It might surprise you that saving for retirement is a relatively young phenomenon. In fact, I am older than the 401(k) concept, which came about in the late 70s. Historically, people typically worked until they died. The next iteration of retirement funding came in the way of company pensions, which rewarded long-term employee loyalty with a retirement benefit. That retirement benefit was paid by the company, not the employee.
Defined contribution plans come in a variety of forms depending on the type of employer. You might be familiar with 401(k), 403(b), 457, and Thrift Saving Plans. What they all have in common is the ability for the employee to decide how much to fund out of their paycheck for their own retirement. Meanwhile, company-funded pension plans are all but extinct.
Before diving into this issue further, really let this sink in: The concept of saving for one’s retirement is roughly forty years old. That’s it. For the approximately forty years prior to that, some workers had a company pension that provided retirement income plus Social Security benefits. And prior to THAT, there was no such thing as retirement – you worked until you died.
Today we still have access to Social Security benefits but typically no pension dollars. If we can retire and live on the meager benefit that Social Security provides, we’re golden. However, more often than not, seniors have difficulty surviving on Social Security benefits alone. Armed with this knowledge, we must take saving for retirement very seriously to have a good quality of life during the golden years.
In previous posts about retirement (linked below), I emphasized the idea of working longer. Understandably, this is an unpopular concept, especially if you are already approaching the “home stretch” toward your retirement target date. Another tough pill to swallow is the need to save more for retirement.
The problem is that most people have lifestyles that are difficult to support with the income they earn. Adding “saving for retirement” to the mix is a non-starter. So, what is a person to do?
Unfortunately, the answer comes down to a choice. Until we develop the ability to magically make more money appear in our bank accounts, we must choose. If we choose to spend all our income today, we sacrifice (or postpone) a comfortable retirement in the future. If instead we elect to spend less now in order to save for retirement, we are sacrificing immediate gratification to shore up our retirement later. It’s a choice.
Creating a spending plan that allows you to do both — spend now and save for later — is the smart approach. A little planning, focus, and discipline allow you to have part of your cake and eat it, too.
Where to save
Defined contribution employer plan: As mentioned earlier, with a DC plan, the employee contributes money to the plan on a pre-tax basis. That means you are funding it today and avoiding taxation on your contributions. However, all the contributions plus any growth in the plan will be taxed when you withdraw it in retirement.
Often, but not always, the employer might match your contributions, up to a limit. Best practice is to fund AT LEAST as much as your employer matches. Honestly, your goal should be to get to maximum funding as soon as you can.
Traditional IRA: Like employer plans, typically the money you contribute to an IRA is pre-tax, and your distributions in retirement will be taxable. The contribution limit is not very high, however, so don’t get lulled into complacency thinking you are maximizing your retirement saving by funding your IRA to the max. It’s a starting place, but $5500 per year (2018 limit) is not going to be enough. (Those 50 and older can contribute an extra $1000 per year. A quick Google search will bring up the current year’s contribution limit.)
Roth IRA: A Roth IRA is my favorite tool for retirement saving, if you are eligible to fund one. Unlike the Traditional IRA, contributions to a Roth are made with after-tax dollars. That means you get no tax benefit now for contributing to the account. However, in retirement, all distributions (the money you contributed plus all growth) come out tax-free. Over time, growing a Roth account offers a wicked-good tax situation for your retirement.
Many employers are now offering a Roth option in their defined contribution plan, so look for that. If you choose it, you may feel a little pain with your current paycheck, because you will be paying tax on the income you are diverting to the Roth. The long-term benefit is worth it, however!
Don’t despair if you haven’t been saving enough. Instead, refocus your attention on how you can adjust your budget to support a higher saving amount. Of course, the earlier you start saving, the better. But just start now, wherever you are in your career. Determine where sacrifices can be made for a more secure retirement.
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Photo credit: Greg Starks ©2018