Retirement Planning Based on Formula 10/20
Renowned financial analysts have provided a handy tool that defines the amount needed in savings and insurance for a comfortable retirement. According to the 20/10 Formula, you need to have 22 times your annual income saved by the time you retire. For example, if you earn $50,000 per year, you will need $1,100,000 in savings. The 22 is rounded down to 20 for simplification but even so, this amount is far in excess of what most Americans have saved at the time of retirement.
The number 10 in Formula 20/10 has to do with protecting your family through life insurance. Many financial professionals suggest an amount equal to 10 times your annual income. Thus, if you earn $50,000 per year, your life insurance needs would be $500,000. This amount would provide the surviving spouse with enough money to care for dependent children for 10 years or more.
Factors Producing Poor Retirement Results
Many people work throughout their life and assume that a company pension or their contribution to a 401k will produce an adequate retirement income. Most employees engage in passive participation without any real understanding of the plan and options for selecting portfolios within the plan based on risk tolerance and objectives. A recent AARP survey revealed that 71% of people with 401Ks, did not know that they were paying fees which could reduce their account balance by as much as 30%. Many were not aware of different retirement options that could be changed as their risk tolerance and objectives changed. Then there are people who receive no retirement benefits at work or are self-employed, and do no retirement planning on their own to save for their future.
All too often, employees, business owners and the self-employed miss out on opportunities to grow assets for future expenses and retirement by not:
- Investing a portion of their income in an individual retirement account (IRA).
- Investing in annuities that produce an income for life, regardless of how long they live.
- Setting up and funding a US 529 College Savings Plan that can accumulate growth tax-free and pay for their children’s tuition, books, room and board.
- Setting up and funding whole life and universal life insurance policies that provide for tax-free withdrawals, a death benefit to heirs, and grow in value based on market growth.
- Purchasing long term care insurance when they are young, healthy, and qualify for very affordable coverage.
Retirement Planning FAQs
The two retirement plans offered by employers to employees include defined benefit plans (pension), and defined contribution plans (401k, 403(b), 457).
A defined benefit or pension plan, pre-defines the amount that the employee will receive at the time of retirement. The amount is generally based on years of service and salary. Although once popular, pension plans have largely been eliminated.
With a defined contribution plan, employees contribute a percentage of their salary which is automatically deducted as pre-tax dollars and invested in the plan monthly. Employers may match employee contributions up to a certain amount. The employer acts as a “plan sponsor” with the plan managed by another company which might be a brokerage firm, mutual fund company, or insurance company. The amount of growth is based on the market and how well investments perform over time. Distributions are taxed as ordinary income and are available without penalties after the age of 59 1/2.
The four types of IRAs, Individual Retirement Accounts, include traditional IRA, Roth IRA, Simple IRA and SEP IRA. Some IRAs are only available for employees and small business owners while others are available for all US citizens.
With traditional IRAs, you are permitted to invest a certain amount of pre-tax dollars per year and defer taxes on gains in your account until the time of withdrawal. Distributions are taxed at the ordinary income tax rate without penalty from age 50 1/2. Distributions must be started at the age of 70 1/2.
Roth IRAs allow a certain amount of contributions per year from after-tax dollars which grow in value and can be withdrawn tax-free after a five year period. Distributions can be withdrawn without penalty after age 59 1/2. There is no requirement to start taking distributions at at any age.
SIMPLE IRAs, Savings Incentive Match Plan for Employees, is a type of traditional IRA available for small businesses and the self-employed. In a SIMPLE IRA, the employer must have no more than 100 employees. They are required to match up to 3% of the employee’s salary or a flat 2% of compensation for each employee with at least $5,000 in compensation for the year, regardless of the amount the employee contributes. Tax deductible contributions have the potential to grow tax-deferred until withdrawal. With Simple IRAs, the 50 1/2 and 70 1/2 rules apply
SEP IRAs, Simplified Employee Pension, is set up by the employer and those who are self-employed. In this IRA, only the business owner is able to contribute. With Sep IRAs, the 50 1/2 and 70 1/2 rules apply.
This is an important question and one that should be answered by a CPA or someone qualified in tax planning. One thing to keep in mind is that there are two ways to obtain a Roth IRA where the account growth accumulates tax free. One is to contribute after tax money in the allowable amount as an individual or employee, whichever is appropriate. The other method is to convert all or part of a pre-existing tax-deferred retirement account into a Roth IRA. Of course, the amount of any Roth contribution is subject to ordinary income taxes. Should you want to increase your growth of investments through a Roth IRA, ask your CPA to help you determine the appropriate method and amount for your situation.
U.S 529 Savings Plans are an investment strategy that allows contributions to accumulate in value and be used to pay for college expenses tax-free. The account is funded with after tax dollars. Parents can participate in any state program, regardless of residency in that state. If their child decides not to go to college, the funds can be transferred and used for another child in the family. if the money is not used for college, it is subject to regular income taxes upon withdrawal plus a 10% penalty on gains. Because these plans are considered to be assets, they can affect eligibility for financial aid for college expenses.
In 1935, the Social Security Act was established by Congress to help supplement retirement incomes. Unfortunately, there is a shrinking pool of employees paying FICA payroll taxes which fund social security. This will produce a shortage of money to pay for social security as future generations reach retirement age.
Currently the age in which one can collect social security has increased and depends on the year of birth. People may start collecting social security early at age 62 or collect maximum benefits by waiting until their full retirement age. Spouses can collect half of a social security benefit amount whether or not he or she worked.
What many people do not understand about social security is that it may not be there for them to collect. This makes it even more important for young people to plan for retirement without depending on social security. By using strategies to accumulate wealth and protect assets during their early and middle adult years, one can expect to enjoy a happy, prosperous retirement that is free of financial stress.
Many people assume that their tax bracket will be lower at the time of retirement. Because taxes are based on combined spousal income with fewer expenses to offset it, many couples find that they are actually in a higher tax bracket after retirement. They may not know that they will pay taxes on their total income earned from social security, salary, interest and capital gains, retirement account withdrawals, and gains from annuity distributions. Social security taxes will not be impacted by tax free withdrawals from Roth IRAs and life insurance policies. A high tax burden can significantly add to financial stress and can keep seniors from living the life they want at retirement. This makes tax planning an important part of a retirement plan.