 [source: IRS Bulliten R-2006-162]. Thus, in a mere six years, the amount that an American Worker over 50 may save towards retirement and defer the taxes rose from $10,500 to $20,500. Wow. When the government allows us to elect to reduce our taxable income by $10,000 in such a short period of time – we should pay attention.
As you can see, for the purpose of accumulating retirement assets, it is very important to become friendly with your Benefits Department. Additionally, understanding your investment options will be helpful for you to create your asset allocation. Another very important factor about your employer sponsored retirement plan is the distribution options. It is important to consider the options to receive income from your plan at the beginning stages of your retirement planning. It is especially true in the U.S. that employer-plans (401Ks) will vary greatly from one to another as far as pay-out options. Be sure to gather this information and understand how to choose your income options before you severe service with your employer.
Another piece of our retirement income puzzle is the benefits that we will receive from the government. Although government sponsored retirement benefits vary from country to country, most are based on a mandatory contributory accounts that we must participate in during our working years, and they will offer us a stream of income from the point of initial withdrawal until we die. In many cases the amount of income will increase to remain consistant with inflation. For example, the US Social Security income will increase for current participants by 4.4% in 2007.
It is important to understand that your social security, like most pension plans, pays income in the form of an annuity. That means that the provider will guarantee you a certain amount of money every year from now until you pass away and this calculation is based on the amount of dollars that you have in the system in actuarial calculation based on your age. As a general rule, the U.S. Social Security System will pay you that same amount over your lifetime regardless of when you take your benefits. Early social security, which may be taken any time after age 62, will pay you smaller benefits over a longer period of time. If you wait for the “retirement age,” age 66 for those born between 1943 – 1954, you will receive greater monthly payments for a shorter period of time. Since these numbers are all based on actuarial calculations solely on the life span of the the median population, when to choose your social security is often a personal decision based on your income and health. Another option is to allow your benefits to continue for your spouse after you pass on. Although this option provides some piece of mind, it will reduce your annual income. Unlike your employer plan, there is no “human resources” to help you determine that best option for you and your family. Financial professionals are somewhat knowledgeable on the social security system, but I recommend that individuals do some research on their own. The US Social Security System Website is a fantastic resource for up -to date information and calculators and is located at www.ssa.gov
The same parameters for retirement income also apply to private and state pension plans. It is important to examine all of the factors to determine which might be best for your and your family. Some financial professionals may recommend a strategy called pension maximization which involves the single life pension pay-out and utilizing the supplemental income to fund a life insurance policy to benefit the spouse.
Planning for retirement is a wonderful adventure where we really get to take stock of the assets that we have accumulated and convert them into a stream of income to fund our dreams. Although we may be more enthusiastic to discuss a “hot stock pick” over coffee with our colleagues, two main sources of our retirement income are usually left out of lunch room conversations: employer -sponsored and government-sponsored benefits. However, both change legislatively and are essential to have on a retirement income radar screen. Finally, I simply can not leave two other “biggies” out of an article on retirement planning; they are healthcare and estate planning. Healthcare may be the most crippling financial demon of our retirement funds and estate planning, the greatest opportunity to save on taxes and maximize our legacy. In closing, please remember that your assets are just the vehicle to your retirement dream! Enjoy planning!
