Retirement Planning
1. The “elephant in the room” for retirement planning is the question of how much money you’ll need to have saved in order to afford the retirement you want. There are four ingredients to determining the “need” answer: How much you’ll be paid by Social Security (and by a pension, if you’re one of the few), how much you want to spend each retired year, how long you’ll be retired, and how quickly the money in your nest egg will grow as it waits for withdrawal. The other vital question, the “donkey in the room,” is how much you’ll need to invest in order to reach that goal. This depends on how long you have until you retire, and again how quickly the money in the account will grow. How are Americans with these questions in general? Unrealistically optimistic: https://www.marketwatch.com/story/retirees-are-overly-optimistic-about-their-financial-future-11620090728 . (Would they be more eager to save for retirement is they realized that every $1 saved as a 25-year-old could grow to $32 by the time they’re 70 years old?)
2. Either you’ve opened your account at the Social Security Administration and can see your specific estimated monthly benefits level, or you can use the average of $1,544 per month, or $18,528 per year. (That’s not a high number, but it’s nice to know that this amount is adjusted every year to keep pace with inflation.) How much you paid into Social Security directly corresponds to how much you’ll receive back from it, per month. If you will be receiving a pension, then every quarter you should receive updates on the estimated amount it’ll pay you per month during retirement.
There are various types of Social Security income, but as this course is about personal financial planning, the income we’re going to focus on is the retirement benefit. And even then, this is a complex topic! I’m going to focus only on the simplest of examples, which is you as an individual, working for a company. (There are many spousal rules for Social Security which… get complicated. And self-employment is also tricky.)
Social Security retirement income depends on two factors: How much you’ve paid in, and how old you are when you start taking the benefits. (Note that whether you’re a U.S. citizen doesn’t matter.)
Factor One
How do you pay in? First, on your W-2, there are “FICA” or “payroll taxes,” at 6.2% of your income. And your employer also pays 6.2% of your income into Social Security on your behalf, as well. So if you’re working for a business, then 12.4% of your income is the amount being contributed to Social Security. (Note that these contributions stop taking money at higher incomes. For 2021, that’s at $142,800. That means that if you make $144,800 during 2021, then you only into Social Security for the first $142,800, and you don’t pay 6.2% from that other $2,000. Why? The philosophy is because the amount Social Security pays retirees is also capped.) But let’s start at the beginning.
If you’ve paid into Social Security at least 10 years, then you qualify to receive retirement benefits during your entire retirement. (I know people delighted to work “under the table,” meaning that they are paid in cash and don’t declare that income on their taxes. This also means they aren’t building up their Social Security records.) The maximum number of years Social Security considers is 35— so try your best to have 35 decent income years in your career path! (This is the first reason I’m going to try to work until I reach 70.) How much you receive from Social Security depends on three factors: how much you’ve paid in, when you’ll begin taking the benefits, and how long you’ll live. How much you’ve paid in is 12.4% of your pay, half paid by you and half paid by your employer, for up to 35 years. If you work more than 35 years, the calculation will use your 35 highest-income years (after adjusting for inflation).
Factor Two
You can begin taking the benefits as early as age 62, but you’ll get much smaller monthly paychecks if you do. If you were born after 1960, then to receive your full standard monthly paychecks, you’ll need to delay receiving them until your 67th birthday. And can you delay longer? Yes, your monthly paychecks will be much larger is you delay until 68, 69 or even to 70. The paychecks grow by about 8% per year for waiting. (This is the second reason I’d like to keep working until 70.)
There’s another reason to wait past age 62 to start receiving your Social Security income: health insurance. Even though our course coverage of “insurance” is the next section, there’s one concept within it that needs to be included in the discussion of when to retire and to begin receiving Social Security income: Medicare. Medicare is the partially-subsidized health insurance program run by the federal government, and currently isn’t available until you reach age 65. So if you retire at age 62 and want to have health insurance coverage, your health insurance will come from a private insurer, and the premium is often extremely expensive. For example, a monthly health insurance premium for a 63-year-old single person might be $2,000 per month. https://www.cnbc.com/2018/12/28/getting-close-to-retirement-here-are-six-key-considerations.html . Your $1,500 per month Social Security income wouldn’t even cover your health insurance of $2,000 per month.
Also, it’s been well-established by polls that Social Security is extremely popular. It’s unreasonable to assume any political party will discontinue Social Security. Whether Social Security gets changed is another matter, but I know of no current plausible plans promoting any changes to be made. For more information on retirement planning, especially Social Security, here’s a reliable source: https://www.usa.gov/retirement.
3. To determine how much you’ll need to spend each retired year, you’ll need to know how much you currently spend, which will be addressed in Chapter 13: Budgeting. Americans are typically bad at budgeting for retirement, as confirmed in this study by the CFPB. (You need to read the Table of Contents for the findings, but reading the actual full report is optional: https://files.consumerfinance.gov/f/documents/cfpb_retirement-security-financial-decision-making_research-brief.pdf.) First, it’s good to know that the financial health of retirees is being examined, because that’s a prerequisite for knowing whether the Social Security and/or Medicare programs are adequate. Second, there are limited conclusions we can draw when there’s dramatic income inequality and wealth inequality in the country, and for studies like this all people are simply lumped together. Third, check out the three “Social Security” lines of Table 3 on page 14. [“FRA” stands for “full retirement age,” which for you and me is 67 years old.] The table shows that later people waited before claiming Social Security benefits, the higher the probability that they could maintain the same spending level five years after retiring. Why might this be? Probably primarily because these people had enough money to delay taking Social Security. But also because these people were able to continue working. We’re each dealt a genetic hand of cards to play, but by taking care of ourselves we can try to improve both the quality and longevity of our stories. To the extent we succeed, we can delay taking Social Security.
The traditional estimates of how much you’ll need to spend each retired year held that it’d be 80%-70% of your annual spending during your pre-retirement years, but due to rising healthcare costs, my suggestion is 100% of your pre-retirement spending level. The good news is that during retirement you can stop contributing toward your retirement, because you’ve reached retirement! The other factor will be lifestyle changes. For example, I know many seniors who envisioned moving upon retirement, only to change their minds for factors they hadn’t considered, such as convenient access to healthcare, the amount of physical labor involved with some rural lifestyles, or natural disaster risks. If you want to travel during retirement, include that in your spending projections. (Want to budget for matching retirement spending to pre-retirement spending? Then during retirement you can spend the amounts you used to save toward retirement. That can be your travel fund or whatever.)
4. The third ingredient is the number of years you’ll be retired. There’s a simple, but not easy, way to avoid specifically estimating the number of years you’ll have between retiring and dying. Many advisors promote models which assume you want to spend your last penny on your deathbed, but to do so, you need to predict when that’ll be. Many people are uncomfortable about that, about estimating when they might die. Here’s another approach: Aim high. If you have loved ones to whom you’d like to leave any leftover wealth, why not assume you’ll live to 100? If you make it to 100, then you’ve budgeted accurately. But if you don’t make it to 100, yet you saved as though you would, then you’ll have leftover wealth which can help those you leave behind. Isn’t that a comforting thought?
5. The estimate for the fourth ingredient, how quickly your nest egg balance will continue to grow, builds on Chapter 9: Investments Planning. Using the industry standard range of 6%-8% seems appropriate as a general ballpark, but in this chapter you’ll see the legal tax avoidance opportunities to help your retirement nest egg grow faster. The faster your balance continues to grow, the longer it’ll last. Here’s a nice introduction to this concept, “Why $1 Million Dollars Is NOT ENOUGH MONEY To Retire! – How Much Do Your NEED? | Minority Mindset,” 19½ minutes: https://www.youtube.com/watch?v=H6VR5UAF_VQ.
6. Elephant Conclusion: Nest Egg Math
You can find your target retirement account balance (“nest egg”) by inputting three estimated numbers into Excel’s “=pv()” formula. The total format is “=pv(rate, nper, pmt, [fv], [type]).” It’s not as bad as it may look, especially as the “[fv], [type]” part can be simply ignored. For simplicity we’ll leave retirement spending planning in annual amounts. “Rate” is the estimated average annual return on your investment portfolio, “nper” is the estimated number of years of retirement (from working until “death,” where “death” may be 100 to avoid hard introspection), and “pmt” (which stands for “payment”) is the amount of your annual retired budget. Here are some examples so you can ensure that you’re using the formula correctly. To show you how they’re done, I’ll make a quick “nest egg” video to run you through these three examples.
a. You estimate your account will grow at 7% annually, that you’ll have 20 years of retirement, and that you’ll spend $60,000 per year during that retirement. The nest egg you’ll need is then “=pv(7%,20,60000-18000).” (The $18,000 is annual Social Security income, so that much isn’t coming from your accumulated savings.) Note that you can’t include either the “$” or the comma from the $60,000 or the $18,000. This scenario requires a retirement account balance of $444,948.60 to achieve, and can be looked at another way. It’s also valid to interpret this as “Once your retirement account balance reaches $444,948.60, you’ll be able to afford 20 years without working (assuming an average account growth rate of 7%).”
b. Your estimates are a 6% return, that you’ll have 15 years of retirement, and that you’ll spend $80,000 per year during that retirement. The nest egg you’ll need is then $602,159.04.
c. My grandfather was young and working as an executive secretary during the Great Depression. One day after his office of 52 people was cut down to 4 people, his boss asked him whether he knew bookkeeping. My grandfather replied that he did, and the next day the office was cut down to 3 people. Then my grandfather spent several long nights with a pharmacist friend, learning bookkeeping! Decades later, my grandfather explained to me “The models said I’d live to 70 or 75, so I planned very carefully for 80. But I just turned 90 and now money’s getting tight.” And you, dear reader, might even reach 100! (Remember from Chapter 4 that there are over 90,000 U.S. citizens who are 100 years old or older.) So your third example is 8%, 30 years, and $70,000. This would require a nest egg of $585,404.73.
7. Next is the “donkey in the room:” how much you’ll need to invest in order to reach that goal. This depends on how long you have until you retire, and again how quickly the money in the account will grow. How long you have until you retire depends on health considerations, the nature of your work, and your decision whether to continue working. As long as the Medicare age is 65, you’ll probably want to ignore that you can take Social Security as early as 62, and work at least until age 65.
8. The U.S. tax law encourages people to save for retirement by offering legal tax avoidance. The main three tax-advantaged account types are the IRA (and Roth IRA), the 401(k) (and Roth 401(k), 403b, Roth 403b 457, Roth 457), and the HSA. First let’s review how investments normally get taxed. Before you invest, you earn money and pay income taxes on those earnings. Then you invest some of those after-tax earnings. When you invest, the amount your investments grow is the capital gains, and when you withdraw that money, the growth amount (the capital gains) counts as income when you file your taxes for the year. So in effect you had income taxed, then you invested it, and then its growth amount also gets taxed. (And if the investments pay dividends or interest payments, those get taxed as income as well, although sometimes at lower rates.) That’s the base case of how investments are taxed without any tax minimization. Now let’s explore the legal ways to avoid some of these taxations.
9. A. The IRA, or Individual Retirement Account, is an account anyone can open at an investment bank. And once you put money into it, you can have that money invested any way you’d like. So what’s the point? Tax savings. The money you put into an IRA (or “Traditional IRA”) gets subtracted from your income before you calculate your income taxes for the year. That saves you money on your taxes. The annual maximum amount you can put into your IRA is $6,000 of your earned income. (That’s from your W-2 income, from working. It can’t be income that someone gifted you.) If you’re 50 years old or older, the government realizes you’re having an “Oh shit!” moment about saving for retirement, and let’s you invest $7,000 per year instead. When you retire and start withdrawing money from your IRA, the amount it grew counts as income and gets included when you file your income taxes.
B. “What is an IRA? | by Wall Street Survivor” 2½ mins: https://www.youtube.com/watch?v=Q4gxHArR7P8 (The $10,000 mentioned at 46 seconds in needs to be corrected. The contribution limit is $6,000 per year if you’re under 50 years old, $7,000 if you’re 50 years old or older. But even if Mike is married, that still means his limits are $6,000 to each of his and his spouse’s IRA’s, if they are under 50. So it still couldn’t be $10,000 into the same account.)
10. A. The Roth IRA is similar, only instead of getting a same-year tax break on the money you invest into the account, the money in the account gets withdrawn completely tax-free after growing. However, people who earn too much income can’t fully contribute to a Roth IRA. For people under 50 years old, the 2021 income limits for contributing the full $6,000 are $125,000 (of MAGI) for filing as single, $198,000 (MAGI) for filing as married filing jointly, so most people don’t have to worry about those: https://www.irs.gov/retirement-plans/amount-of-roth-ira-contributions-that-you-can-make-for-2021 .
B. Worthless teaser title, but worthwhile article: http://money.com/money/5639021/suze-orman-retirement-roth-ira-strategy/. Well-known investor Bill Ackerman recommends we save 6-12 months of living expenses, and here’s Orman suggesting 8 months. Either way that’s a lot, so this recommendation that Roth IRA funds can be used for emergencies enables you to start investing that much sooner.
11. Choosing between the Traditional IRA and Roth IRA is guessing when you’ll face the higher income tax rates, now versus during retirement. The Roth IRA is the option chosen by Dr. Stewart, because income tax rates are currently low by historical standards, and because if natural disasters are going to increase in severity in the future, taxes will need to increase for disaster relief efforts. (And taxes will eventually increase to pay for the stimulus packages being passed due to covid-19.)
12. A. Before turning to videos which explain the 401(k) better than I could and which explain the IRA more entertainingly than I could, there’s one common misperception I’d like to address: In the past, students have had the mistaken thought that either the IRA or 401(k) are investments. They aren’t. Instead, they are types of accounts. “IRA” stands for “individual retirement account,” so when people say “IRA account,” they’re being redundant. (People commonly say that anyway.) Once you have money in any of those accounts, then you need to decide how that money is invested. Otherwise, your money is just sitting there as cash (or as a money market investment, which grows at a very very slow but stable rate). Here’s an analogy: When most people hear that someone is a student-athlete, they think “Oh cool, what sport?” There are many possible sports, of course. Similarly, when you hear someone has “invested in an IRA or 401(k),” you should think “Oh cool, how is that money invested?”
B. “What is a 401(k)? | by Wall Street Survivor” 2½ mins: https://www.youtube.com/watch?v=tP4zWCS4dMM. From what I’ve heard, matching is much more common than profit-sharing, but matching is great! The amounts you contribute which are matched instantly double, if it’s 100% matching. Where else can you instantly double your money?
C. Minority Mindset’s “The TRUTH About Your 401(k) That No One Tells You,” 9½ mins: https://www.youtube.com/watch?v=4YdlcpxvF6c. Jaspreet reviews why pensions died and 401(k)’s replaced them, then clarifies the problem of 401(k) fees and lack of diversification. (Note that I disagree with his suggestion of investing in physical gold.) It’s a great detail that he mentions FICA taxes are calculated prior to 401(k) [or Traditional IRA] contributions! For the vast majority of people, FICA taxes are the 6.2% you pay into Social Security plus the 1.45% you pay into the Medicare program: https://www.investopedia.com/terms/f/fica.asp. Also, note that Jaspreet is correct: Under current law, there’s a lower tax rate on capital gains than on ordinary (earned) income. So that aspect is a relative disadvantage to a 401(k) and advantage to non-tax-advantaged investing, as odd as that sounds. I totally agree that tax rates will probably increase in the future.
1. “401(k) and IRA 101 (Investing Basics 3/3, Retirement Basics ½)” 5¼ mins: https://www.youtube.com/watch?v=ApHRfYA1A-Y. This contrasts the 401(k) from the similar 403(b), and gives excellent advice on prioritizing your investing. To contrast the 403(b) from the 457, here’s a concise article: https://www.investopedia.com/articles/personal-finance/111615/457-plans-and-403b-plans-comparison.asp .
2. [Optional] SYCO: Simplify Yourself, Complicate Others (Personal advice) I advocate being a SYCO! This concept is simplifying your life, but not falling into the habit of assuming anyone else’s life is also simplified. I’ve known way too many people who try to live like Batman, where they have one personality at home, and a separate one for work. This doesn’t work well. It limits your success in both arenas. Yes, one extreme is to be your home personality all the time, but most people find this very professionally limiting. The other extreme is to be a complete “sell-out,” and completely adopt whatever personality you think the company wants you to have. This can lead to great dissatisfaction, which then can hinder your career.
The solution I propose is for you to think about this challenge and to make a conscious decision on how to marry the two personalities. Once you’ve been able to strike a happy balance between the two, then everything will be easier, which means you can be more successful, both at work and at home. And now that I’ve exposed you to this concept, it may seem obvious! But trust me, many people don’t think of this kind of simplification, so they fail to pursue it. And here’s the second part: Assume others around you have neither pursued nor achieved this simplification, this consistency of personality. But “complicate others” goes further. Remember the “three brains” idea of Section 8, that people have their brains when it comes to money, their brains when it comes to sex, and their brains for everything else? Well now there’s the added dimension of these possibly being different in professional settings versus home settings. Consciously try to limit how much you generalize the behavior of others. You’ll avoid making mistakes and they’ll enjoy the freedom you’re affording them by your open-mindedness.
3. A. Investopedia is a generally great source, and this “8 Essential Tips for Retirement Saving” is no exception: https://www.investopedia.com/articles/investing/111714/8-essential-tips-retirement-saving.asp. We’ll look more into HSA’s further down this list, but this article introduced them to the class.
B. And another great read at Investopedia. This is a bit long, but that’s only because it’s full of great details: https://www.investopedia.com/articles/personal-finance/111313/six-critical-rules-successful-retirement-investing.asp. Remember, if you’re reading through this and some parts bore you because you already know them, that’s a good sign of your learning!
C. “Investing Basics: Planning for Retirement” 4½ minutes: https://www.youtube.com/watch?v=3N6xlCxyWKY&app=desktop. I’m not a fan of TD Ameritrade, but I’m a fan of this video they made. (And I’m a fan of Schwab, which is buying TD Ameritrade, apparently for a good price: https://www.cnbc.com/2020/06/04/shares-of-charles-schwab-jump-after-sources-say-doj-approves-deal-for-td-ameritrade.html.)
D. “Beginners Guide | How to start investing for retirement?” 5½ minutes: https://m.youtube.com/watch?v=Kqz82QZ5KXk. Excellent honesty.
E. “Beginner’s Guide to Retirement Plans (401k, IRA, Roth IRA / 401k, SEP IRA, 403b)” 11 minutes: https://www.youtube.com/watch?v=QyAxMOPA7Z0 .
4. Spending habits: http://money.com/money/5632796/the-psychological-trap-that-could-quietly-kill-your-retirement/ Instead of calling it “lifestyle creep,” this article calls it “lifestyle inflation,” but it’s the same concept. The defense I suggest is that if you actually do those budgeting spreadsheets of Chapter 13, then when a raise occurs, you can decide where to spend (or invest) the extra money. For example, would I rather celebrate great news with a $100 dinner now, or would I rather add that to my retirement account and have an extra $317 in 15 years when I retire? I’d rather wait for the $317, which sometimes frustrates my wife.
5. Millennials on retirement: https://www.cnbc.com/2019/03/22/millennials-are-overwhelmingly-in-favor-of-this-one-retirement-thing.html. The word was spreading, but then covid-19 was too. So this year-old story may no longer apply, but here’s more recent news: https://money.com/millennials-student-debt-retirement-savings/ .
6. Planning on Retiring to Florida? http://money.com/money/5638871/we-will-miss-the-warm-winters-retirees-are-fleeing-florida-as-climate-change-threatens-their-financial-future/. Climate change is predicted to cause more erratic weather and more costly natural disasters. One of the repercussions will be higher future tax rates. That again makes the Roth versions of IRA and 401(k) preferable to their traditional counterparts: https://www.cbsnews.com/news/climate-change-thwaites-melting-scientists-warm-water-antarctica-doomsday-glacier/?ftag=CNM-00-10aac3a .
7. Last new concept for this retirement planning section is the Health Savings Account, which has been slowly gaining popularity. Here are some excellent introductions and explanations: “HSA Basics and Surprising Strategies | Mark J Kohler” 5½ minutes: https://www.youtube.com/watch?v=zI8uFLDnJC8, “High-Deductible Health Plan (HDHP) and Health Savings Account (HSA) Basics” 4 minutes: https://www.youtube.com/watch?v=s8SFZf3MLCM, “Why Max Out Your HSA | BeatTheBush” 6 minutes: https://www.youtube.com/watch?v=fHs7HX6kw1w. And finally, a “10 myths” style article from Kiplinger (a source I generally recommend): https://www.kiplinger.com/slideshow/insurance/T027-S003-10-myths-about-health-savings-accounts/index.html. After adding these ten details, I think you know everything you need to know about HSA’s.
8. Overall conclusion: Everyone is likely to have health care costs sometime in their future, so here’s my ranked list of retirement investing suggestions. For money you think you can put away without missing it, (as there can be difficulties and/or penalties for making pre-retirement withdrawals), I suggest the following:
a. Invest in a 401(k) (or 403(b), or 457) plan to the point of maxxing out matching (typically 3%-6% of salary). This should be your “bare minimum” strategy, and I suggest this even while paying off debts. To take the high road, try to get the answers on the fees of the various offerings within the 401(k) menu of investments, and hopefully it features a low-cost index fund.
b. If you’ve gotten your credit card debts to $0 and can keep them there, then I suggest opting for a high-deductible insurance plan if doing so lets you qualify for an HSA, and if so, then contributing to your HSA (max $3,450/yr. single, $6,900/yr. married filing jointly or head of household; either +$1,000 if 55 or older).
c. If you’ve paid off your student loans, then I suggest contributing to a Roth IRA ($6,000 per person per year single or married filing jointly, +$1,000 if 50 or older). Note that if you’re filing MFJ and one person doesn’t have earned income, the other person can contribute to each their own and to their spouse’s Roth IRA’s.
d. If you want to invest more than that, do you have dependents? Consider a 529 Plan (Chapter 12) and/or life insurance (Chapter 11).
e. If you want to invest more than that, consider non-tax-advantaged investments or, depending on the relative fees versus the relative tax rates, increasing the rate at which you contribute to your 401(k) (or 403(b), 457).
Quiz
1.Might it actually affect your spending habits now to think about how $1 at age 25, if invested, could easily be $32 at age 70? Explain whether it might.
2. Explain the logic of your retirement age goal (and include the age). (Assume you will retire someday.)
3.Picturing yourself during (the assumed) retirement, do you predict having grandchildren?
4. If taking a leisurely walk every day, starting now, would add 5 healthy years to your senior years, would you be able to start that walking habit?
5. Of Jaspreet’s four investment styles he reviews, which would be Dr. Stewart’s favorite, and which is Jaspreet’s favorite?
6. If you want to spend $50,000 per year for each of your retired 25 years, and your account will average 7.125% annual returns, then how large a nest egg do you need to achieve that goal?
7. Social Security income changes by approx. 8% per year, lower if you’re not FRA, higher if you are, from 62 to 70. If your annual Social Security income would be $18,000 at age 67, what would it be at age 62? 70?
8. Suppose you make $50,000 and are taxed 25% on it before you invest the total after-tax amount. In year 1 that amount grows by 8%, and then that growth amount is taxed 25%. Same for years 2, 3 and 4. How much did you invest at the beginning, and what are the after-tax account balances at the end of 1, 2, 3 and 4?
9. Two people have identical investing patterns, only one invests through an IRA and the other doesn’t. If the income tax rate for each person is 25%, which account ends up larger? Do we know by how much?
10. Two people have identical investing patterns, only one invests through a Roth IRA and the other doesn’t. If the income tax rate for each person is 25%, which account ends up larger? Do we know by how much?
11. Do you predict you’ll face higher income tax rates when you are mid-career or when you first retire? Explain.
12. A friend of yours says they know they should open a Roth IRA, but they really want to invest in stocks. What advice can you offer them?
13. Can you invest in any fund you want with IRA money? With 401k money?
14. Optional items aren’t graded. It’d be contradictory if they were. Here’s hoping it’s not yet 11pm on the day the quiz is due!
15. There are items A through E. Explain which one most deserves to be removed.
16. Explain how lifestyle inflation could be a sign that the person is unhappy.
17. ‘What are the three whammies of the “triple whammy?” With which of the three does Dr. Stewart disagree?
18. How much sea-level-rise could the collapse of the Thwaites Galcier cause? ( don’t go for the low housing prices of living in a flood plain.)
19. Are the tax benefits of a HSA more like the tax benefits of an IRA or like a Roth IRA, or what?
20. Explain what “matching” means, in this context, as though you’re explaining it to a great-grandmother.