Everyone desires the sure thing, the safest path, and the most unquestionable of choices. But life is full of uncertainty, and there is no time like the present to see this. With uncertainty comes risk. Only gamblers find risk compelling. And that’s because they know how to manage it (or at least they think they do). Typically, though, no one likes risk.
Crossing the threshold into retirement magnifies the uncertainty you must deal with. Wouldn’t it be to your advantage to fully understand what those experienced with retirees see as the major problems people have when they retire? Here are five such problems for you to think about and possibly prepare for.
If you don’t plan, you plan to fail. The same goes for organizing your finances. Of the problems mentioned in this article, organizing your finances ranks as the one you should do well before you retire. By getting things in order in advance of retirement, you’ll better prepare yourself for the choices you have to make. “The main problem people face upon retirement is organizing their financial lives and finding new purpose,” says Robert Reilly, a member of the finance faculty at the Providence College School of Business and a financial advisor at PRW Wealth Management in Boston.
“If they have not already done some formal financial planning, replicating their old paycheck can be a daunting task. Most workers are used to a certain cycle for their paycheck and had a routine in place to pay their monthly bills. Significant time and effort can be required to figure out a new budget, new payment methods for healthcare and other major bills.”It’s natural to have several questions when you retire. Organizing your finances represents the best way to tackle the uncertainty of retirement.
“The two cornerstone questions faced by those anticipating retirement are ‘Am I going to be OK?’ and ‘Can I afford to financially support the lifestyle I have worked all my life toward?’ Neither of these questions can be answered with the level of accuracy and confidence that people want until they have taken the time to organize their thoughts about what being OK in their retirement looks like,” says Doug Dahmer, CEO and founder of Retirement Navigator in Burlington, Ontario.
“Retirees significantly underestimate the amount of cash flow that can be uncovered during retirement by employing a strategically sound drawdown strategy. The financial impacts are often measured in the hundreds of thousands of dollars. However, there is no way to optimize a retirement lifestyle plan that cannot be successfully funded and there is no way to develop a strategically sound retirement funding strategy without the granularity of understanding where the peaks and valleys of year-to-year spending occur.
As such, they must organize their thoughts and pre-test their expectations as it relates to their specific version of knowing they will ‘be okay’ once they have retired.”
Transitioning to a new lifestyle
Once you step into the river of retirement, you’ll find yourself immersed in a different current. It’s not the first time you’ve entered a whole new world, but it’s probably been a long time since you’ve had that experience. As mentioned above, the first challenge—or self-doubt—will center on money. But, in the end, it comes down to your ability to live a new life.
“The main problems I see as a wealth advisor often hit several areas,” says Clint McCalla, Senior Wealth Manager at LourdMurray in San Diego. “A big one is not saving enough based on the lifestyle the retiree wants. They simply can’t afford to do the things they want to do. The other problem is boredom or a loss of purpose.
I also see relationship issues emerge between significant others as you are now potentially spending more time together, which is an adjustment. For anyone going through this transition, you need to be realistic about how quickly you adapt to a new lifestyle. It isn’t going to happen overnight. Take time to figure it out, and don’t pressure yourself to meet the expectations you had going into retirement.”
The greatest problem is usually the one you least expect. When it hits, it hits big. It means you haven’t prepared for it. As a result, it leads to anxiety. The angst can be justified, or it can simply result from your being surprised. “The biggest challenge people face when they retire is failing to account for inflation,” says Chris Kampitsis, a financial planner at The SKG Team at Barnum Financial Group in Elmsford, New York.
“They assume falsely that the amount they will need to withdraw in year one is the same amount they might need to withdraw in year ten or twenty. People also drastically underestimate their spending. Conversely, they also tend to overestimate how much they can safely withdraw from their nest egg.”
Inflation, even when it trickles in, will have ramifications deep into retirement. It’s one reason financial professionals suggest you keep a significant portion of your retirement savings in long-term investments. This will allow your portfolio to grow even in retirement.
“The main issues for retirees are replacing income in an inflationary environment, preparing for unknown future healthcare costs and long-term care costs, and feeling confident to spend money when they have been good savers,” says Emily C. Rassam, senior financial planner at Archer Investment Management in Charlotte, North Carolina. “I met with a client who is afraid to start distributions even though she has saved well and has plenty to cover current distributions and future expenses.”
All the above problems can lead to the most vexing of worries, that of financial insecurity. This feeling isn’t all bad, as it represents a defensive tactic that can help protect you from the worst-case scenario. “People usually just don’t have enough to retire,” says Bob Chitrathorn, CFO CFO-0.4% and vice president of Wealth Planning at Simplified Wealth Management in Corona, California.
“They simply retire and will try to make do with what they have, without knowing how long the amount of money they have may or may not last! There are many factors that can compound your fears concerning money. Working longer may exasperate this (although it may also offer advantages.) “The main problems people face when they retire are financial insecurity, health issues and social isolation,” says Derek Miser, investment advisor and CEO at Miser Wealth Partners in Knoxville, Tennessee.
“Many people rely on their pension income to survive, and if this income is reduced due to higher retirement age, it can cause financial hardship. Health issues often become more prevalent in older age, and these may only be compounded by working longer. Also, many people struggle with social isolation when they retire, as they can lose touch with their work colleagues and struggle to find a new sense of purpose.”
Just because you make it through the money-related obstacles doesn’t mean you won’t have problems in retirement. For example, do you know the answer to this question: What is the meaning of your life? Discovering the answer for you is easier to know than you think. Still, fewer spend the time and effort needed to look into themselves. The lack of purpose becomes more apparent once you retire.
“The main problems people face when they retire depends on the situation,” says Anna Rappaport, member and volunteer of the Society of Actuaries in Chicago. “For example, some people have major financial challenges, and others do not; some get depressed and bored. People need to contribute and have purpose in life. If their main purpose was their job, they need to find a new passion and/or purpose. Also, many people retire not by choice–either due to job problems, health issues or their family needing them as caregivers.”
These non-monetary problems can be more detrimental than issues dealing with the financial side of your life. Fortunately, they can be addressed in the same way. “Retirement can be a challenge for many, and it is a bit of an archaic construct,” says Lawrence Sprung, founder of Mitlin Financial in Hauppauge, New York. “The concept was built when people’s life expectancies were much lower.
There can be a tremendous loss of purpose for those that retire early, putting them in a position not to experience joy and undergo mental health struggles. Just like you financially plan for retirement, you need to plan mentally too.” Don’t underestimate the loss of purpose. During your career, you had a regular schedule. That gave your life purpose. You might even think it gave your life meaning. This all changes in retirement.
“One of the main problems people face when they retire is a lack of purpose and meaning in their lives,” says Dennis Shirshikov, the Head of Growth for Awning.com in New York City and a professor at the City University of New York, where he teaches finance, economics, and accounting. “Many retirees struggle with feelings of boredom, loneliness, and isolation, which can lead to depression and other mental health issues.”
Whether it’s financial problems or mental hurdles, retirement presents a challenge. Are you ready to take on that challenge? And what will you do to address these challenges? There are answers you can consider.
Even the name of the system inspires energy and passion. Are you ready to set your life on FIRE?
FIRE is Finance and Philosophy
FIRE (short for Financial Independence, Retire Early) is served in many flavors, all of which are based on core ingredients listed on Reddit’s financial independence sub-reddit.
At first blush, the principles look like they’ve been copied and pasted from your garden-variety personal finance blog: spend less, grow your income, harness the power of compounding. But FIRE really is more of a life philosophy than anything, combining personal finance with a DIY work ethic, opportunistic side hustles, life hacking, and the tenets of anti-consumerism.
Where the FIRE community definitely breaks from the personal finance pack is in its approach to spending and saving.
Set Your Savings on Fire
Perhaps you’ve already internalized the lessons of investing in low-cost, tax efficient mutual funds; of contributing just enough to your 401(k)s to get the employer matching; of padding the pot with some part-time work or other side hustle that brings in cash. That’s great, but it’s probably not enough to achieve FIRE.
When it comes to saving, FIRE does not screw around. According to the aforementioned sub-reddit, FIRE’s adherents strive “to save a large percentage (generally more than 50 percent) of your income to accelerate achieving FI.” This is quite a break from the dismal US savings rate, which clocked in at 2.7 percent in 2016. Layer in our proclivity for debt (and lingering student loans) and you can see that FIRE is an indirect rebellion against consumerism.
Now, there are two ways to boost your savings: by (not-so-easily) increasing your income or by (painstakingly, but anyone can do it) reducing your spending. Guess FIRE comes down on that one? “Your wants and needs aren’t written in stone, and less spending is powerful at any income level,” the financial independence subreddit reminds us.
And yet it’s one thing to cut spending here and there, and quite another to follow the FIRE principle of “simplifying and redesigning your lifestyle to reduce spending.”
Just researching this story, though, I picked up some non-obvious behaviors that, put to regular use, might help me hit an aggressive savings goal, while simultaneously improving my quality of life. For example, I could take advantage of living in a dense and bike-able city to cut down on commuting expenses, all the while forcing myself to exercise. And instead of eating out, an alternative “affordable luxury” could be learning to cook.
This could even become a productive family bonding activity that also satisfies a creative urge, all the while improving our health (and of course saving money). The next level of FIRE includes elaborate strategies around credit-card churning and travel hacking, neither of which are for the fainthearted. The former involves signing up for new credit cards to capture the bonus (typically cash or airline miles), hitting the minimum spend, and then canceling before you have to pay the annual fee.
To hit the minimum spend (and liberate yourself to move on to the next card) there are more aggressive strategies like buying gift cards to places where you know you’ll shop in the future (i.e. Target or Amazon) or prepaying large expenses like insurance. While churning can be a profitable activity, it requires meticulous organization (one missed payment can wipe out the gains) and can hurt your credit in the short-term.
Most of the rewards from churning are in the form of airline miles. Travel hacking is the practice of arbitraging these miles to get the, umm, most mileage. Travel hackers delight in the fact that each accumulated point has a plethora of conversion options to maximize its value as a mile. A vanilla airline mile is generally understood to be worth 1 cent to 1.5 cents, yet travel hackers boast about redeeming a first class flight at what equates to amounts as high as 9.7 cents per mile.
What makes these sacrifices worthwhile? The holy grail is getting your total savings to equal 25 times your annual spending, a calculation implied by the Safe Withdrawal Rate, or SWR. The SWR, generally accepted to be 4%, is the amount one can safely withdraw from their nest egg, without risking running out of money.
Makes Sense, but it Ain’t for Me
Thankfully there are different kinds of FIRE to fit different kinds of lifestyles. There’s FatFIRE, for example, for those living in high cost cities (i.e. requiring $2 million of savings in New York City) while seeking to achieve FIRE with a “great lifestyle;” and leanFire for those capping expenses at under $40k.
Still unconvinced that FIRE is for you? Consider the final principle on Reddit’s main financial independence page: Discovering and achieving life goals: “What would I do with my life if I didn’t have to work for money?”
This cuts to FIRE’s existential core and applies to everybody. What is the relationship between your happiness and your money? What is freedom from the corporate grind worth to you—but more importantly, what would you do with this newfound freedom? For those of us slogging away at our desks decades away from retirement, it might feel like a moot point. But are we just subconsciously avoiding contemplation of the deeper meaning of our lives?
Mr. Money Mustache (nee Peter Adeney) is the frugality movement’s de facto chief evangelist. A former software engineer who blogs about personal finance, he says he and his wife cut back on spending and regularly saved two-thirds of their salaries, enabling them to retire in their early 30s. Free from the grind, Adeney theorizes that money obfuscates our understanding of ourselves and that FIRE is a mere beacon toward happiness. As he once told the Mad Fientist’s Financial Independence podcast:
By understanding what happiness means and helping to decouple the idea of happiness from owning certain things, you can really amaze yourself at how fun your life can be—because that’s the whole secret to living a rich life; it’s not feeling like you need more than you already have. … [R]etirement and early retirement and financial independence, it’s really a quest for happiness. So study that independently of the money, and then that makes the money part easier.
Many older workers are not proactive about taking steps to help ensure they can work as long as they want or need, one expert said. (Photo: Getty Creative)
Many workers are staying on the job longer or plan to before going into their golden years. More retirees said they retired at ages 66-69, rising from 11% in 2021 to 14% in 2022, according to the latest annual survey by the Employee Benefit Research Institute (EBRI) and Greenwald Research.
And 7 in 10 workers expect to work for pay as a source of their retirement income, and 1 in 5 are counting on it as a major source, according to the EBRI poll. A growing percentage of workers say they will never retire – 15% in 2022, up from 10% in 2021, according to the EBRI survey.
Unfortunately, expectations of working in retirement can backfire. For workers who plan to work in some fashion for pay after they retire, that desire still appears to be more of a nice notion than a reality. Only 27% of retirees have employment income, according to the EBRI poll.
‘Sad commentary that health insurance has to be such a big factor’
That desire to remain employed is backed up by other recent surveys. More than half of workers (57%) plan to work in retirement citing a variety of reasons ranging from the income to keeping their brains alert, or the social connection, according to the most recent study by the nonprofit Transamerica Center for Retirement Studies.
The specter of soaring medical costs alone is stomach-churning. The average couple age 65 retiring this year and enrolled in Medicare may need approximately $315,000 saved (after tax) to cover healthcare expenses in retirement, according to the Fidelity Retiree Health Care Cost Estimate.
That’s what motivated Russ Eanes, an author, to get back in the workforce after retiring five years ago from his job as chief executive at MennoMedia, a book publisher. A year ago, he went back to work at GetSetUp, an interactive website that delivers virtual education to older adults.
The impetus: A steady paycheck and access to a health insurance plan.
“It’s a sad commentary that health insurance has to be such a big factor in these decisions,” Eanes told Yahoo Money.. “I’m on Medicare as of February, but my wife is a year behind, so we have to scramble to figure out how to have her covered for another year. While I was making out okay as a freelancer, it can be feast or famine.”
Older workers are not always ‘proactive’
But getting back to work or staying employed is not always easy, and in some cases, it can be the workers themselves who short-change their ability to stay on the job longer.
“Many 50+ workers are not proactive about taking steps to help ensure they can work as long as they want and need,” Catherine Collinson, CEO and president of nonprofit Transamerica Institute and Transamerica Center for Retirement Studies, told Yahoo Money. “Among those employed by for-profit companies, our research showed that only 62 % are focused on staying healthy so they can continue working and just 44% are keeping their job skills up to date.”
Only a small percentage are networking and meeting new people (16%), taking classes to learn new skills (12%), scoping out the employment market and opportunities available (10 %), attending virtual conferences and webinars (9%), or obtaining a new degree, certification, or professional designation (5 %), Collinson said.
Meantime, more than 2 in 5 workers expect a gradual transition to retirement, according to the EBRI survey.
In reality, “only a fraction of companies offer employees the option of a phased retirement,” Collinson said. “Our most recent employer survey finds 27% of employers offer a formal phased retirement program.”
Even more troubling– nearly half of retirees retired earlier than they planned.
“Back-to-work plans can be upended by unexpected health challenges and caregiving demands,” Nancy Collamer, a retirement coach and author of “Second-Act Careers: 50+ Ways to Profit from Your Passions During Semi-Retirement,” told Yahoo Money.
The median expected retirement age for workers — age 65 — and the reported retirement age of retirees —age 62, according to the EBRI survey. Two-thirds said their early retirement was for a reason out of their control, such as a health problem or disability, company downsizing or reorganizations, or caregiving for a loved one.
Some of those reasons were amplified by the pandemic.
Since March 2020, 1.1 million more Americans between the ages of 55 and 74 retired earlier than what would have been expected during normal times, according to a recent report from The New School’s Schwartz Center for Economic Policy Analysis. The number of those who retired involuntarily a year after losing a job was 10 times higher than pre-pandemic times, the report found.
‘Beginning to feel the impact of inflation’
This trend may be shifting. As of March 2022, 3.2% of workers who were retired just one year ago are now employed again, according to research by Nick Bunker, the director of economic research at Indeed Hiring Lab.
One caveat: while the EBRI Retirement Confidence Survey was conducted as the inflation rate had already begun its rapid rise, and at that time, the majority of workers and retirees reported being confident that they had enough money to keep up with inflation in retirement, the economic picture is grimmer now.
With the inflation rate at 8.3% in April of 2022, down slightly from 8.5% in March, which was the highest since December of 1981, and the S&P 500 index off its January peak by 16.6%, that exuberance may be fading.
“Some workers are beginning to feel the impact of inflation, and the number is likely to grow,” Copeland said. “How the economy evolves over the next few months is likely to result in workers reconsidering where they stand regarding retirement. If inflation continues at historic rates and the stock market continues falling, more workers will be reevaluating their retirement plans.”
If things you thought were true were actually wrong, when would you want to know? When I was a child, I recall my mother saying that drinking and driving was against the law. For many years after that, whenever I saw someone drinking a soda while driving, I assumed they were criminals. Years later, I figured out that my mother was talking about drinking alcohol while driving.
I can laugh at the absurdity of this today, but it is the perfect example of how easy it can be to carry around half-truths when you don’t know what you don’t know.
Many people go through life believing things without ever considering the possibility that those things are actually wrong. I see it every day in nearly every conversation I have with people: the misinterpretation of financial terms, the misapplication of various wealth strategies and confusion about how much risk they are actually taking.
Why does this happen? Well, the internet gives everyone instant access to unlimited amounts of information. Unfortunately, there is rarely any context, and we have a tendency as human beings to process information as true or false based on the source and a basic understanding of the topic. If Google says it, then it must be true! As a result, people end up with a false sense of confidence and a laundry list of beliefs that aren’t necessarily true.
Misconceptions come with costly consequences
Your financial future rests on your understanding of what you’re doing and why you’re doing it, and the consequences are real. Any misinterpretations you may have about money could potentially destroy your quality of life and reduce your chances of experiencing true financial freedom.
The biggest obstacle to unlearning something you have always thought was true is to accept the possibility of having inaccurate information. Once you do that, unlearning bad financial information is not as complicated as you may think.
The biggest misconception I see over and over again is the focus on accumulation. People tend to evaluate their progress or level of financial success based on how much money they accumulate. While having money in the bank is important, reliable cash flow should be the ultimate goal.
Think about it: You can survive without any money accumulated, but you cannot easily get by without cash flow. Cash flow can be generated in any number of ways: a paycheck from your job, a business you own or a passive-income source. Regardless of where it comes from, cash flow is like water – you simply cannot survive without it. (To see some strategies for increasing cash flow in retirement, check out my Cash Flow Guide (opens in new tab).)
How to know if your money is fulfilling its primary purpose
Money is obviously a big part of our lives, so we have a tendency to desire more of it. But how do you decide how much is enough?
What I find is that people often use arbitrary account balances and rates of return to assess how much progress they have made, but neither of these things actually indicates whether your money is fulfilling its primary purpose: income replacement, also known as cash flow.
While having money is, of course, part of the equation, it is the wrong measurement for success. A lot of people with plenty of money still struggle with not feeling financially free or confident, and that is a problem.
Achieving financial confidence starts with answering these two questions:
How much actual income do you have coming in right now that you don’t have to work to receive? I am talking about actual dollars being deposited into your checking account or brokerage account.
If you quit working tomorrow, how much money would you need to cover all of your expenses? This includes taxes, trips, lifestyle expenses, etc.
If you’re like most people, there is a gap between how much income you’re receiving and how much you need. (That is why you work, to fill that gap.) If you want to stop working, you’ll need to figure out how to close this gap with passive income.
How is financial security different from financial freedom?
So, how do you do that? Start by understanding the difference between financial security and financial freedom.
The idea of financial security cannot necessarily be defined by exact numbers or percentages and is often expressed as a feeling of safety. That’s why most people focus on reducing debt and accumulating money. They believe that spending less, paying less in interest and earning more on their investments is what will lead them to a successful retirement.
Having large sums of money brings a sense of financial security, but it does not create financial freedom. If you’re like most people, knowing creates more confidence than assuming, and a good way to know is to complete a Gap Report™. (Get your GAP Report™ here (opens in new tab).)
Security vs. independence vs. freedom
I speak with people every week who have millions of dollars saved but don’t feel financially free. They say things like, “I think I will be OK,” or “I feel OK with what I have,” but their word choices — “I think” and “I feel” — say it all: They are not confident.
In short, if you have large sums of money, but you are still working to support your income needs, worried about market returns or uncertain about the future… that is not freedom.
There is a middle ground where you have both financial security and lifestyle flexibility in the short term, which I refer to as “financial independence.” For instance, many business owners have companies or real estate that create a revenue stream. Their business runs without their full attention, allowing them flexibility to do what they want when they want, but they must still contribute at some level in order to maintain their income sources.
Rental properties are the perfect example of great cash flow machines that generate income to potentially support your lifestyle and help you achieve financial independence. It is obviously a good thing to have these assets growing and producing income, but it still takes time and effort.
You may have a pretty great life collecting rent from your tenants, but the simple fact that you must collect it is work, not to mention addressing repairs and upkeep, managing expenses and (worst of all) dealing with unhappy people.
There is nothing wrong with running a business to provide cash flow. For some people, their business is their passion, but it is difficult to achieve true financial freedom when the business income relies upon you showing up.
This is why many people who have considerable rental properties often cash out and move to sources of passive income — because they want true financial freedom.
A true source of passive income is one where you don’t have to do anything to generate it, including Social Security, pensions, annuities, private markets and royalties.
Now, we can argue about the definitions of financial security vs. independence vs. freedom, but that would be missing the point.
Passive income is the path to financial freedom
Failing to understand the differences comes with a cost. If the point is to have enough passive income to cover your cash flow needs, why would you spend thirty-plus years measuring your progress based on account balances and rates of return?
As you can see, words matter, and definitions are important. These conflicting ideas could be why so many people think that they are on the path toward achieving freedom but never seem to reach it. They fall short of the goal because they don’t truly understand what is needed to have financial freedom and are steadfast on accumulating assets.
We all know we need to save for retirement, but it can be tricky to know which of all the various tax-advantaged accounts to prioritize with our limited savings. Making the wrong choice could cost us in higher taxes, less flexibility, or even missing out on free money. Here are some factors to consider in prioritizing your retirement savings:
Did you max out a Roth IRA?
The main advantage of a Roth IRA is that any earnings are tax-free as long as you’ve had the account open for at least 5 years and are over age 59 1/2. However, you can also withdraw the sum of your contributions for any reason with no tax or penalty in the meantime. Any earnings you withdraw before 5 years and age 59 ½ may be subject to taxes and a 10% penalty, but the contributions come out first. (Exceptions to the 10% penalty include education expenses and up to $10k for a first-time home purchase.)
Since you always have access to the contributions, they can double as part of your emergency fund. If you already have emergency savings, you can simply contribute them to a Roth IRA up to the annual limit. Just be sure to keep the Roth IRA somewhere safe and accessible like a savings account or money market fund until you’ve built up an adequate emergency fund (enough to cover at least 3-6 months’ worth of necessary expenses) somewhere else. At that point, you can invest the Roth IRA more aggressively to grow tax-free for retirement.
If you don’t have an emergency fund, having at least a few thousand dollars in cash reserves should be your first priority. Otherwise, you could find yourself raiding another retirement account (and possibly paying early withdrawal penalties) or falling behind on rent, mortgage or car payments in an emergency. Having to complete a withdrawal form to tap your Roth IRA could also discourage you from tapping it for frivolous things.
If your income is too high to contribute to a Roth IRA, you can contribute to a traditional IRA and then convert it to a Roth IRA. As long as you don’t have any other pre-tax IRA money, you only pay taxes on the earnings you convert. If you do have other pre-tax IRA money, see if you can roll them into your employer’s retirement plan by the end of the year to avoid some tax complications.
Does your employer match retirement plan contributions?
If so, maxing that match should be your next priority. Where else are you going to get a guaranteed return on your money? Don’t leave that free money on the table! Of course, you also get all the other benefits of your retirement account like pre-tax contributions or tax-free growth, possibly low cost or unique investment options, the ability to borrow against it and pay yourself the interest, and creditor protections.
Are you eligible to contribute to a health savings account (HSA)?
If you’re enrolled in a qualified high-deductible health insurance plan, you can make pre-tax contributions to a health savings account and use the money (and any earnings) tax-free for qualified healthcare expenses. Whatever you don’t spend on health care now can typically be invested and used for any purpose penalty-free after age 65 as part of your retirement savings.
The money could also be used tax-free to pay for qualified medical expenses in the future, including some Medicare and long-term care insurance premiums. When you consider that you’ll most likely have medical expenses in retirement, you might even want to try to pay for healthcare costs from other savings. This allows the HSA money to grow as long as possible to be used tax-free for healthcare costs in retirement.
Are you eligible to contribute to a 457 plan?
This retirement account is available to many public sector employees and has the same tax benefits and contribution limits as a 401(k) and 403(b). However, there is no early withdrawal penalty. This added flexibility gives it a priority over the others if you’re under age 55.
Have you maxed out your employer’s retirement plan?
If not, this should be your next priority for all the non-match reasons given under #2. Keep in mind that even if you’ve hit your pre-tax/Roth limits, your plan may allow you to contribute after-tax. You can then convert the after-tax dollars to a Roth account so they can then grow to eventually be tax-free. Some plans allow you to do a Roth conversion while you’re working there. Otherwise, you can roll the money to a Roth IRA.
Are you investing tax-efficiently outside tax-advantaged accounts?
If you’ve maxed out all of your eligible tax-advantaged accounts, you can still save and invest for retirement in a regular investment account. Since your interest, dividends, and capital gains will be taxed each year, you’ll want to use this account for the investments that generate the least taxes. That means individual stocks and ETFs, low turnover mutual funds, and municipal bonds. Taxable bonds, high turnover mutual funds, and REITs should be held in the tax-sheltered accounts as much as possible.
If you’re not sure how to do that, it could be a good reason to hire a financial advisor or use a tax-aware robo-advisor. As you can see, knowing which accounts to contribute to first isn’t always straightforward. If you’d like additional help making this decision, consider consulting a qualified and unbiased financial professional. Don’t let this lead to analysis paralysis though. Contributing to a less than ideal account is still much better than not contributing at all.
Since their introduction in the early 1980s, defined contribution (DC) plans, which include 401(k)s, have all but taken over the retirement marketplace. Roughly 86 percent of Fortune 500 companies offered only DC plans rather than traditional pensions in 2019, according to a recent study from insurance broker Willis Towers Watson.
The 401(k) plan is the most ubiquitous DC plan among employers of all sizes, while the similarly structured 403(b) plan is offered to employees of public schools and certain tax-exempt organizations, and the 457(b) plan is most commonly available to state and local governments.
The employee’s contribution limit for each plan is $20,500 in 2022 ($27,000 for those aged 50 and over).
Many DC plans offer a Roth version, such as the Roth 401(k) in which you use after-tax dollars to contribute, but you can take the money out tax-free at retirement.
“The Roth election makes sense if you expect your tax rate to be higher at retirement than it is at the time you’re making the contribution,” says Littell.
A 401(k) plan is a tax-advantaged plan that offers a way to save for retirement. With a traditional 401(k) an employee contributes to the plan with pre-tax wages, meaning contributions are not considered taxable income. The 401(k) plan allows these contributions to grow tax-free until they’re withdrawn at retirement. At retirement, distributions create a taxable gain, though withdrawals before age 59 ½ may be subject to taxes and additional penalties.
With a Roth 401(k) an employee contributes after-tax dollars and gains are not taxed as long as they are withdrawn after age 59 1/2.
Pros: A 401(k) plan can be an easy way to save for retirement, because you can schedule the money to come out of your paycheck and be invested automatically. The money can be invested in a number of high-return investments such as stocks, and you won’t have to pay tax on the gains until you withdraw the funds (or ever in a Roth 401(k)). In addition, many employers offer you a match on contributions, giving you free money – and an automatic gain – just for saving.
Cons: One key disadvantage of 401(k) plans is that you may have to pay a penalty for accessing the money if you need it for an emergency. While many plans do allow you to take loans from your funds for qualified reasons, it’s not a guarantee that your employer’s plan will do that. Your investments are limited to the funds provided in your employer’s 401(k) program, so you may not be able to invest in what you want to.
What it means to you: A 401(k) plan is one of the best ways to save for retirement, and if you can get bonus “match” money from your employer, you can save even more quickly.
A 403(b) plan is much the same as a 401(k) plan, but it’s offered by public schools, charities and some churches, among others. The employee contributes pre-tax money to the plan, so contributions are not considered taxable income, and these funds can grow tax-free until retirement. At retirement, withdrawals are treated as ordinary income, and distributions before age 59 ½ may create additional taxes and penalties.
Similar to the Roth 401(k), a Roth 403(b) allows you to save after-tax funds and withdraw them tax-free in retirement.
Pros: A 403(b) is an effective and popular way to save for retirement, and you can schedule the money to be automatically deducted from your paycheck, helping you to save more effectively. The money can be invested in a number of investments, including annuities or high-return assets such as stock funds, and you won’t have to pay taxes until you withdraw the money. Some employers may also offer you a matching contribution if you save money in a 403(b).
Cons: Like the 401(k), the money in a 403(b) plan can be difficult to access unless you have a qualified emergency. While you may still be able to access the money without an emergency, it may cost you additional penalties and taxes, though you can also take a loan from your 403(b). Another downside: You may not be able to invest in what you want, since your options are limited to the plan’s investment choices.
What it means to you: A 403(b) plan is one of the best ways for workers in certain sectors to save for retirement, especially if they can receive any matching funds. This 403(b) calculator can help you determine how much you can save for retirement.
A 457(b) plan is similar to a 401(k), but it’s available only for employees of state and local governments and some tax-exempt organizations. In this tax-advantaged plan, an employee can contribute to the plan with pre-tax wages, meaning the income is not taxed. The 457(b) allows contributions to grow tax-free until retirement, and when the employee withdraws money, it becomes taxable.
Pros: A 457(b) plan can be an effective way to save for retirement, because of its tax advantages. The plan offers some special catch-up savings provisions for older workers that other plans don’t offer, as well. The 457(b) is considered a supplemental savings plan, and so withdrawals before age 59 ½ are not subject to the 10 percent penalty that 403(b) plans are.
Cons: The typical 457(b) plan does not offer an employer match, which makes it much less attractive than a 401(k) plan. Also, it’s even tougher to take an emergency withdrawal from a 457(b) plan than from a 401(k).
What it means to you: A 457(b) plan can be a good retirement plan, but it does offer some drawbacks compared to other defined contributions plans. And by offering withdrawals before the typical retirement age of 59 ½ without an additional penalty, the 457(b) can be beneficial for retired public servants who may have a physical disability and need access to their money.
An IRA is a valuable retirement plan created by the U.S. government to help workers save for retirement. Individuals can contribute up to $6,000 to an account in 2022, and workers over age 50 can contribute up to $7,000.
There are many kinds of IRAs, including a traditional IRA, Roth IRA, spousal IRA, rollover IRA, SEP IRA and SIMPLE IRA. Here’s what each is and how they differ from one another.
A traditional IRA is a tax-advantaged plan that allows you significant tax breaks while you save for retirement. Anyone who earns money by working can contribute to the plan with pre-tax dollars, meaning any contributions are not taxable income. The IRA allows these contributions to grow tax-free until the account holder withdraws them at retirement and they become taxable. Earlier withdrawals may leave the employee subject to additional taxes and penalties.
Pros: A traditional IRA is a very popular account to invest for retirement, because it offers some valuable tax benefits, and it also allows you to purchase an almost-limitless number of investments – stocks, bonds, CDs, real estate and still other things. Perhaps the biggest benefit, though, is that you won’t owe any tax until you withdraw the money at retirement.
Cons: If you need your money from a traditional IRA, it can be costly to remove it because of taxes and additional penalties. And an IRA requires you to invest the money yourself, whether that’s in a bank or in stocks or bonds or something else entirely. You’ll have to decide where and how you’ll invest the money, even if that’s only to ask an adviser to invest it.
What it means to you: A traditional IRA is one of the best retirement plans around, though if you can get a 401(k) plan with a matching contribution, that’s somewhat better. But if your employer doesn’t offer a defined contribution plan, then a traditional IRA is available to you instead — though the tax-deductibility of contributions is eliminated at higher income levels.
A Roth IRA is a newer take on a traditional IRA, and it offers substantial tax benefits. Contributions to a Roth IRA are made with after-tax money, meaning you’ve paid taxes on money that goes into the account. In exchange, you won’t have to pay tax on any contributions and earnings that come out of the account at retirement.
Pros: The Roth IRA offers several advantages, including the special ability to avoid taxes on all money taken out of the account in retirement, at age 59 ½ or later. The Roth IRA also provides lots of flexibility, because you can often take out contributions – not earnings – at any time without taxes or penalties. This flexibility actually makes the Roth IRA a great retirement plan.
What it means to you: A Roth IRA is an excellent choice for its huge tax advantages, and it’s an excellent choice if you’re able to grow your earnings for retirement and keep the taxman from touching it again.
IRAs are normally reserved for workers who have earned income, but the spousal IRA allows the spouse of a worker with earned income to fund an IRA as well. However, the working spouse’s taxable income must be more than the contributions made to any IRAs, and the spousal IRA can either be a traditional IRA or a Roth IRA.
Pros: The biggest positive of the spousal IRA is that it allows a non-working spouse to take advantage of an IRA’s various benefits, either the traditional or Roth version.
Cons: There’s not a particular downside to a spousal IRA, though like all IRAs, you’ll have to decide how to invest the money.
What it means to you: The spousal IRA allows you to take care of your spouse’s retirement planning without forcing your partner to have earned income as would usually be the case. That may allow your spouse to stay home or take care of other family needs.
A rollover IRA is created when you move a retirement account such as a 401(k) or IRA to a new IRA account. You “roll” the money from one account to the rollover IRA, and can still take advantage of the tax benefits of an IRA. You can establish a rollover IRA at any institution that allows you to do so, and the rollover IRA can be either a traditional IRA or a Roth IRA. There’s no limit to the amount of money that can be transferred into a rollover IRA.
A rollover IRA also allows you to convert the type of retirement account, from a traditional IRA or 401(k) to a Roth IRA. These types of transfers can create tax liabilities, however, so it’s important to understand the consequences before you decide how to proceed.
Pros: A rollover IRA allows you to continue to take advantage of attractive tax benefits, if you decide to leave a former employer’s 401(k) plan for whatever reason. If you simply want to change IRA providers for an existing IRA, you can rollover your account to a new provider. As in all IRAs, you can buy a wide variety of investments.
Cons: Like all IRAs, you’ll need to decide how to invest the money, and that may cause problems for some people. You should pay special attention to any tax consequences for rolling over your money, because they can be substantial. But this is generally only an issue if you’re converting your account type from a traditional IRA or 401(k) to a Roth IRA.
The SEP IRA is set up like a traditional IRA, but for small business owners and their employees. Only the employer can contribute to this plan, and contributions go into a SEP IRA for each employee rather than a trust fund. Self-employed individuals can also set up a SEP IRA.
Contribution limits in 2022 are 25 percent of compensation or $61,000, whichever is less. Figuring out contribution limits for self-employed individuals is a bit more complicated.
“It’s very similar to a profit-sharing plan,” says Littell, because contributions can be made at the discretion of the employer.
Pros: For employees, this is a freebie retirement account. For self-employed individuals, the higher contribution limits make them much more attractive than a regular IRA.
Cons: There’s no certainty about how much employees will accumulate in this plan. Also, the money is more easily accessible. This can be viewed as more good than bad, but Littell views it as bad.
What it means to you: Account holders are still tasked with making investment decisions. Resist the temptation to break open the account early. If you tap the money before age 59 ½, you’ll likely have to pay a 10 percent penalty on top of income tax.
With 401(k) plans, employers have to pass several nondiscrimination tests each year to make sure that highly compensated workers aren’t contributing too much to the plan relative to the rank-and-file.
The SIMPLE IRA bypasses those requirements because the same benefits are provided to all employees. The employer has a choice of whether to contribute a 3 percent match or make a 2 percent non-elective contribution even if the employee saves nothing in his or her own SIMPLE IRA.
Pros: Littell says most SIMPLE IRAs are designed to provide a match, so they provide an opportunity for workers to make pre-tax salary deferrals and receive a matching contribution. To the employee, this plan doesn’t look much different from a 401(k) plan.
Cons: The employee contribution has a limit of $14,000 for 2022, compared to $20,500 for other defined contribution plans. But most people don’t contribute that much anyway, says Littell.
What it means for you: As with other DC plans, employees have the same decisions to make: how much to contribute and how to invest the money. Some entrepreneurs prefer the SIMPLE IRA to the SEP IRA – here are the key differences.
Alternatively known as a Solo-k, Uni-k and One-participant k, the Solo 401(k) plan is designed for a business owner and his or her spouse.
Because the business owner is both the employer and employee, elective deferrals of up to $20,500 can be made, plus a non-elective contribution of up to 25 percent of compensation up to a total annual contribution of $61,000 for businesses, not including catch-up contributions.
Pros: “If you don’t have other employees, a solo is better than a SIMPLE IRA because you can contribute more to it,” says Littell. “The SEP is a little easier to set up and to terminate.” However, if you want to set up your plan as a Roth, you can’t do it in a SEP, but you can with a Solo-k.
Cons: It’s a bit more complicated to set up, and once assets exceed $250,000, you’ll have to file an annual report on Form 5500-SE.
Traditional pensions are a type of defined benefit (DB) plan, and they are one of the easiest to manage because so little is required of you as an employee.
Pensions are fully funded by employers and provide a fixed monthly benefit to workers at retirement. But DB plans are on the endangered species list because fewer companies are offering them. Just 14 percent of Fortune 500 companies enticed new workers with pension plans in 2019, down from 59 percent in 1998, according to data from Willis Towers Watson.
Why? DB plans require the employer to make good on an expensive promise to fund a hefty sum for your retirement. Pensions, which are payable for life, usually replace a percentage of your pay based on your tenure and salary.
A common formula is 1.5 percent of final average compensation multiplied by years of service, according to Littell. A worker with an average pay of $50,000 over a 25-year career, for example, would receive an annual pension payout of $18,750, or $1,562.50 a month.
Pros: This benefit addresses longevity risk – or the risk of running out of money before you die.
“If you understand that your company is providing a replacement of 30 percent to 40 percent of your pay for the rest of your life, plus you’re getting 40 percent from Social Security, this provides a strong baseline of financial security,” says Littell. “Additional savings can help but are not as central to your retirement security.”
Cons: Since the formula is generally tied to years of service and compensation, the benefit grows more rapidly at the end of your career. “If you were to change jobs or if the company were to terminate the plan before you hit retirement age, you can get a lot less than the benefit you originally expected,” says Littell.
What it means to you: Since company pensions are increasingly rare and valuable, if you are fortunate enough to have one, leaving the company can be a major decision. Should you stay or should you go? It depends on the financial strength of your employer, how long you’ve been with the company and how close you are to retiring. You can also factor in your job satisfaction and whether there are better employment opportunities elsewhere.
Guaranteed income annuities are generally not offered by employers, but individuals can buy these annuities to create their own pensions. You can trade a big lump sum at retirement and buy an immediate annuity to get a monthly payment for life, but most people aren’t comfortable with this arrangement. More popular are deferred income annuities that are paid into over time.
For example, at age 50, you can begin making premium payments until age 65, if that’s when you plan to retire. “Each time you make a payment, it bumps up your payment for life,” says Littell.
You can buy these on an after-tax basis, in which case you’ll owe tax only on the plan’s earnings. Or you can buy it within an IRA and can get an upfront tax deduction, but the entire annuity would be taxable when you take withdrawals.
Pros: Littell himself invested in a deferred income annuity to create an income stream for life. “It’s very satisfying, it felt really good building a bigger pension over time,” he says.
Cons: If you’re not sure when you’re going to retire or even if you’re going to retire, then it may not make sense. “You’re also locking into a strategy that you can’t get rid of,” he says.
In addition, annuities are complex legal contracts, and it can be difficult to understand your rights and rewards for signing up for an annuity. You’ll want to be fully informed about what the annuity will and won’t do for you.
What it means to you: You’ll be getting bond-like returns and you lose the possibility of getting higher returns in the stock market in exchange for the guaranteed income. Since payments are for life, you also get more payments (and a better overall return) if you live longer.
“People forget that these decisions always involve a trade-off,” Littell says.
The Thrift Savings Plan (TSP) is a lot like a 401(k) plan on steroids, and it’s available to government workers and members of the uniformed services.
Participants choose from five low-cost investment options, including a bond fund, an S&P 500 index fund, a small-cap fund and an international stock fund — plus a fund that invests in specially issued Treasury securities.
Pros: Federal employees can get a 5 percent employer contribution to the TSP, which includes a 1 percent non-elective contribution, a dollar-for-dollar match for the next 3 percent and a 50 percent match for the next 2 percent contributed.
“The formula is a bit complicated, but if you put in 5 percent, they put in 5 percent,” says Littell. “Another positive is that the investment fees are shockingly low – four hundredths of a percentage point.” That translates to 40 cents annually per $1,000 invested – much lower than you’ll find elsewhere.
Cons: As with all defined contribution plans, there’s always uncertainty about what your account balance might be when you retire.
What it means to you: You still need to decide how much to contribute, how to invest, and whether to make the Roth election. However, it makes a lot of sense to contribute at least 5 percent of your salary to get the maximum employer contribution.
Cash-balance plans are a type of defined benefit, or pension plan, too.
But instead of replacing a certain percentage of your income for life, you are promised a certain hypothetical account balance based on contribution credits and investment credits (e.g., annual interest). One common setup for cash-balance plans is a company contribution credit of 6 percent of pay plus a 5 percent annual investment credit, says Littell.
The investment credits are a promise and are not based on actual contribution credits. For example, let’s say a 5 percent return, or investment credit, is promised. If the plan assets earn more, the employer can decrease contributions. In fact, many companies that want to shed their traditional pension plan convert to a cash-balance plan because it allows them better control over the costs of the plan.
Pros: It still provides a promised benefit, and you don’t have to contribute anything to it. “There’s a fair amount of certainty in how much you’re going to get,” says Littell. Also, if you do decide to switch jobs, your account balance is portable so you’ll get whatever the account is worth on your way out the door of your old job.
Cons: If the company changes from a generous pension plan to a cash-balance plan, older workers can potentially lose out, though some companies will grandfather long-term employees into the original plan. Also, the investment credits are relatively modest, typically 4 percent or 5 percent. “It becomes a conservative part of your portfolio,” says Littell.
What it means to you: The date you retire will impact your benefit, and working longer is more advantageous. “Retiring early can truncate your benefit,” says Littell.
Also, you’ll get to choose from a lump sum or an annuity form of benefit. When given the option between a $200,000 lump sum or a monthly annuity check of $1,000 for life, “too many people,” choose the lump sum when they’d be better off getting the annuity for life, says Littell.
Cash-value life insurance plan .Some companies offer insurance vehicles as a benefit. There are various types: whole life, variable life, universal life and variable universal life. They provide a death benefit while at the same time building cash value, which could support your retirement needs. If you withdraw the cash value, the premiums you paid – your cost basis – come out first and are not subject to tax.
“There are some similarities to the Roth tax treatment, but more complicated,” says Littell. “You don’t get a deduction on the way in, but if properly designed, you can get tax-free withdrawals on the way out.”
Pros: It addresses multiple risks by providing either a death benefit or a source of income. Plus, you get tax deferral on the growth of your investment.
Cons: “If you don’t do it right, if the policy lapses, you end up with a big tax bill,” says Littell. Like other insurance solutions, once you buy it, you are more or less locked into the strategy for the long term. Another risk is that the products don’t always perform as well as the illustrations might show that they will.
What it means to you: These products are for wealthier people who have already maxed out all other retirement savings vehicles. If you’ve reached the contribution limits for your 401(k) and your IRA, then you might consider investing in this type of life insurance.
Unless you’re a top executive in the C-suite, you can pretty much forget about being offered an Nonqualified deferred compensation plans (NQDC) There are two main types: One looks like a 401(k) plan with salary deferrals and a company match, and the other is solely funded by the employer.
The catch is that most often the latter one is not really funded. The employer puts in writing a “mere promise to pay” and may make bookkeeping entries and set aside funds, but those funds are subject to claims by creditors.
Pros: The benefit is you can save money on a tax-deferred basis, but the employer can’t take a tax deduction for its contribution until you start paying income tax on withdrawals.
Cons: They don’t offer as much security, because the future promise to pay relies on the solvency of the company.
“There’s some risk that you won’t get your payments (from an NQDC plan) if the company has financial problems,” says Littell.
What it means to you: For executives with access to an NQDC plan in addition to a 401(k) plan, Littell’s advice is to max out the 401(k) contributions first. Then if the company is financially secure, contribute to the NQDC plan if it’s set up like a 401(k) with a match.