Annual Retirement Savings Targets

Once you know how much you want to save for retirement, you need a plan for building that savings.  Your annual retirement savings target depends on your total savings target, how many years you have until you want to retire and how much risk you are willing to take in your portfolio.  In this post, I’ll provide information you can use to set targets for how much to contribute to your retirement savings each year.

Key Variables

There are several variables that will impact how much you’ll want to target as contributions to your retirement savings each year.  They are:

  • Your total retirement savings target.
  • How much you already have saved.
  • The number of years you are able to contribute to your retirement savings.
  • How much risk you are willing to take in your portfolio.
  • The impact of taxes on investment returns between now and your retirement. That is, what portion of your retirement savings will be in each of taxable accounts, tax-deferred retirement savings accounts and tax-free retirement savings accounts.  For more information on tax-deferred and tax-free retirement savings accounts, check out this post.  I provide a bit more insight on all three types of accounts in these posts on how to choose which assets to buy in which type of account in each of the US and Canada.

Some of these variables are fairly straightforward.  For example, you can check the balances of any accounts with retirement savings that you already have and you can estimate (within a few years, at least) how many years until you retire.

Other variables are more challenging to estimate.  For example, I dedicated a whole separate post to the topic of setting your retirement savings target.

Your Risk Tolerance

Your risk tolerance is a measure of how much volatility you are willing to take in your investments.  As indicated in my post on risk, the more risk you take the higher your expected return but the wider the possible range of results.  My post on diversification and investing shows that the longer period of time over which you invest, the less volatility has been seen historically in the annualized returns.

Here are a few thoughts that might guide you as you figure out your personal risk tolerance.

  • If you have only a few years until you retire, you might want to invest fairly conservatively. By investing conservatively, you might want to invest in money market or high-yield savings accounts that currently have yields in the 1.75% to 2% range.
  • If you have five to ten years until you retire or are somewhat risk averse (i.e., can’t tolerate the ups and downs of the stock market), you might want to invest primarily in bonds (discussed in this post) or bond mutual funds. Depending on the maturity, US government bonds are currently yielding between 1.5% and 2% and high-quality corporate bonds are currently returning between 2.5% and 4%.
  • If you have a longer time period to retire and/or are able to tolerate the volatility of equities (discussed in this post), you might invest in an S&P 500 index fund or an index fund that is even more risky. These funds have average annual returns of 8% or more.

As can be seen, the more risk you take, the higher the average return.  As you are estimating how much you need to save each year for retirement, you’ll need to select an assumption about your average annual investment return based on these (or other) insights and your personal risk tolerance.

Taxability of Investment Returns

In addition to considering your risk tolerance, you’ll need to adjust your investment returns for any taxes you need to pay between the time you put the money in the account and your retirement date.  For this post, I’ve assumed that your savings amount target includes income taxes, as suggested in my post on that topic.  If it does, you only need to be concerned with taxes until you retire in estimating how much you need to save each year.

In the previous section, you selected an average annual investment return.  The table below provides approximations for adjusting that return for Federal income taxes based on the type of financial instruments you plan to buy and the type of account in which you hold it.

US – Taxable

Canada – Taxable

All Tax-Deferred & Tax-Free Accounts

Money Market

Multiply by 0.75

Multiply by 0.75

No adjustment

Bonds and Bond Mutual Funds

Multiply by 0.75

Multiply by 0.75

No adjustment

Equity Mutual Funds

Multiply by 0.85

Multiply by 0.87

No adjustment

Equities and Index Funds

Multiply by 0.85

Multiply by 0.87

No adjustment

Further Refinements to Tax Adjustments

You’ll need to subtract your state or provincial income tax rate from each multiplier. For example, if you state or provincial income tax rate is 10%, you would subtract 0.10 from each multiplier. For Equities and Index Funds, the 0.85 multiplier in the US-Taxable column would be reduced to 0.75.

The assumptions in this table for equities and index funds in particularly and, to a lesser extent, equity mutual funds, are conservative.  Specifically, if you don’t sell your positions every year and re-invest the proceeds, you will pay taxes less than every year.  By doing so, you reduce the impact of income taxes.  Nonetheless, given all of the risks involved in savings for retirement, I think these approximations are useful even if they cause the estimates of how to save every year to be a bit high.

Also, the tax rates for bonds and bond mutual funds could also be conservative depending on the types of bonds you own.  The adjustment factors shown apply to corporate bonds.  The tax rates on interest on government bonds and some municipal bonds are lower.

Calculation of After-Tax Investment Return

From the table above, it is clear that calculating your after-tax investment return depends on both the types of investments you plan to buy and the type of account in which you plan to hold them.  The table below will help you calculate your overall after-tax investment return.

Investment Type

Account Type

Percent of Portfolio Pre-tax Return Tax Adjustment

Product

Money Market, Bonds or Bond Mutual Funds

Taxable

0.75

Equity Mutual Funds, Equities, Index Funds

Taxable

0.85 if US; 0.87 if Canada

All

Other than Taxable

1.00

Total

There are three assumptions you need to enter into this table that reflect the types of financial instruments you will buy (i.e., reflecting your risk tolerance) and the types of accounts in which you will hold those assets in the Percent of Portfolio column.  These assumptions are the percentages of your retirement savings you will invest in:

  • Money markets, bonds or mutual funds in taxable accounts.
  • Equities, equity mutual funds and index funds in taxable accounts.
  • Tax-deferred or tax-free accounts (IRAs, 401(k)s, RRSPs and TFSAs).

For each of these three groups of assets, you’ll put the average annual return you selected from the Risk Tolerance section above in the Pre-Tax return column.  You also may need to adjust the multipliers as discussed above.

Once you have filled in those six boxes, you will multiply the three numbers in each row together to get a single product in the last column of each row.  Your weighted average after-tax investment return will be the sum of the three values in the last column.

Illustration of Weighted Average Return Calculation

I have created an illustration in the table below.  For this illustration, I have assumed that you will invest 50% of your portfolio in bonds and 50% in equities.  You are able to put 60% of your portfolio in tax-deferred and tax-free accounts.  Although not consistent with my post on tax-efficient investing, you split your bonds and stocks between account types in the same proportion as the total.  As such, you have 20% of your portfolio in taxable accounts invested in each of bonds and equities.  The 60% you put in your tax-deferred and tax-free accounts goes in the All Other row.

Investment Type

Account Type

Percent of Portfolio Pre-tax Return Tax Adjustment

Product

Money Market, Bonds or Bond Mutual Funds

Taxable

20% 3% 0.75

0.5%

Equity Mutual Funds, Equities, Index Funds

Taxable

20% 8% 0.85 if US; 0.87 if Canada

1.4%

All

Other than Taxable

60% 5.5% 1.00

3.3%

Total

5.2%

I’ll use a pre-tax return on bonds of 3% and equities of 8%.  Because the All Other category is 50/50 stocks and bonds, the average pre-tax return for that row is the average of 3% and 8% or 5.5%.

I then calculated the products for each row.  For example, in the first row, I calculated 0.5% = 20% x 3% x 0.75.  The weighted average after-tax investment return is the sum of the three values in the product column or 5.2% = 0.5% + 1.4% + 3.3%.  The 5.2% will be used to help estimate how much we need to save each year to meet our retirement savings target.

Annual Savings Targets

By this point, we have talked about how to estimate:

  • Your total retirement savings target
  • The number of years until you retire
  • An after-tax investment return that is consistent with your risk tolerance and the types of accounts in which you plan to put your savings

With that information, you can now estimate how much you need to save each year if you don’t have any savings yet.  I’ll talk about adjusting the calculation for any savings you already have below.

I assumed that you will increase your savings by 3% every year which would be consistent with saving a constant percentage of your earnings each year if your wages go up by 3% each year.  For example, if you put $1,000 in your retirement savings this year, you will put another $1,030 next year, $1,061 in the following year and so on.  In this way, your annual retirement savings contribution will be closer to a constant percentage of your income.

Annual Savings/Total Target

The graph and table below both show the same information – the percentage of your retirement savings goal that you need to save in your first year of savings based on your number of years until you retire and after-tax annual average investment return.

After-tax Return

Years to Retirement
5 10 15 20 25 30 35

40

2%

17.6% 7.8% 4.6% 3.0% 2.1% 1.6% 1.2% 0.9%

3%

17.3% 7.4% 4.3% 2.8% 1.9% 1.4% 1.0% 0.8%

4%

16.9% 7.1% 4.0% 2.5% 1.7% 1.2% 0.9% 0.6%

5%

16.6% 6.8% 3.7% 2.3% 1.5% 1.0% 0.7%

0.5%

6% 16.3% 6.5% 3.5% 2.1% 1.3% 0.9% 0.6%

0.4%

7% 16.0% 6.2% 3.2% 1.9% 1.2% 0.7% 0.5%

0.3%

8% 15.7% 6.0% 3.0% 1.7% 1.0% 0.6% 0.4%

0.3%

As you can see, the more risk you take, the less you need to save on average.  That is, as you go down each column in the table or towards the back of the graph, the percentage of your target you need to save in the first year gets smaller.  Also, the longer you have until you retire (as you move right in the table and graph), the smaller the savings percentage.  I caution those of you who have only a few years until retirement, though, that you will want to think carefully about your risk tolerance and may want to use the values in the upper rows of the table corresponding to lower risk/lower return investments, as there is a fairly high chance that your savings will be less than your target due to market volatility if you purchase risky assets.

How to Use the Table

First find the percentage in the cell with a row that corresponds to your after-tax investment return and a column that corresponds to your time to retirement.  You multiply this percentage by your total retirement savings target.  The result of that calculation is how much you need to save in your first year of saving.  To find out how much to save in the second year, multiply by 1.03.  Keep multiplying by 1.03 to find out how much to save in each subsequent year.

Earlier in this post, I created an example with a 5.2% after-tax investment return.  5.2% is fairly close to 5%, so we will look at the row in the table corresponding to 5% to continue this example.  I have calculated your first- and second-year savings amounts for several combinations of years to retirement and total retirement savings targets for someone with a 5% after-tax investment return below.

Years to Retirement

Savings % from Table (5% Row) Total Retirement Savings Target First-Year Savings Amount Second-Year Savings Amount

5

16.6% $500,000 $83,000 $85,490

15

3.7% 2,000,000 74,000

76,220

30 1.0% 500,000 5,000

5,150

40 0.5% 1,000,000 5,000

5,150

The first-year savings amounts in this table highlight the benefits of starting to save for retirement “early and often.”   It is a lot easier to save $5,000 a year than $75,000 or $85,000 a year.  By comparing the last two rows, you can see the benefits of the extra 10 years between 30 years of savings and 40 years of savings.  With the same starting contributions, on average, you end up with twice as much if you save consistently for 40 years than if you do so for 30 years.

Adjusting for Savings You Already Have

The calculations above don’t take into account that you might already have started saving for retirement.  If you already have some retirement savings, you can reduce the amount your need to save each year.

The math is a bit complicated if you don’t like exponents, but I’ll provide a table that will make it a bit easier.  To adjust the annual savings calculation for the amount you already have saved, you need to subtract the future value of your existing savings from your total retirement savings target.  The future value is the amount to which your existing savings will grow by your retirement date.  The formula for future savings is:

where n is the number of years until you retire.  The annual return is the same return you’ve been using in the formulas above.  If you don’t want to deal with the exponent, the table below will help you figure out the factor by which to multiply your current amount saved.

After-tax Return

Years to Retirement
5 10 15 20 25 30 35

40

2%

1.10 1.22 1.35 1.49 1.64 1.81 2.00 2.21

3%

1.16 1.34 1.56 1.81 2.09 2.43 2.81 3.26

4%

1.22 1.48 1.80 2.19 2.67 3.24 3.95 4.80
5% 1.28 1.63 2.08 2.65 3.39 4.32 5.52

7.04

6% 1.34 1.79 2.40 3.21 4.29 5.74 7.69

10.29

7% 1.40 1.97 2.76 3.87 5.43 7.61 10.68

14.97

8% 1.47 2.16 3.17 4.66 6.85 10.06 14.79

21.72

Illustration of Adjustment for Existing Savings

Let’s say you have $50,000 in retirement savings, 25 years until you retire and have selected an annual return of 5%.  You would use the factor from the 5% row in the 25 years column of 3.39.  You multiply $50,000 by 3.39 to get $169,500.

If your total retirement savings target is $1,000,000, you subtract $169,500 and use an adjusted target of $830,500.  Using the same time to retirement and annual return, your annual savings target is 1.5% of $830,500 or $12,458.  This annual savings amount compares to $15,000 if you haven’t saved any money for retirement yet.

Caution

Having been subject to Actuarial Standards of Practice for most of my career (which started before the standards existed), I can’t finish this post without providing a caution.  All of the amounts that I’ve estimated in this post assume that you earn the average return in every year.  There aren’t any financial instruments that can guarantee that you’ll earn the same return year in and year out.  As mentioned above, riskier assets have more volatility in their returns.  That means that, while the average return is higher, the actual returns in any one year are likely to be further from the average than for less risky assets.

As such, you should be aware that the amounts shown for annual savings will NOT assure you that you will have your target amount in savings when you retire.  I suggest that, if possible, you set a higher target for your total retirement savings than you think you’ll really need or save more each year than the amounts resulting from these calculations. You don’t want to be in the situation in which my friend found herself at age 59 starting over financially.

 

Retirement Savings: How Much Do You Need

Retirement Savings

Retiring is one of the riskiest financial decisions you will make. On the day you retire, you can calculate your net worth. You won’t know, however, how much retirement savings you need because you don’t know:

  • how much you will actually spend on day-to-day expenses
  • how much those expenses will be impacted by inflation
  • whether you’ll have significant medical or other expenses
  • how long you will live or
  • what returns you will earn on your investments.

I retired a little over a year ago and realized that, even though I have a lot of money saved, it wasn’t enough to give me confidence we wouldn’t run out.  I took on a large consulting project to help cover our expenses for the next year or two. Researching this post, though, added even more confidence as we have more than enough to meet some of the simple rules of thumb.   We will see what happens.

In this post, I’ll provide some insights about how to think about a target you might want to set for your retirement savings.  As a follow up, I’ll talk about how much you need to save to meet your retirement savings goal in this post.

4% Rule and Multiply by 25 Rule

As I checked to see what others were saying on this topic, I found a very common theme for determining how much you need to save for retirement.  In some places, it was called the 4% Rule and, in others, the Multiply by 25 Rule.  Being the math geek that I am, my first thought was that 4% = 1/25 so they are the same thing!  It turns out that, in the nitty gritty details, the Multiply by 25 Rule is intended to tell you how much you need to have available on the day you retire while the 4% Rule guides you in how much you can spend in your first year of retirement.  Nonetheless, as explained below, they both result in the same amount needed in savings on your retirement date.

4% Rule for Retirement Spending

The 4% rule is intended to tell you how much you can spend from your retirement savings each year.  Let’s say you have $1,000,000 in invested assets when you retire.  It says you can spend 4% of that amount or $40,000 (including all of your expenses and taxes) in your first year of retirement.  In each subsequent year of your retirement, you can spend $40,000 increased for the cumulative impact of inflation since you retired.   The 4% Rule assumes that you are invested 50% in stocks and 50% in bonds.

4% Rule Illustration

The graph below shows the amount you can spend each year (blue bars which use the left axis scale) and the amount you’ll have remaining at each age (red line which uses the right axis scale) if you retire at 65, inflation is 3% per year, bonds earn 2.5% and stocks earn 7% annually. These assumptions are similar to long-term average assumptions that are common these days.

As you can see, in this scenario, the amount you can spend increases from $40,000 when you are 65 to almost $100,000 a year when you are 95 solely due to inflation. In the first few years, your spending is less than your investment returns, so your savings increases.  After you turn 72, your savings exceeds your investment returns so your savings starts to decrease.

4% Rule Background

The 4% rule was developed by William Bengen and is presented in detail in a 1994 study published in the Journal of Financial Planning.  (If you like numbers and graphs, check out this paper. It is a surprisingly easy read.)

Using historical data from 1926 to 1991, Bengen found that there were no 50-year periods in which a retiree would run out of money if his or her initial withdrawal rate was 3.5% or lower.  With a 4% initial withdrawal rate, the shortest time period in which the savings ran out was 33 years.  In only 10% of the scenarios did the money last for less than 40 years.

If you turn this rule around and know how much you want to spend in your first year of retirement, say $60,000, you can calculate the amount you need to have saved by dividing that amount by 4% (=0.04).  In this example, you need $1,500,000 (=$60,000/0.04) in savings on the day you retire using this rule.

Multiply by 25 Rule for Retirement Savings

The Multiply by 25 Rule says that the amount you need in retirement savings is 25 times the amount you want to spend in the first year of retirement.  Using the example above in which you want to spend $60,000 in your first year of retirement, you would calculate that you need $1,500,000 (=25 x $60,000) in savings.  As I said, the math is the same for determining how much you need to save because multiplying by 25 is the same as dividing by 0.04.  It is just that the rules are stated from different perspectives (how much you can spend given the amount saved as opposed to how much you need to save giving how much you want to spend).

When do you need more or less?

As indicated, those rules make assumptions that might not be right for you. There are a number of personal factors that impact how much you need in retirement savings.

Your Risk Tolerance

The 4% Rule assumes that you invest half in bonds and half in stocks. Some people are willing to take more risk by investing more heavily in stocks. Other people can’t tolerate the ups and downs of the stock market, so invest more heavily in bonds. As shown in this chart below, taken from my post on diversification and investing, the higher percentage of stocks in your portfolio, the higher your average return (the blue lines) but the more likely you are to lose some of your principal (the portion of the whiskers that fall below 0).


If you plan to put more than 50% of your retirement assets in stocks, you can withdraw a bit more than 4% each year. Turning that around, it means you need a bit less than 25 times your estimated expenses in your first year of retirement. The table below was copied with permission from a March 19, 2019 article from Schwab found at this link.  It shows how your time horizon (see below) and investment risk impact the 4% Rule.

Life Expectancy and Retirement Age

The analysis underlying the 4% Rule focuses on a retirement period of 30 years.  If you retire in your mid-60s, it would imply that you would most likely have enough money to last through your mid-90s.  If you are in poor health or have a family history of dying early, you could consider spending a bit more than 4% (that is, multiply by less than 25 to determine how much you need to save).

On the other hand, if you plan to retire at 45 and want to have enough money to last until you are 95, you’ll need to save more.  The Schwab table above shows planning horizons up to 30 years.  Based on the numbers in the table, it looks like you could subtract about 0.1 percentage points from the numbers in the 30-year row for each year your planning horizon extends beyond 30 years to estimate how much you need to save.

For example, if you want to be highly confident (90% sure in this case) you will have enough money to last for 50 years, you would be looking at 20 years beyond the 30-year horizon.  Multiplying 20 years by 0.1 percentage point is 2.0%.  According to the table, you can spend 4.2% of your savings in the first year with a Moderately Conservative portfolio and 90% (highly) confident that you won’t run out of money in 30 years.  My approximation would subtract 2.0% from 4.2% to estimate that you could spend about 2.2% of your savings in the first year if you wanted to be 90% confident you won’t run out of money in 50 years.  You could then divide your estimated first year expenses by 2.2% or multiply by 45 to estimate how much you need to save.

Other Sources of Income

Some people’s employers provide defined benefit retirement plans.  These plans generally pay a flat amount every month starting at normal retirement age (as defined by the employer) until death.  In the US, people who have worked or whose spouses have worked are eligible for Social Security benefits, as discussed in this post.  Many other countries have similar programs.

When you are estimating how much you need to save for retirement, you can consider these sources of income.  If all of your other sources of income increase with inflation, it is a fairly straightforward adjustment.  You just need to subtract the income from these other sources from your first-year-of-retirement expenses before applying the 4% Rule (as adjusted for other considerations).

For example, if you plan to spend $100,000 a year in retirement and have $40,000 of Social Security and defined benefit plan benefits,  you would subtract $40,000 from $100,000 to get $60,000.  Using the Multiply by 25 Rule, you would multiply $60,000 by 25 to get $$1.5 million instead of multiplying the full $100,000 by 25 which would indicate you need $2.5 million in savings.  In this example, you need $1 million less in savings because you have other sources of income.

Unfortunately, most defined benefit plan benefits do not increase with inflation.  The math for adjusting the Multiply by 25 Rule is fairly complicated.  I’ve developed a simple approximation that you can use that will get you close to the correct percentage.  To approximate the adjustment to the amount you Multiply by 25, divide your defined benefit plan income by 2 before subtracting it from your first-year expenses.

You Want to Leave Your Assets to your Beneficiaries

I remember being a teenager and having my father explain to me how much I needed to save for retirement.  The approach he proposed was that you could spend 2% of your assets which is equivalent to a Multiply by 50 Rule.  (No wonder I was nervous about my finances when I retired!)  His logic was as follows:

  • Invest in the stock market and get a 10% return.  (He did this analysis a long time ago, when stock market average returns, inflation and taxes were all considered to be a bit higher than they are today, but not by so much as to make the logic faulty.)
  • You will pay taxes of 40% of your returns, which makes your after-tax return 6%.
  • Inflation will be 4% per year.  Because he wanted his investment income in every year to cover his expenses without dipping into the principal, he had to re-invest 4 percentage points of his investment return so he would have 4% more investment income in each subsequent year.
  • Subtracting the 4% reinvestment from the 6% after-tax return leaves an amount equal to 2% of his investments that he could spend each year (excluding taxes because he separately considered them).

So, if you are like my father, you will want to save closer to 50 times your first-year retirement expenses, rather than 25 times.  It is important to remember that my father’s Multiply by 50 rule applies to your expenses excluding income taxes and the Multiply by 25 Rule applies to your expenses including income taxes, so they aren’t quite directly comparable.

Liquidity of your Assets

As indicated above, the 4% Rule assumes your assets are invested 50% in stocks and 50% in bonds. You may have other assets that contribute to your net worth, such as equity in your home, your personal property, a family farm and rental property, among others. These other assets are all consider illiquid – that is, you can’t convert them to cash easily. Further, some of them are assets that you never want to have to convert to cash to cover expenses, such as your home and personal property.

As you project how much you will have in retirement savings, you’ll want to exclude any equity in your house as it isn’t available to invest.  A portion of it may be available at some point if you plan to downsize, but you’ll want to be cautious about including it in your savings plan.  Other of these assets, such as rental property, could be liquidated to cover retirement expenses.  In your planning, though, you’ll need to make sure you consider the selling costs (e.g., real estate agent’s commission) and taxes you need to pay on capital gains and that they may not generate a return as high as underlies the 4% Rule.

Irregular Large Expenses

The analysis that supports the 4% Rule assumes that you have the same expenses every year and that they change due only to inflation. That’s not how life works! You may want to be like me and want to take an expensive vacation every three or four years in retirement, you’ll likely have to replace your car at least once in retirement or you could have major home repairs if you own your home.  In addition, end-of-life medical bills can be very expensive.

As you are determining your first-year retirement expenses, you’ll want to include amounts for any such expenses in your budget at their average annual cost.  For example, let’s say I want to take a vacation (in addition to my already budgeted travel expenses) every five years that has a total cost of $10,000.  I need to add $2,000 (= $10,000 per vacation divided by one vacation every 5 years) to my regular annual expenses for these big vacations.  Similarly, if I plan to buy a $25,000 car every 15 years, I need to add $1,667 (= $25,000/15) to my annual expenses.  In both cases, you would add these amounts to your budgeted expenses before you divided by 4%.

How to Set Your Personal Target

So, what can you do to estimate your personal retirement savings target? Follow the following steps.

Make a Budget for Today if You Don’t Already Have One

It is hard to estimate your expenses in retirement, but it is very helpful to understand what you are spending today.  If you don’t have a budget or haven’t tracked your expenses to see where your money is going, I suggest starting there.  Here is a link to a post I wrote with a spreadsheet to help you monitor your expenses.

Estimate Your Expenses in Your First Year of Retirement

Next, look at your current budget and/or spending and estimate how it would change if you were retired today.  On what types of things might you want to spend money in the future that you don’t spend now?  Might you want to buy special gifts for your grandchildren that are more extravagant than what you spend for your children’s gifts now?  Also think about expenses you have now that you won’t have in the future, such as commute expenses and possibly a separate wardrobe for work.

Be sure to think about Social Security (or equivalent) and income taxes. In addition to Federal income taxes, you may pay state or provincial and possibly local income taxes.  If you plan to live somewhere else in retirement, it might have a higher or lower tax rate.  In the US, Social Security taxes are 6.2% (12.4% I you are self-employed) of your wages up to the limit ($128,400 in 2019).  As you adjust your budget, you can eliminate Social Security taxes and will want to think about whether your state or provincial and local tax rate will be substantially different from their current rates.

Some people say that your expenses will decrease by 20% when you retire.  In my very short retirement, I find I’m spending more than I expected as I have more time to do things and many of them cost money.  This post from Financial Samurai provide some insights as to how retirement might impact your expenses.

Increase Your Retirement Expenses for Special Purchases

Do you want to travel? How often do you think you’ll need to buy replacement cars and how much do you think you’d spend if you bought one today? What other expenses might you have that aren’t in your budget? For each of these expenses, divide the amount by the time between them to estimate an average annual cost, as I illustrated earlier in this post.

Adjust Your Budget for Inflation

All of the amounts you’ve estimated so far are in today’s dollars.  That is, they reflect the current prices of every item.  You’ll want to increase these amounts for inflation between now and the time you retire.  Over long periods of time, annual inflation has averaged 3% to 3.5% though it has been a bit lower recently.  To adjust your budget for inflation, you’ll want to multiply it by 1.03n, where n is the number of years until you retire.  Don’t like exponents?  The table below provides approximate multipliers by number of years until you plan to retire.

Years 5 10 15 20 25 30 35 40 45
Factor 1.15 1.35 1.55 1.80 2.10 2.45 2.80 3.25 3.80

Subtract Other Sources of Income

If you think you’ll have a defined pension plan benefit or will receive social insurance (Social Security) benefit, you can subtract those amounts from your inflation-adjusted budget.  My post on Social Security provides insights on how to estimate your benefits for my US readers.

Figure Out your Risk Tolerance and Length of Retirement

If you want to be almost 100% confident you will have enough money to last for your full retirement, regardless of how long it is, and leave most or all of your principal to your heirs, multiply the difference between your inflated budget (excluding income taxes) and other sources of income by 50 to derive your retirement savings target.

If you plan to be retired for only 10 years, you can multiply by a number as low as 10, according to the chart from Schwab. Where between those two numbers you choose is up to you. The longer you expect to be retired, the more conservative your investments and the more confident you want to be that you won’t run out of money, the higher your multiplier.

 

 

Traditional vs Roth Retirement Plans

The difference between Roth vs Traditional plans for retirement is primarily about tax rates. Other differences relate to when you can or must withdraw your savings.  With one exception, the same withdrawal rules apply to both 401(k)s and Individual Retirement Accounts (IRAs), so I’ll refer to both 401(k)s and IRAs collectively as Roth and Traditional plans.  In this post, I will:

  • Describe the four different combinations of tax-advantaged retirement savings plans in the US.
  • Provide information about contribution limits.
  • Talk about the major differences between Roth vs Traditional plans.
  • Give you the nuts and bolts of the tax considerations so you can make an informed decision as to where to put your retirement savings.

Key Take-Aways – Roth vs Traditional Plans

While there are several differences between Roth vs Traditional plans, some of which may be important to some of you, the biggest difference has to do with when you pay taxes on the money you have saved.  As will be explained below, you pay taxes before you put money in a Roth plan and you don’t pay taxes on Traditional plan money until you withdraw it.

Characteristics that make a Roth plan a better option than a Traditional plan for you include:

  • Your salary and spending are likely to go up a lot before you retire.
  • You anticipate having a lot of taxable income in retirement, such as from a part-time job, a pension or savings not in a tax-sheltered retirement plan.
  • The expectation that tax rates will increase.

If none of these characteristics apply to your situation, a Traditional plan is likely to be better for your than a Roth plan.

As you are thinking about saving for retirement, you’ll want to think about not only where to save, but also a target for your retirement savings and how much you need to save each year.

Mechanics of Tax-Advantaged Retirement Savings Plans

In the US, there are two types of tax-advantaged retirement savings plans, each with two variations.

Types of Plans

The two types of plans are:

  • Individual Retirement Accounts (IRAs). An IRA is an account that you establish on your own at a bank, brokerage house or other financial institution that offers IRAs.  You make contributions to your IRA and can select one of many different choices for investments.  Allowed investment classes include stocks, bonds, real estate, mutual funds, ETFs, money market and other savings accounts and annuities, among other.
  • 401(k)s. A 401(k) is usually an employer sponsored plan, though you can open an individual 401(k) if you are self-employed. You can contribute a portion of your salary to the 401(k).  Many employers will match some or all of your contribution.  In a 401(k), you are restricted to the investment options offered by your employer, usually mutual funds and ETFs.

Two Variations

The two variations of each of IRAs and 401(k)s are Roth and Traditional plans.  When you set up an IRA, you have the choice of designating it as a Roth vs a Traditional IRA.  Your employer (or you if you have an individual 401(k)) determines whether to offer a Roth vs a Traditional plan. For information about the types of investments that are best held in each type of account, check out these posts for and Canada.

Maximum Contributions

For 2019, the maximum combined contribution to all of your IRAs combined is $6,000, plus another $1,000 if you are 50 or older.  The maximum combined contribution to your 401(k) plan is $19,000 ($25,000 if you are 50 or older).  The 401(k) contribution limits apply to money you deposit in your 401(k) and excludes any funds contributed by your employer.

Major Differences between Roth vs Traditional Plans

There are four major differences between Roth vs Traditional plans.

  • Roth contributions are restricted if your income is high, as discussed below.
  • You pay a penalty on any withdrawals you make from Traditional plans before the year in which you turn 59.5.
  • There are required minimum distributions on all plans except Roth IRAs.
  • The timing of paying taxes on the money in Roth and Traditional plans is different.

Restrictions on Roth Contributions

If your modified adjusted gross income is more than a certain threshold ($137,000 for single taxpayers in 2019, $193,000 for taxpayers who are married filing jointly), the tax law does not allow you to put as much in a Roth IRA and, if your income is high enough, do not allow you to directly contribute to a Roth IRA. However, you can contribute to a Traditional IRA and then very quickly transfer the money to a Roth IRA.  This transfer is called a “roll over.”  If you fall in this category, I suggest talking to your tax advisor or broker to make sure the process follows the IRS rules.

Early Withdrawal Penalty on Traditional Plans

If you withdraw money from your Traditional retirement plan before the year in which you turn 59.5, you will have to pay income taxes on the withdrawal (see below for more) and you will have to pay a tax penalty equal to 10% of your withdrawal amount.

With a Roth plan, you can make withdrawals at any time without paying a penalty, as long as you are either at least 59.5 or you made contributions in each of the previous five years.  If you are younger than 59.5, you can withdraw your contributions without paying any tax, but will pay taxes on any investment earnings (interest, dividends or appreciation) on your contributions.  I’ve read in some places that the every withdrawal is assumed to be a mix of your contributions and earnings, but I read the IRS web site as saying that you are assumed to withdraw your contributions first and then any earnings. If you want to make withdrawals before you are 59.5, I suggest talking to a tax advisor to make sure you understand the tax consequences.

Required Minimum Distributions

All tax-advantaged retirement accounts, except Roth IRAs, have minimum distribution requirements. By April 1 of the year in which you turn 70.5, you need to start withdrawing money from these accounts.

The amount you need to withdraw is the balance at the beginning of the year divided by your life expectancy, as calculated by the IRS.  The same life expectancy is used for everyone, based on their age, except people whose sole beneficiary is their spouse and their spouse is more than 10 years younger.  For most people, your life expectancy, according to the IRS web site, in the year you turn 70.5 is 27.4 years. So, if you have $50,000 at the beginning of that year in a Traditional IRA or any 401(k), the minimum withdrawal would be $1,824.  The penalty for not making the minimum withdrawal is very steep – 50% of the amount that you were required to withdraw but didn’t!

Even though I am retired and able to start withdrawing from my retirement savings, this minimum distribution requirement difference between a Roth IRA and the other accounts has not seemed important to me, as I assume I will need to withdraw money from my other retirement plans to support my expenses.  I may change my mind as I get older and have to start making withdrawals, as these withdrawals may increase my taxes more than necessary if I have other funds available to cover expenses.

Dollars and Cents of Taxes

The biggest difference between Roth vs Traditional retirement plans is the way they are taxed.

Taxes on Contributions

Briefly, Roth contributions are made with after-tax money, while Traditional contributions are made with pre-tax money.  After-tax money means that you have already paid income taxes on the money you contribute. Pre-tax money means that you do not pay income taxes on the money when you contribute it.

In practice, you can deduct the amount of any contributions to Traditional plans from your income on your tax return, but you don’t get to deduct Roth contributions.  The amount of your wages reported by your employer on your W-2 has usually already been reduced for contributions you have made to a Traditional 401(k).  There is a specific line on your tax return for Traditional IRA contributions.

Taxes on Withdrawals

You do not pay any taxes on withdrawals from Roth plans, but you do on Traditional plans.  Just the opposite of when you contribute the money.

Comparison

If the tax rate applicable to your contributions and withdrawals (a lot more on that in a minute) were the same, it wouldn’t matter whether you put your money in a Traditional vs Roth plan!   For a Traditional plan, you contribute the amount you have available, earn a return and withdraw it after paying taxes.  That is:

Money in Traditional plan = Contribution x (1 + compound investment return) x (1 – tax rate)[1]

For a Roth plan, you start with the amount you have available, pay taxes on it, contribute what you have left, earn a return and withdraw it.  That is:

Money in Roth plan = Contribution x (1 – tax rate) x (1 + compound investment return)

Because you can change the order of the terms when multiplying (the associate property for math geeks like me), these two amounts are equal as long as the applicable tax rate when you make your contribution is the same as when you make your withdrawal.

What You Need to Know About Taxes

The Federal government and most states tax your income.  There is a small handful of states with no income tax.  Because state income taxes vary so widely, I will focus only on Federal income taxes.  If you want more information about your state income taxes (and you’ll want to know at least a bit about them for your decision-making process), I suggest visiting your state’s web site or contacting your tax advisor.

The Federal income tax system is very complicated.  In this post, I will focus on aspects of the calculation that impact your choice between Traditional vs Roth retirement plans.  As with state income taxes, if you have questions about your specific situation, I suggest you contact a qualified tax advisor.

There are two steps in calculating your Federal income tax.

  1. Calculate your taxable income.
  2. Determine the taxes that apply to your taxable income.

Taxable Income

Your taxable income is the sum of all sources of income minus your deductions.

Income

The most common sources of income include:

  • Wages
  • Interest and dividends, other than those from US Government bonds
  • Capital gains and losses
  • Pension income and withdrawals from retirement plans, other than Roth plans
  • A portion of your social security benefits, as discussed in this post
  • Self-employment income
  • Alimony

Reductions and Deductions

These amounts are reduced by a number of items, including the following:

  • Contributions to Traditional retirement plans
  • Contributions to Health Savings Accounts
  • Alimony paid
  • Some student loan interest

The total of your income excluding this amounts is called your Adjusted Gross Income.

You can then choose to either itemize your deductions or use the standard deduction.  The standard deduction is $12,000 if you file individually and $24,000 if you file jointly with your spouse.  (There are also separate thresholds for most aspects of the tax calculation for married filing separately and head of household.  I will not provide the specifics for these filing statuses.  You can find more information at www.irs.gov.)

Itemizing your deductions is quite complicated.  Briefly, here are the most common deductions:

  • Medical expenses, but only the portion that exceeds 7.5% of your adjusted gross income
  • State and local income and property taxes, up to $10,000
  • Some or all of your mortgage interest
  • Charitable donations

People usually use the standard deduction unless their itemized deductions are higher than the standard deduction in which case they use their itemized deductions.

Taxable income is adjusted gross income minus deductions.

Calculating Your Taxes

For most people, the regular tax rates are applied to your taxable income.  People with high incomes and especially those with a large amount of deductions have to calculate a second tax called alternative minimum tax. According to the Tax Policy Center, a very small percentage of people with income between $200,000 and $1 million and about 10% – 15% of people with income more than $1 million will pay the alternative minimum tax. I am going to assume that most of you are not subject to the alternative minimum tax, so will not discuss it here.

If you do not have any dividend income or capital gains, you can calculate your taxes from tables provided by the IRS.

Tax Table for Single Taxpayers

Here is the table for single taxpayers for tax year 2018.

Taxable Income is More Than: But Not More Than: Fixed Part of Tax Tax Rate Threshold Above Which Tax Rate is Applied
$0 $9,525 $0 10% 0
9,525 38,700 952.50 12% 9,525
38,700 82,500 4,453.50 22% 38,700
82,500 157,500 14,089.50 24% 82,500
157,500 200,000 32,089.50 32% 157,500
200,000 500,000 45,689.50 35% 200,000
500,000 150,689.50 37% 500,000

Tax Table for Taxpayers Who Are Married Filing Jointly

Here is the table for taxpayers who are married filing jointly for tax year 2018.

Taxable Income is More Than: But Not More Than: Fixed Part of Tax Tax Rate Threshold Above Which Tax Rate is Applied
$0 $19,050 $0 10% 0
19,050 77,400 1,905 12% 19,050
77,400 165,000 8,907 22% 77,400
165,000 315,000 28,179 24% 165,000
315,000 400,000 64,179 32% 315,000
400,000 600,000 91,379 35% 400,000
600,000 161,379 37% 600,000

How to Use Tax Tables

To calculate your taxes from these tables, you:

  • Determine the range in which your taxable income falls.
  • Take your taxable income and subtract the value in the last column.
  • Multiply the difference by the percentage in the second-to-last column.
  • Add the amount in the middle column.

For example, if you are single and your taxable income is $50,000, your tax is

($50,000 – $38,700) x .22 + $4,453.50 = $7,093.50

If you have dividend and capital gain income, the calculations are a bit more complicated as those types of income are sometimes taxed at different rates.

Key Points about Taxes as They Relate to Contributions

Let’s look at a couple of examples to see how Roth and Traditional retirement plans affect your taxes today.

John’s Contributions

In the first example, John’s sole source of income is wages of $60,000.  He doesn’t have a lot of expenses to itemize, so takes the standard deduction of $12,000.  The table below compare the taxes he will pay if he makes contributions of $5,000 to either a Roth and a Traditional retirement plan.

Traditional Roth Difference
Wages $60,000 $60,000 $0
Deduction for IRA 5,000 0 5,000
Standard Deduction 12,000 12,000 0
Taxable Income 43,000 48,000 5,000
Tax 5,400 6,500 1,100

 

If we take the tax difference and divide by the difference in taxable income, i.e., $1,100/$5,000 = 22%, we get what is known as the marginal tax rate on your IRA contribution. A “marginal” rate is the amount by which the result changes if you make an addition or subtraction to one value in the calculation.  It differs from the average tax rate which would be the total tax divided by taxable income. For the Roth column, the average tax rate is 13.5%.  It is the weighted average of the 10%, 12% and 22% tax rates that are combined to determine your taxes if your taxable income is between $38,700 and $82,500.

The marginal tax rate will be important because it is the tax rate we need to evaluate whether you are better off making a contribution to a Roth or Traditional plan.

Jane’s Contributions

Let’s look at another example.  Jane’s situation is similar to John’s except she makes $90,000.  She also takes the standard deduction and has no other income.

Traditional Roth Difference
Wages $90,000 $90,000 $0
Deduction for IRA 5,000 0 5,000
Standard Deduction 12,000 12,000 0
Taxable Income 73,000 78,000 5,000
Tax 12,000 13,100 1,100

Her marginal tax rate is also 22% (=1,100/5,000), calculated using the differences in the table above.

Key Points about Taxes as They Relate to Withdrawals

The key focus of the Roth vs. Traditional decision is how the marginal tax rate compares at the time contributions are made with the marginal tax rate at the time withdrawals are made.  So, now we will look at what John’s and Jane’s situations might look like if they were retired and making withdrawals.  For this part of the illustration, we will assume that there hasn’t been any inflation or changes in tax rates between now and the time they retire.

We will assume John’s Social Security benefit is $2,000 per month and he has expenses (including income taxes) of $60,000 a year in retirement.  His Social Security totals $24,000, so he needs an additional $36,000 from his retirement accounts to cover his expenses.  (He will actually need to withdraw more from a Traditional account to cover the taxes on his Social Security benefits and withdrawals, but I will ignore those for now as they add a lot of complication without having much impact on the conclusion.)

John’s Withdrawals

Let’s look at John’s tax calculation in his retirement.  As a reminder, a portion of your Social Security benefits become taxable if the value in the Test Sum row is greater than $25,000.  For more details on this calculation, see my post on Social Security benefits.

Traditional Roth Difference
Social Security benefits $24,000 $24,000 $0
Taxable Withdrawal 36,000 0 36,000
Test Sum = 50% of SS + Taxable Withdrawal 48,000 12,000 36,000
Taxable SS benefit 16,400 0 16,400
Adjusted Gross Income 52,400 0 52,400
Standard Deduction 12,000 0 12,000
Taxable Income 40,400 0 40,400
Tax 4,828 0 4,828

John’s marginal tax rate in retirement is 12% (=$4,828/$40,400).  He is better off if he contributes to a Traditional retirement plan, as he would reduce his taxes at a 22% marginal rate when he makes his contributions with the Traditional plans as compared to reducing his taxes at a 12% marginal rate when taking his withdrawals with the Roth plans.  That is, a Traditional plan is better if the marginal tax rate when you withdraw the money is less than the marginal rate when you contribute it.

Jane’s Withdrawals

Now we will look at Jane’s situation in retirement.  In her profession, most people she knows get significant raises between her age and retirement.  She anticipates that her salary will be more than $150,000 (before inflation) when she retires. With her higher income, her monthly Social Security benefit will be $3,000 or $36,000 a year.  Jane expects to have gotten accustomed to her higher salary so has estimated that she will have $120,000 a year in expenses.  She plans to save some money in taxable accounts (i.e., not in tax-advantaged retirement accounts) and will get a pension from her employer. These two amounts contribute $44,000 a year to her retirement income.  She will need to withdraw $40,000 from her retirement savings accounts to cover her expenses. Her tax calculation in retirement is as follows:

Traditional Roth Difference
Social Security benefits $36,000 $36,000 $0
Taxable Withdrawal 40,000 0 40,000
Other Taxable Income 44,000 44,000 0
Test Sum = 50% of SS + Taxable Withdrawal 102,000 62,000 40,000
Taxable SS benefit 30,600 23,800 6,800
Adjusted Gross Income 114,600 67,800 46,800
Standard Deduction 12,000 12,000 0
Taxable Income 102,600 55,800 46,800
Tax 18,914 8,216 10,698

Her marginal tax rate in retirement is 23% (=$10,698/$46,800).  In her case, her marginal tax rate in retirement is higher than when she makes her contributions, so she is better off putting her contributions in a Roth retirement plan.  That is, it is better for to pay the taxes at the lower rate before she contributes money to a Roth plan than to pay the taxes at a higher rate on Traditional plan withdrawals in retirement.

How John’s and Jane’s Situations Differ

Jane’s situation differs from John’s in two ways:

  1. Her retirement expenses are expected to be much higher than her current salary, pushing her into a higher tax bracket in retirement than she is in today.
  2. She is funding some of her retirement expenses with other sources of income that are taxable which causes the marginal tax rate on her Traditional withdrawals to be higher than if all of her non-Social Security income were from her retirement plans.

How Taxes Have Changed

It is pretty clear that your spending when you retire would have to be much higher than your current income before a Roth retirement plan would be preferred under the current tax structure.  However, the tax structure changes frequently so it is impossible to know your marginal tax rate in retirement.  To shed some light on how much tax rates might change, I’ve compiled information from this site on historical tax rates.

Marginal Tax Rates Over Time

The graph below shows the marginal tax rate for four different taxable income levels: $40,000; $60,000; $100,000 and $200,000.  I adjusted these four amounts for inflation from 2018 back to each year shown in the chart. For example, the Social Security wage adjustment from 2000 to 2018 is 1.565.  I therefore looked up the marginal tax rate in 2000 for $25,559 (=$40,000/1.565) when creating the $40,000 line in this chart.

Tax rates prior to 1985 were much higher than they are today.  They were fairly constant from 1985 to 2014 with a few ups and down primarily at the higher income levels.  In 2015, the marginal tax rates for all but the $60,000 level in the chart increased. The increase for the $40,000 level brought the tax rate for people at that income to its highest level ever. In 2018, all of the tax rates decreased.

For people with taxable income in the $60,000 to $100,000 range, current tax rates are about as low as they have been in the past 35 years.  There is also a common sentiment that those with higher incomes should pay even higher taxes than they currently do.  Given the current financial condition of the Federal government, it seems more likely than not that tax rates will go up, making Roth plans more attractive.  One possible exception is people with lower incomes, e.g., at or below the $40,000 threshold in the graph, as their tax rates are high by historical standards.

How to Decide

Here are some guidelines you can use to decide whether a Roth or a Traditional plan is better for you. Characteristics that make a Roth plan better include:

  • Your salary and spending are likely to go up a lot before you retire.
  • You anticipate having a lot of taxable income in retirement, such as from a part-time job, a pension or savings not in a tax-sheltered retirement plan.
  • An expectation that tax rates will increase.

One suggestion I have seen that is interesting is to put some of your retirement savings in each of a Roth and a Traditional plan which you can do as long as the total doesn’t exceed the limit on contributions.  In this way, a portion of your retirement savings is protected from large increases in tax rates, but you still have the benefit of reducing your taxes now. This approach is similar to what I did. All of my 401(k) savings is in Traditional plans, while my IRA savings is all in a Roth plan.


[1]Here is a quick explanation of the (1 – tax rate) term in these formulas.  The pre-tax value is Contribution x (1 + compounded investment return) which can be thought of as Contribution x (1 + compounded investment return) x 1.  The tax on that amount is equal to Contribution x (1 + compounded investment return) x tax rate.  To get the after-tax return, we subtract the tax from the pre-tax value.   When we pull out the common term and group them (i.e., apply the distributive property of multiplication over subtraction for you math geeks), we get Contribution x (1 + compounded investment return) x (1 – tax rate).

Social Security: How Much Will I Get in Retirement

Social Security is a key pillar in most American’s retirement plans, especially those approaching retirement.  Many younger workers, though, have serious concerns about whether they will receive any benefits at all.  Even at current levels, Social Security benefits are not enough to support most people.  Understanding what impacts your Social Security benefits and how much you might get, whether you plan to retire soon or not for many years, are important components in determining how much money you’ll need to save.

Key Take-Aways

Here are the key take-aways from this post.  I’ll discuss these points in greater detail below.

  • While it is likely you will be able to collect some Social Security benefits when you retire, regardless of your age, the current combination of Social Security tax rate, benefit levels and normal retirement age is unsustainable. It will not be possible to pay benefits at current levels starting in roughly 2034 unless there is one or more of (a) an increase in the Social Security tax rate, (b) an increase in the wages subject to the Social Security tax, (c) a decrease in benefits or (d) a delay in the normal retirement age.
  • If you retire soon and start collecting your Social Security benefits at your normal retirement age (67 for most of you), they will replace between roughly 15% and 50% of your ending salary, with those of you making more money getting a higher dollar amount but a lower percentage of your ending salary.
  • You can start collecting benefits any time between your 62ndand 70th birthdays. The longer you wait, the higher your monthly benefit.   If you could be sure that you were going to die before you were between roughly 80 and 82, you would likely be better off collecting benefits at age 62.  Otherwise, you are better off delaying the start of your benefits.

Knowing how much you are likely to get in Social Security benefits is an important component of figure out how much you need to save for retirement and therefore how much you need to save each year.

How Likely Am I to Collect Benefits?

The most recent report from the Social Security Administration covers actual results through 2017.  In 2018, benefits and expenses paid under Social Security were expected to exceed total revenues for the first time in many years.  Revenue to the Social Security system comes from taxes paid by employees and employers and from interest and principal from the Social Security Trust Fund.  Under middle-of-the-road assumptions, the Trust Fund is estimated to be depleted in 2034.

Changes in Birth Rates

The decreases in the Trust Fund are due in large part to the birth patterns in the US, along with the lengthening of life expectancies.  Currently, the baby boom generation is receiving benefits and the “baby bust” generation and its employers are paying taxes.  The graph below shows the number of births in the US by year[1] and, specifically, the numbers of births during the baby boom and baby bust time periods.

Contributors vs. Beneficiaries

The graph below shows the number of workers paying social security taxes and the number receiving benefits.

The green line (beneficiaries) goes up faster than the blue line (covered workers). The ratio of the number of beneficiaries per worker (purple line corresponding to right axis) continues to go up in this intermediate projection through 2095, though at a much slower rate starting in 2035.  The higher number of people born each year starting in 1990 who will be in the workforce and the relatively smaller number of people who will be retiring from the baby bust generation allow the ratio to flatten.

What Does This Mean?

Just because the Trust Fund is depleted doesn’t mean there will be more benefits paid.  In fact, the current intermediate estimate is that 77% of the benefits can be paid in 2034 from the taxes collected that year.

If the assumptions in the intermediate forecast are reasonable, something will have to change.  Four options are:

  • Increase the tax rate. It is estimated that the Trust Fund will stay solvent for at least 75 years if the tax rate is increased immediately from 12.4% (currently split between employers and employees) to 15.18%.
  • Decrease benefits. Either a 17% reduction in benefits for existing and future beneficiaries or a 21% reduction in benefits for future beneficiaries is estimated to allow the Trust Fund to stay solvent for at least 75 years.
  • Collect taxes on 100% of wages. Currently, you pay taxes on wages up to the same cap that is used in determining your benefits.
  • Increase the normal retirement age.

What Does This Mean for You?

Clearly, something will have to change between now and the time Millennials retire and certainly before most of us die.  It is unclear what combination of the changes above will be implemented.

When I do my retirement planning, I consider two scenarios – one in which I receive my full Social Security benefits using the current benefit levels and one in which I receive no Social Security benefits.  I’m sure that what will actually happen will be somewhere between the two, so if I can live without any Social Security benefits (maybe not as nicely as I’d like), I can be more confident of having my desired retirement if I receive some or all of them.

What Determines My Benefits

There are two steps in the formula for determining the monthly benefit you will get if you start collecting benefits at your “normal retirement age.”

Normal Retirement Age

The table below, from the Social Security Administration web site, shows the normal retirement age based on year you were born.

Year Born Normal Retirement Age
1943-1954 66
1955 66 and 2 months
1956 66 and 4 months
1957 66 and 6 months
1958 66 and 8 months
1959 66 and 10 months
1960 & later 67

 

For most of you, your normal retirement age is currently 67.  In the remainder of this post, I’ll use 67 as the normal retirement age.  If you were born prior to 1960, you’ll need to revise the statements for your normal retirement age.

Data Needed to Apply Formula

The first step in the process requires your total wages by calendar year since you first started working.  The Social Security Administration usually sends this information to you every year or you can get the information on line if you are willing to put your social security number in the Social Security Administration’s web site.

As an aside, I always laugh when I get my wage statement.  I worked for my father’s company when I was 14.  My mother did all the financial reporting and must have reported the $100 of cash wages I made because it appears on my statement!

The Details of the Formula

For each calendar year, the Social Security Administration has determined two numbers: (1) an adjustment factor for inflation between the calendar year and today and (2) a cap on the amount of wages that are considered in the calculation.  The maximum amount of wages earned in 2018 considered in the benefit formula is $128,400.  The caps going back to 1980 are shown in the graph below.

These amounts and the inflation adjustment factors can also be seen in the table on the second page of this pdf.

In the first step of the calculation, you take the lesser of the wages you earned and the cap for each calendar year.  You multiply the result by the inflation adjustment factor for every calendar year.

You then figure out the 35 years in which your adjusted and capped wages were the highest.  If your wages increased faster than inflation (for example due to merit raises and/or promotions), the most recent 35 years will be the highest.  You then calculate your average monthly adjusted wages as the sum of your adjusted wages using the amounts for the 35 years you identified as having the highest values and divide by 420 (the number of months in 35 years).

Currently, your monthly benefit is equal to the sum of:

  • 90% of the lesser of your average monthly adjusted wages and $926.
  • 32% of the lesser of your average monthly adjusted wages, reduced by $926, and $4,657.
  • 15% of your average monthly adjusted wages minus $5,583.

Illustrations of the Benefit Calculation

The maximum monthly benefit you can get if your normal retirement age occurred in 2018 is approximately $3,100.  You would receive this benefit if, in at least 35 years during your career, you earned at least the cap (i.e., $128,400 for 2018, divided by the inflation factors for prior years).

Dollar Amounts

The table below shows the monthly benefit you would get at your normal retirement age under a number of assumptions regarding (a) your starting wage and (b) how much more than inflation your wages increased each year, e.g., from job changes, merit raises or promotions.

Merit Raise %\Starting Salary $30,000 $40,000 $50,000 $60,000 $70,000
0% $1,337 $1,603 $1,870 $2,137 $2,361
1% 1,498 1,819 2,140 2,387 2,538
2% 1,702 2,091 2,396 2,578 2,745
3% 1,960 2,375 2,585 2,741 2,850
4% 2,287 2,543 2,706 2,820 2,897

 

Percentage of Wages Replaced

To put these values in perspective, the table below shows these benefits as a percentage of the 2018 wages for each of these combinations.

Merit Raise %\Starting Salary $30,000 $40,000 $50,000 $60,000 $70,000
0% 53% 48% 45% 43% 40%
1% 42% 39% 36% 34% 31%
2% 34% 31% 29% 26% 24%
3% 28% 25% 22% 19% 17%
4% 23% 19% 16% 14% 13%

 

This table shows that Social Security currently replaces between roughly an eighth and a half of pre-retirement earnings, with people earning less having a higher percentage of income replaced than those earning more.  Note, though, that people earning less get lower benefits in absolute dollars; they just replace a greater percentage of their pre-retirement earnings.

What if I Start Collecting Early or Late?

The benefit amount that results from the calculations above is what you will get if you start collecting benefits at your normal retirement age. Once you start collecting monthly benefits, they increase in most years for inflation (also, known as the cost of living adjustment). The adjustment is determined by the Social Security Administration based on changes in the Consumer Price Index for Urban Wage Earners and Clerical Workers (known as CPI-W).   The graph below shows the cost of living adjustments since 1959.

Age-Based Adjustment Factors

If you choose to start collecting earlier (as young as age 62) or later (as old as age 70), that amount is adjusted.  The adjustments are:

  • For each month you are younger than your normal retirement age when you start collecting benefits, up to 36 months, your benefit is reduced by 5/9 of a percent or 0.56%.
  • For each additional month you are your normal retirement age minus 36 months, your benefit reduced is further reduced by 5/12 of a percent or 0.42%.
  • For each month you are older than your normal retirement age when you start collecting benefits, your benefit is increased by 8/12 of a percent or 0.67%.

The table below provides the factors that apply if you start your benefits in your birthday month, assuming your normal retirement age is 67.

Age when Benefits Start Adjustment Factor
62 0.70
63 0.75
64 0.80
65 0.87
66 0.93
67 1.00
68 1.08
69 1.16
70 1.24

 

Illustration

For example, if the monthly benefit starting at your normal retirement age is $2,500, your benefit if you started at age 62 would be $1,750 adjusted for changes in the cost of living between the year you turned 62 and your normal retirement age.  By the time you attained your normal retirement age, you would be receiving 30% (= 1 – 0.7) less than if started collecting your benefits at your normal retirement age.

Similarly, if the monthly benefit starting at your normal retirement age is $2,500, your benefit if you started at age 70 would be $3,100 (= $2,500 increased by 24%) plus changes in the cost of living between the year you turned 67 and your normal retirement age.

If you assume that you can earn an annual after-tax return of 3% on your retirement savings, you are better off starting your benefits at age 62 if you die before you turn 79.  If you die after you turn 82 with the same 3% return, you are better off starting your benefits at age 70.  As your after-tax return assumption increases, the ages at death increase. At a 6% after-tax return, the ages shift upwards by three years. Of course, none of us know when we are going to die, but might have some indication based on our overall health and family history.

Are Social Security Benefits Taxed?

Determining income taxes on Social Security benefits is complicated.  Because my purpose here is to give you an overview, I will provide a slightly simplified version.  If you are interested in the details, I suggest contacting your tax advisor or reviewing IRS Publication 915 available on the IRS web site.

The Formula

The first step in determining how much of your Social Security benefits will be subject to tax is to calculate the total of all of your taxable income (e.g., distributions from traditional IRAs and 401ks, taxable interest, dividends and capital gains, and any wages and pension income).  In the calculation that determines how much of your benefits are subject to income taxes, you add 50% of your social security benefits to your total taxable income.  I will call this total the Test Sum.

The table below shows what portion of your 2018 social security benefits would be subject to tax based on the value of the Test Sum

Test Sum Portion of SS benefits subject to tax
<= $25,000 None
Between $25,000 and $34,000 50% of the lesser of your SS benefit and (Test Sum – $25,000)
>$34,000 The lesser of 85% of your SS benefit and $4,500 plus 85% of (Test Sum – $34,000)

Example

Here is an example.

  • Mary started collecting Social Security benefits in January 2018.
  • In 2018, she collected $25,000 of Social Security benefits.
  • She took $23,000 from her Traditional IRA so the sum of her Social Security benefits and IRA distributions equaled 80% of her pre-retirement salary.

Her Test Sum is $23,000 + 50% of $25,000 or $35,500.  She falls in the highest category in the table so would pay tax on the lesser of 85% of her Social Security benefit (= $25,000 x 0.85 = $21,250) and $4,500 plus 85% of the excess of Test Sum over $34,000 (= $4,500 + .85 x ($35,000 – $34,000) = $4,500 + $850 = $5,350).  Because $5,350 is less than $21,250, she will pay taxes on $5,350 of her Social Security benefit.

If, instead, Mary had no IRA withdrawals and no other income, she would fall in the lowest category in the table and would pay tax on none of her Social Security benefit. At the other extreme, if she had other taxable income of $100,000, she would pay tax on 85% of her Social Security benefit or $21,250.

Next week, I’ll talk about how Social Security benefits affect your decision as to whether to use a Traditional or Roth account for your retirement savings.


[1]https://www.infoplease.com/us/births/live-births-and-birth-rates-year, February 21, 2019.

Retirement Savings/Saving for Large Purchases

In my previous post, I presented the first part of a case study that introduced Mary and her questions about what to do with her savings. In this post, I will continue the case study focusing on retirement savings and saving for large purchases. 

Case Study

To help set the stage, I created a fictitious person, Mary, whose finances I use for illustration.

  • Mary is single with no dependents.
  • She lives alone in an apartment she rents.
  • She makes $62,000 per year.
  • Mary has $25,000 in a savings account at her bank and $10,000 in her Roth 401(k).
  • Her annual budget shows:
    • Basic living expenses of $40,000
    • $5,000 for fun and discretionary items
    • $10,000 for social security, Federal and state income taxes
    • $4,000 for 401(k) contributions
    • $3,000 for non-retirement savings
  • Mary has $15,000 in student loans which have a 5% interest rate.
  • She owns her seven-year-old car outright. She plans to replace her car with a used vehicle in three years and would like to have $10,000 in cash to pay for it.
  • She has no plans to buy a house in the near future.
Mary's-Savings-Infographic

Her questions are:

  • Should I start investing the $25,000 in my savings account?
  • Should I have a separate account to save the $10,000 for the car?  
  • What choices do I have for my first investments for any money I don’t set aside for my car?
  • Should I pay off some or all of the principal on my student loans?

I talked about a framework for thinking about her savings and setting aside money for expenses she doesn’t pay monthly and emergency savings here.  In this post, I’ll focus on the rest of her savings.  I answer her questions about student loans here

Designated Savings

Designated savings is the portion of your investable asset portfolio that you set aside for a specific purchase, such as a car or home. Mary would like to buy a car for $10,000 in three years.  She needs to designate a portion of her savings for her car.

As part of her savings framework, Mary

  • Will set aside $13,000 for emergency savings.
  • Has $12,000 in her savings account after setting aside the $13,000 for emergency savings.
  • Included $3,000 a year for non-retirement savings in her budget, some of which she can use for her car.

Mary has decided she will use $5,500 as the start of her designated savings to replace her car. After reading this post, she has decided to pay cash for a car, rather than borrow or lease,  She will add half of her $3,000 of non-retirement savings each year to bring the total available balance to $10,000 in three years.  If Mary’s car becomes unrepairable sooner, she can use some of the money in her emergency savings, but will want to replenish that account as soon as she can.

Considerations for Investment Choices

When I’m saving money for a large purchase, such as a car or a down payment on a house, I’m willing to invest in something less liquid than a savings account or a money market account. That is, I don’t have to be able to access the money on a moment’s notice.  

I do, however, want a similar level of security.  It is very important to me that the market value of my investment not go down as I don’t want to risk my principal.  Because I tend to have time frames that are less than one year for these types of purchases, I tend to put my designated savings in certificates of deposit. 

Certificates of Deposit and Treasury Bills

In Mary’s case, she has three years.  She might consider longer-term certificates of deposit (CDs) or short-term government bonds. (Click here to learn more about bonds.) A CD is a savings certificate, usually issued by a commercial bank, with a stated maturity and a fixed interest rate.  

A treasury note is a form of a bond issued by the US government with a fixed interest rate and a maturity of one to 10 years.  A treasury bill is the same as a treasury note, except the maturity is less than one year.  When the government issues notes, bills and bonds (which have maturities of more than 10 years), it is borrowing money from the person or entity that buys them.  The table below shows the current interest rates on CDs and treasury bills and notes with different maturities.

Maturity CD[1] Treasury[2]
1-3 Months 2.32% 2.3%
4-6 Months 2.42% 2.5%
7-9 Months 2.56% N/A
10-18 Months 2.8% 2.7%
1.5–2.5 Years 3.4% 2.8%
3 Years N/A 2.85%
5 Years N/A 2.9%

When thinking about whether to buy CDs or Treasury bonds, Mary will want to consider not only the differences in returns, but also the differences in risk.  

Risks of Owning a Bond

Bonds have two key inherent risks – default risk and market risk

  • Default risk is the chance that the issuer will default on its obligations (i.e., not pay you some or all of your interest or principal).  Treasury notes, bills and bond issued by the US are considered some of the safest bonds from a default perspective.  I’m not aware that the US government (or Canadian government for that matter) has ever not paid the interest or repaid the principal on any of its debt. 
  • Market risk emanates from changes in interest rates that cause changes in the market values of bonds.  As interest rates go up, the market values of bonds go down.  All bonds come with a maturity date that is almost always stated in the name of the bond.[3]   If you buy a bonddon’t sell it until it matures and the issuer doesn’t default, you will get the face amount (i.e., the principal) of the bond no matter how interest rates change.  Thus, if you hold a bond to maturity, you eliminate the market risk

In summary, using certificates of deposit or Treasuries held to maturity can increase your investment return relative to a savings account without significantly increasing the risk that you’ll lose the money you’ve saved.  

Mary’s Decision

Because she can buy them easily at her bank or brokerage firm and they are currently yielding more the Treasuries with the same maturity, Mary has decided to buy 2.5-year CDs, earning 3.4%, with the $5,500 she has set aside to buy her car.

Long-term Savings – What to Buy

Mary has $6,500 in her savings account that isn’t needed for her emergency savings or her replacement car. She wants to start investing it or use it to pay down some of her student loans.  I’ll talk about her student loans next week.

Mary doesn’t want to spend a lot of time doing research, so is not going to invest in individual securities.[4]  Instead, she is looking at mutual funds and exchange-traded funds (ETFs).  A benefit of these funds over individual securities is that they own positions in a lot of companies so it is easier for Mary to diversify[5]her portfolio than if she bought positions in individual companies.

Mutual Fund and ETF Considerations

Briefly, here are some of the features to consider in selecting a mutual fund or an ETF.  I note that you may not have answers to a lot of these questions, but they should help you get started in your thinking[6].

  • The types of positions it holds and whether they are consistent with your investment objectives. Is the fund concentrated in a few industries or is the fund intended to produce the same returns as the overall market (such as the S&P 500 or Dow Jones Industrial Average)?  Does it invest in larger or smaller companies?  Does the fund focus on growth or dividend-yielding positions?  Is it an index fund or actively-traded?
  • The expense load.  All mutual fund and ETF managers take a portion of the money in their funds to cover their expenses.  The managers make their money from these fees.  Funds are required to report their expenses, as these reduce your overall return on investment.  There are two types of expense load – front-end loads and annual expenses.  If you buy a fund with a front-end load, it will reduce your investment by the percentage corresponding to the front-end load when you buy it.  Almost all funds have annual expenses which reduce the value of your holdings every year.  Although funds with lower expense loads generally have better performance than those with higher loads, there may be some funds that outperform even after consideration of a higher expense load.
  • Historical performance.  Although historical performance is never a predictor of future performance, a fund that has a good track record might be preferred to one that has a poor track record or is new.  As you review returns, look not only at average returns but also volatility (such as the standard deviation).  A fund with higher volatility should have a higher return.

Mutual Funds and ETFs – How to Buy

You can buy mutual funds directly from the fund management company.  You can also buy mutual funds and ETFs through a brokerage company.  If you buy them through a brokerage company, you will pay a small transaction fee but it is often easier to buy and sell the funds, if needed.  Holding these assets in a brokerage account also lets you see more of your investments in one place.

Mary’s Decision

Mary decides to invest in an S&P 500 index fund (a form of exchanged-traded fund that is intended to track S&P 500 returns fairly closely).  Since 1950, the total return on the S&P 500 corresponds to 8.9% compounded annually.  It is important to understand that the returns are very volatile from month-to-month and even year-to-year, so she might not earn as much as 8.9% return over any specific time period.[7]

Retirement Savings – What Type of Account?

As Mary thinks about her long-term savings, she not only wants to decide how to invest it, but also in what type of account to put it – a tax-sheltered retirement savings account or a taxable account she can access at any time[8].  In addition, she needs to think about how much she needs in total to retire and how much she will need to set aside each year.

Retirement Account Contribution Limits

In the US for 2018, she is allowed to contribute $18,500 ($24,500 after age 50) to a 401(k) plus $5,500 ($6,500 after age 50) to an Individual Retirement Account.  

In Canada, the 2018 maximum contribution to group and individual Registered Retirement Savings Plans (RRSPs) combined is the lesser of 18% of earned income or $26,230.  The 2018 maximum contribution to group and individual Tax-Free Savings Accounts (TFSAs) is $5,500.  If you didn’t make contributions up to the limit last year, you can carry over the unused portion to increase your maximum contribution for this year.

In Canada, there are no penalties for early withdrawal from a RRSP or TFSA as long as the withdrawal is not made in the year you make the contribution, so it is easy to take advantage of the tax savings.  If you make the withdrawal from an RRSP, you need to pay taxes on the withdrawal.  In the US, there is a 10% penalty for withdrawing money from a 401(k) or IRA before the year in which you turn 59.5. As such, the choice of putting your money in a 401(k) or IRA needs to consider the likelihood that you’ll want to spend your long-term savings before then.

Returns: Taxable Account vs. Roth IRA/TFSA

Mary has decided she won’t need the money for a long time.  She will decide how much to put in her retirement account and taxable accounts after she looks at her student loans.  Mary’s savings is considered after-tax money.  As such, she can put it in a Roth IRA or TFSA.  She will not pay taxes on the money when she withdraws it.  If she didn’t put the money in a Roth IRA or TFSA, she would have to pay income taxes on the investment returns.[9]  If she puts it in a Traditional IRA or RRSP, the amount of her contribution will reduce her taxable income but she will pay taxes on the money when she withdraws it. This graph compares how Mary’s money will grow[10]over the next 30 years if she invests it in a Roth IRA or TFSA as compared to a taxable account.  

Savings comparison, Roth vs Taxable savings

As you can see, $4,000 grows to just over $30,000 over 30 years in a taxable account and just over $50,000 in a Roth account assuming a constant 8.9% return and a 20% tax rate.

Key Points

The key takeaways from this case study are:

  • You may need to save for large purchases over several years.  The amount you need to set aside today as designated savings for those purchases depends on how much they will cost, when you need to buy them and how much of your future budget you can add to those savings.
  • Certificates of deposit are very low-risk investment instruments that can be used for designated savings.  
  • Treasuries with maturity dates that line up with your target purchase date can also be used for designated savings.  By holding bonds to maturity, you eliminate the market risk.
  • Mutual funds and ETFs require less research and more diversification than owning individual companies (unless you own positions in a very large number of companies).  These instruments are an easy way to get started with investing.

Your Next Steps

This post talks about Mary’s situation.  Here are some questions you can be asking yourself and things you can do to apply these concepts to your situation.

  1. Identify the large purchases you want to make.  These purchases can include a car, an extravagant vacation or a house, among other things.  For each purchase, estimate when you will want to spend the money and how much they will cost. 
  2. Determine how much of your savings you can set aside for these large purchases.  Look at your budget to make sure you can set aside enough money to cover the rest of the cost.  If you can’t, you’ll need to either make changes to your aspirations or your budget.  In my budgeting series starting in a few weeks, I’ll dedicate an entire post to what to do when your expenses are more than your income.  
  3. Decide whether to start a relationship with a brokerage firm.  Last week, I provided a list of questions to help you get started if you do.
  4. Look into options for your designated savings.
    • What are the returns offered by your bank or, if you have one, brokerage firm, on certificates of deposit with terms corresponding to when you need your designated savings? 
    • How do Treasury returns compare to certificates of deposit?
  5. Decide how much of your long-term savings you want to put into retirement accounts and how much will be left for other savings.  I put as much as I could into retirement accounts, but always made sure I had enough other savings for large purchases that I hadn’t identified in enough detail to include in designated savings.  If you want to retire before the year you turn 59.5, you’ll also want to keep enough long-term savings out of your retirement accounts to cover all of your expenses until that year. 
  6. Decide whether you want to start investing your long-term savings in mutual or exchange traded funds or in individual stocks.  If mutual or exchange traded funds, take a look at the list of questions above.

[1]https://www.schwab.com/public/schwab/investing/accounts_products/investment/bonds/certificates_of_deposit, November 17, 2018.

[2]www.treasury.gov, November 17, 2018.

[3]Some bonds have features that allow the issuer to re-pay the principal before the maturity date.  For this discussion, we will focus on bonds that do not give the issuer that option.  These bonds are referred to as “non-callable.”  Bonds that can be re-paid before the maturity date are referred to as callable bonds.

[4]For those of you interested in investing in individual equities, a guest blogger, Riley of Young and The Invested (www.youngandtheinvested.com), will write about how to get started with looking at individual companies right after the first of the year.

[5]Portfolio diversification is an important concept in investing.  I’ll have a few posts on this topic in the coming months.

[6]If you are interested in more information on selecting mutual funds, I found a nice article at https://www.kiplinger.com/article/investing/T041-C007-S001-my-9-rules-for-picking-mutual-funds.html

[7]This volatility is often referred to as the risk of a financial instrument and is another important concept in investing. Look for insights into the trade-off between risk and reward coming soon.

[8]I’ll cover retirement savings more in a future post.

[9]Income taxes on investments are somewhat complicated.  For the illustrations here, I’ll assume that Mary’s combined Federal and state tax rate applicable to investment returns is 20% and that all returns are taxable in the year she earns them.  There are some types of assets for which that isn’t the case, but identifying them is beyond the scope of this post.

[10]For illustration, this graph shows a constant 8.9% return.  Over long periods of time, the S&P 500 has returned very roughly 8.9% per year on average.  The returns vary widely from year-to-year, but for making long-term comparisons a constant annual return is informative even though it isn’t accurate. 

Investment Options in Retirement Savings Plans

All investment decisions are a trade-off between risk and reward. In this post, I’ll focus on how risk and reward affect your decision among the investment options in your employer-sponsored retirement plans.

If you look at returns over very long periods of time, well diversified, riskier investments tend to produce higher returns with lower risk. For most of these investments, “a very long period of time” is somewhere between 10 and 30 years. That doesn’t mean that the riskiest investments will always outperform the less risky investments in every 10 or 20 year period, but, if you look at enough of them, they generally will on average.

When I Take More Risk

Very briefly, three characteristics I use to help decide whether I want to lean towards a more or less risky investment are:

    • With only a small amount to invest, I will tend to be purchase less risky investments than if I have a larger amount because I have less of a cushion and I want to protect it.
    • When I know I will need the money very soon, I invest in less risky investments (or possibly keep it in a savings or checking account). With longer time periods, riskier investments have more time to recover if they have a large decline. If I need the money soon, I might not have enough money for my purchase if the values declined.
    • If I have almost as much money as I need for a purchase that isn’t going to be made for a while (for example when I had enough money saved for my children’s college education), I will purchase less risky investments as I don’t need a high rate of return to meet my objectives and also want to protect my savings.

     

  • If you aren’t comfortable with the concept of risk, I suggest looking at my post on that topic.

    Common Choices

    Commonly available investment options in employer-sponsored retirement plans are listed below. I have put them in an order that roughly corresponds to increasing risk.

    • Money market funds – Money market funds invest in what are considered short-term, liquid (easily sold) securities. They are similar to, but slightly riskier than, interest-bearing savings accounts.
    • Stable value funds – A stable value fund usually buys and sells highly-rated corporate or government bonds with short to intermediate times to maturity. The return on a stable value fund is the sum of the changes in the market value plus the coupon payments on the bonds held by the fund.   Because stable value funds tend to buy bonds with shorter times to maturity than typical bond mutual funds, they often have lower returns and be less risky.
    • Bond Mutual Funds – Bond mutual funds buy and sell bonds. The return on a bond mutual fund is the sum of the changes in the market value plus the coupon payments. Although they don’t track exactly, the market values of bonds tend to go down when interest rates go up and vice versa.
    • Large Cap Equity Mutual Funds – These funds buy and sell stocks in large companies, often defined as those with more than $10 billion of market capitalization (the total market value of all the stock it has issued).
    • Small Cap Equity Mutual Funds – These funds buy and sell stocks in smaller companies.
    • Foreign Equity Mutual Funds – These funds buy and sell stocks in foreign companies. Every foreign equity fund is allowed to define the countries in which it invests.   You’ll want to look to see in what countries your fund options invest to evaluate their level of risk.
    • Emerging Market Equity Mutual Funds – These funds buy and sell stocks in companies in countries that are considering emerging markets. Morocco, the Philippines, Brazil and South Africa are examples of currently emerging markets.
    • Retirement Date Funds – These fund managers buys bond mutual funds and equity mutual funds.  Each fund has a range of retirement dates associated with it.  The fund manager selects the allocation between bond funds and stock funds based on its evaluation of the amount of mix you should take given the length of time to retirement.  The key advantage of a retirement date fund is that you don’t have to make any decisions – the fund manager does it all.  The disadvantages of retirement date funds include the fact that they ignore your personal risk tolerance, they don’t consider other assets you may own outside the retirement date fund and some of them have fairly high fees, since the retirement date fund manager receives a fee on top of the fees charged by the mutual funds selected by the fund manager.

    Other Choices

    Some employers offer index funds which are variations on equity mutual funds. An index fund’s performance tracks as closely as possible to a major stock market index. The Dow Jones Industrial Average, the Standard & Poors (S&P) 500 or the Russell 2000 are examples of indices. The first two indices have risk and return characteristics somewhat similar to large cap equity mutual funds. The Russell 200 is more closely aligned with a medium or small cap equity mutual fund.

    Increasingly, employers are offering Target Retirement Date Funds as an option. The fund manager not only selects the individual securities that will be owned by the fund, but also chooses the mix between equities and bonds.   In theory, the number of years until the target retirement dates for that fund determines the mix of investments. For example, a fund with a target retirement date range of 2021 through 2025 might be invested more heavily in bonds than a fund with a target retirement date range of 2051 through 2055. People who are close to retirement are often more interested in protecting their investments (i.e., want less risk). On the other hand, people who don’t plan to retire for many years are often more willing to take on additional risk in exchange for higher returns. You can accomplish the same mix yourself using bond funds and equity funds, but some people prefer to let the fund manager make that decision.

    Some employers allow or require you to invest in company stock in their defined contribution plans. Many of these employers consider an investment in the company’s stock as an indication of loyalty. I view it as a very risky investment option. I discuss the benefits of diversification in this post. If your investment portfolio is diversified, it means that a decline in value of any one security will not adversely impact the total value of your portfolio too severely. If you purchase your employer’s stock, you are investing in a single company rather than investing in the larger number of companies owned by a mutual fund. In a really severe situation, you could lose your job and the stock value could drop significantly, leaving you with much smaller savings and no salary. As such, you take on much less risk if you select a mutual fund than company stock.

    How I Decided

    As I made my 401(k) investment selections, I thought about what other investments I had, if any, and used the 401(k) choices to fill in the gaps. That is, I used my 401(k) investment selections to increase my diversification. When I was young, I selected two or three funds that had US exposure to each of small and large cap equities. As I had more money both in and out of my 401(k), I still selected two or three funds, but invested in at least one fund with foreign or emerging market exposure to further diversify my holdings.

    Fine Print

    As a reminder, I am not qualified to give investment advice for your individual situation. Nonetheless, I can provide insights about the types of investment options I’ve seen in employer-sponsored retirement plans. I’ll describe the characteristics of most of these investment vehicles in more detail in later posts, but want to touch on them now as many of you will be making employee benefit elections before then.