401ks have been around for years and have been an ever increasingly popular way to save money for retirement. 

More and more businesses run some type of deferred contribution plan and they are a great way to attract and retain key employees.

401ks are great from an employee standpoint because they are relatively quick to sign up for, fairly easy to pick funds in and once the initial set up has been done, your contributions are taken out of your paycheck automatically. 

It’s an easy way to save.

But, did you know that by contributing to your 401k you could be creating a giant time bomb?  Here’s a look at why:

What is a tax deferred account?

 A tax deferred account is simply an account that allows you to put in pre-tax contributions for retirement.  The money inside grows without having to pay taxes every single year – they are deferred until some time down the road.

Things like 401ks and IRAs and for small business owners – Simple IRAs and SEP IRAs are examples of tax-deferred accounts.

What is a retirement time bomb?

A retirement time bomb is when you put all or most of your retirement savings into these tax-defferred accounts like 401ks and Traditional IRAs.

When you get into retirement and start withdrawing your money, you have to pay taxes on every single dollar you pull out!

At what rate?

It depends, but the money you pull out is taxed as ordinary income, which means for those of you who think your taxes will go down in retirement – you might be in for a big surprise when all of that money is taxed as though you earned it!

For those of you who have socked away a lot of money into tax-deferred accounts for retirement – these have become a ticking time bomb waiting to explode! 

And Uncle Sam is licking his chops!

What should you do about it?

1. Figure out how much you need for retirement
2. Re-evaluate your accounts – determine if you are properly balanced from a tax perspective
3. Consider other options – look at accounts like Roth IRAs to detemine if it’s right for you.
4. Make a plan to diversify from a tax perspective – figure out how muchyou can get into a tax-free bucket and start shifting money either through contributions or Roth Conversions.

What about you?

Are you holding a retirement time bomb?  What have you done to diversify yourself from a tax standpoint?

Remember as a kid how excited you were for your birthday to come?  It couldn’t arrive fast enough!  Presents, cake and everyone making a big deal of you was great! 

You probably couldn’t wait to turn 13 and finally become a teenager.  Then maybe you looked forward to 16 so you could get your license.  18 to vote.  At 21 you could legally drink and 25 got you a discount on your auto insurance. 

After that, you may have spent the rest of your time wishing you were 25 again.

It’s in our nature to look forward to milestones.  After all, they are a rite of passage and a big achievement.

Did you know you’ve got some retirement milestones to look forward to?

Being unaware of these milestones will cost you money!

Milestone #1 – Age 50

In 2002, the government changed the rules on contributions to retirement plans and IRA’s.  They allowed a “catch-up” provision for older individuals.  If you are age 50 or older, you may now contribute an extra $1,000 to your IRA’s and an additional $5,500 to your 401k’s in 2009. 

This is a great deal for those looking to sock some extra cash away for retirement!

Milestone #2 – Age 55

Age 55 is a big deal for those looking to retire early for the simple fact that if you retire or separate from service the year you turn 55 or after, you are allowed to take 401k distributions without getting whacked with a 10% penalty! 

Let me say that again…NO PENALTY for early retirement distributions.  This is known as the “Age 55 Exception”. 

Get this – if you roll your money to an IRA, the deal is off the table.  That’s right, you must leave it in the 401k, but you are allowed to take out as much as you want, whenever you want.

Milestone #3 – Age 59 1/2

I doubt most of you celebrate Half Birthdays, but this is one you’ll want to throw a party for!

This is the traditional age in which you can withdraw your retirement money without fear of Uncle Sam hitting you over the head with a 10% penalty for pre-mature distributions.

Milestone #4 – Age 62

62 is a big age as well for the simply because you can now qualify for Social Security benefits.  It doesn’t mean you have to take them or even that you should take them, but you at least have the option available to you.  Don’t forget it will be a reduced benefit, but a benefit nonetheless.

Milestone #5 – Age 65

At this age you are now qualified to take Medicare, which is social insurance including two main parts.  Part A covers hopsitalization and Part B acts as your medical insurance. 

If at this point you are not receiving Social Security benefits then you need to apply for Medicare and will want to do that three months before you turn 65.

Milestone #6 – Age 66-67

If you were born between 1943 and 1954 then your full retirement age (FRA), or the age in which you can collect 100% of your entitled Social Security benefits is age 66. 

For those born in 1955 you have to wait an additional two months.  The government adds two more months to the waiting period for each year until 1960 (i.e. if you were born in 1958, your FRA is age 66 and 6 months). 

If you were born in 1960 or beyond your FRA is age 67. 

I hear a lot of people tell me “I can’t retire until 67″.  What they usually mean is they can’t collect full Social Security benefits until age 67.  You can retire whenever you want, you just won’t get your full benefits until then.

Milestone #7 – Age 70 1/2

Here is another one of those Half Birthdays, however, this one doesn’t justify much celebration.

In the year you turn 70 1/2 good ol’ Uncle Sam says you MUST start pulling money out of your IRA’s or 401k’s. 

What? Surely that’s a typo right?  Sorry to bear bad news, but you MUST start pulling money out of your retirement plans. 

In effect, Uncle Sam says to you, “Great job saving that big chunk of money in your 401k and deferring the taxes for all these years, we love you, now it’s time to pay the Piper, which is why we love you even more at this age!”

What do I mean by MUST?  Well, if you want to try to get around pulling money out and paying taxes on it, just realize that you will be subject to a 50% penalty on your distribution!!  Ouch!

This is known as RMD or Required Minimum Distributions.  There is a special formula based on life expectancy that the IRS uses to determine your RMD.  See these worksheets at the IRS website for more info.

One last note on the 70 1/2 rule.  This only applies to your pre-tax retirement accounts.  In other words, money that you have not previously paid taxes on.  So, your Roth IRAs (which consist of after-tax money) do not apply when discussing RMDs. 

So What.

Now that you know about these important milestones what should you do about it? 

If you are unsure how much you need for retirement and are trying to decide where to save more money you may want to keep the 70 1/2 rule in the back of your mind.

Regardless of age, it makes sense for you to look into whether a Roth IRA is right for you.  You might be able to contribute to them OR you might be able to convert existing pre-tax money to a Roth IRA.

If you are 50 or older that’s easy – you should be socking away as much as you can for your retirement.

If you want to retire early you might be able to take advantage of the age 55 exception and early Social Security Benefits.

Knowledge is key to making the right decisions when it comes to retirement.  Don’t let your birthdays come and go without taking advantage of opportunities that exist for your retirement.

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“I’d like to retire in 10 years”, Jack said as he sipped his coffee.  “How much do you think I’ll need?”

“It depends” I responded. 

“Well, I read that people these days need at least a million or two to retire comfortably.  Is that right?” Asked Jack as he set his coffee on the desk and leaned forward nervously. 

“Not necessarily.”  I responded.  Jack sat back and sipped his coffee again.  “You know, it really depends on a lot of variables Jack.”

“Like what?”

“Well, for example, what do you plan on doing in retirement?  Do you want to travel the world, play golf every day and buy a lake house?”  I asked.

“I would like to play golf a few times a week and take a nice vacation once or twice a year.  Other than that I live a pretty simple life.”

“OK, that’s a good start, tell me a little more.  Do you owe anything on your mortgage or have any other liabilities?” I asked.

“Yes.  I still owe on my mortgage and I have a home equity loan that I took out to help pay for the kids college tuition” Jack responded. 

“We also have some credit card debt, probably about average for most people right?” Jack asked looking for some reassurance.

“Yeah, a lot of people have those things, but that will have an impact on you.  Have you saved anything for retirement or will you be getting a pension from work?” I asked.

“Yes, I have a 401k  I’ve been saving into for quite a few years and a couple of small Roth IRAs.  Plus I will get a pension from work.” Jack replied.  “But don’t I need 70 or 80 percent of my income in order to retire?  I’m not sure my pension and social security will be enough”

“There are no hard and fast rules Jack” I answered. “Every situation is different.”

“Well, how much will I need to retire then?”

Although the above conversation is fictional, it represents a fairly typical dialogue that I have on a regular basis.  Most people want to know a set dollar amount saved or percentage of income needed for retirement.  Unfortunately, it’s just not that simple.  Here are some things to consider when determining how much you’ll need for retirement.

Photo by Krazy Kake Bakers

 

 

Income & Assets

Take stock of your income.  Will you be receiving Social Security or a pension?  Will you be working part-time, doing consulting work or turning your hobby into a business in retirement?

Have you saved into your 401k or built up other assets that can be used for retirement.  According to a recent study by AARP, a safe withdrawal rate (or percentage you can safely withdraw from your principal without running out) is four percent.  Most people don’t pull out a steady percentage, but typically will do an “as needed” approach.  According to the study, If you have $500,000 saved up, you can safely withdraw $20,000 annually and not tap the principal. 

Expenses & Liabilities

Income and assets are very important, but to me these are the bigger items to look at.  Take inventory of your expenses and liabilities.  Will you need to buy your own health insurance or will you protect against a possible need for assisted living or a chronic illness?  Do you plan on traveling the U.S., buying that golf membership or spending money on a vacation home?  These things will obviously dictate how much income you need? 

Do you still owe on your mortgage and credit cards, or are you debt free?  If you have no debt and a fairly simple lifestyle you will be able to retire on much less than if you want to travel the world and you already have all kinds of liabilities.

Short Answer and Simple Calculation

The short answer to the question, “How much money do I need to retire?” is “It depends”.  Because every person and situation is different there are just no hard and fast rules to help determine what’s appropriate. 

The simplest way to calculate how much you need is to add up all your sources of income and subtract out your planned expenses in retirement.  If there is a shortage, you will need your savings to supplement.  If the amount needed is greater than four percent, then you probably need to save more or push back your retirement date.  If that amount is less than four percent then you have done a good job of minimizing expenses and maximizing your income and assets and your retirement picture looks much better.

Consider these general guidelines as a starting point.  Every situation is different and unique.  If you want to delve more  in depth into this question of how much is needed, there are many great retirement calculators on the web that will also take inflation and your rates of return on your savings into consideration. 

Bottom Line

Save more, spend less, get rid of debt and live a fairly simple lifestyle and you will be headed down the right path.

No doubt most people have heard of a Roth IRA, after all, they’ve been around since 1998.  Although they’ve been available for over 11 years, I’m constantly amazed by how many people are just simply unsure of exactly what they are or what they do. 

The Basics: What is an IRA?

An IRA is simply an Individual Retirement Account (IRA) that provides investors an opportunity to save for retirement in a tax-advantaged way.  Generally, you must wait until 59 1/2 to withdraw the money without IRS penalty. 

A Roth IRA is an Individual Retirement Account named after its legislative sponsor, late senator Bill Roth, that was established in 1998 to provide an alternative method of saving for retirement that offers different tax advantages than the Traditional IRA. 

Features

The main difference between the Traditional and the Roth IRA is how it is taxed.  With a Traditional  IRA, you typically contribute before-tax (with some exceptions) money to the account.  Depending on your eligibility, you can deduct your contributions from your income on your current year taxes.  You receive the tax break now.  The money grows tax-deferred so when you pull your savings out in retirement you have to pay taxes on every single dollar you withdraw at whatever your current tax rate is at the time.

The Roth IRA is just the opposite.  You contribute after-tax dollars to the account and the money still grows tax-deferred.  You cannot deduct your contributions; however, in retirement you can withdraw your money (provided you meet certain qualifications) completely tax free. Not only that, but as long as your Roth IRA has been in existence for five years, your beneficiaries on the account can pull out money income-tax free, so the Roth IRA becomes a nifty estate planning tool as well.

Advantages

1. Obviously the biggest advantage to the Roth IRA is the tax-free withdrawals in retirement.  This can be a huge potential tax savings for you especially if you think tax rates will be going up.

2. The Roth offers more flexibility on withdrawals prior to retirement.  You can withdraw your principal (your contributions)  tax and penalty free at any time during the life of the Roth IRA.  To an undisciplined person might have trouble with this, but someone who runs into a bind an is cash strapped can have a little comfort knowing they have some additional money available.  This is a huge plus compared to the Traditional IRA, where you would pay a 10% penalty on any pre-59 1/2 withdrawals as well as taxes.  

3. Another advantage is that you can contribute to the Roth even if you are covered by an employer-sponsored retirement plan (401k etc).  With the Traditional IRA you are subject to income testing to determine if you could contribute when covered already by a plan  at work. Even if you could contribute, you don’t get to take advantage of the deduction on your taxes.  So the Roth becomes the perfect additional savings plan when you already have a 401k or other employer plan.

 4. For older folks, the fact that you do not have to take withdrawals is a major advantage as well.  With a Traditional IRA, the government forces you to take money out at age 70 1/2 or face a 50% penalty for not withdrawing your savings.  The main reason is of course to generate tax revenue.  Since Roth IRA distributions are tax free, you don’t have to worry about this rule. 

Key Tradeoffs

1. Your contributions are limited.  Currently in 2009, you may only contribute $5,000 and if you are over 50 you can contribute an additional $1,000 for a “catch-up” provision.  Depending on your income, you might be phased out of your contributions.  For example, a couple making between $166,000 and $176,000 will have their contributions limited.  Income over $176,000 disqualifies you for Roth contributions altogether.  Try this online calculator to determine how much you can contribute to a Roth.

2. You still might have to pay taxes on non-qualified distributions.  In order to meet the specifications for a qualified distribution, you must have had the Roth opened for at least five years and meet one of the following:

• Reached age 59 1/2 by the time of the withdrawal
• Withdrawal is due to qualifying disability
• Withdrawal is made for first-time homebuyer expenses (up to $10,000) 

Again, you are still able to withdraw your contributions at any time without penalty or taxes.

3. Tax treatment differs depending on the state.  The tax laws mentioned above correspond to federal law.  Your state may have differing laws for Roth IRAs You should check with your tax advisor to ensure you won’t have to pay state taxes. 

How Do I Get One?

You can open a Roth IRA through any financial institution, bank, life insurance or mutual fund company or even right online through a brokerage website.  Where you establish one primarily depends on your own needs and preferences.  There are many investment options available as well, so consider the types of investments that will suit your needs (i.e. stocks, funds, CDs, ETFs etc).

Contributions must be made by the time you file your tax return. So in essence you have until April 15 of the following year to get your Roth contributions in for the previous tax year. 

The Roth IRA can be a great investment and retirement savings vehicle for many people.  Be sure to do your homework, develop a plan, assess your needs and be comfortable with your decision.