Sunday, August 30, 2009

Retirement Planning: Possible Money Sources You Can Count On

When you have a ballpark estimate of the amount of money you need for retirement, we need to figure our where that money will come from.

While employment income seems like the obvious answer, there are actually many sources of funds you can potentially access to build your retirement nest egg. Once you lay them all out clearly, you can then determine how much money you'll need to save every month in order to reach your retirement goals.

There are typically several sources of retirement savings for the average individual. These include the following:

1. Employment Income
As you progress through your working life, your annual employment income will probably be the largest source of incoming funds you receive - and the largest component of your contributions to your retirement fund.

For your retirement plan, simply write down what your after-tax annual income is. Then subtract your annual living expenses. The amount left over represents the discretionary savings you have at your disposal.

Depending upon how the numbers work out, you may be able to save a large portion of your employment income toward your retirement, or you may only be able to save a little. Be sure to use a budget and include all your recurring expenses. One way to ensure you save the projected amount for retirement is to treat the amount you plan to save as a recurring expense.

Regardless, figure out the maximum amount of your employment income you can contribute to your retirement fund each year. Also, if you are able to work part time during your retirement years, include this information in your retirement income calculations. For example, let's assume that Alison's after-tax earnings are $34,000, and her living expenses are $2,000 per month, or $24,000 per year, and that she will not be working during her retirement.

Thus, Alison has $10,000 per year of discretionary savings. She can choose to contribute all of this money to her retirement plan, or she can contribute a portion of it to her retirement fund and spend the rest on a vacation or something else she desires, but we know that her available retirement funds from her employment income add up to $10,000.

For U.S. residents, disposable income that is earmarked for retirement savings can be deposited to an after-tax account, where earnings are added to your income and taxed each year; or to a retirement account, such as a Traditional IRA, where earnings are tax-deferred, or a Roth IRA, where earnings could be tax-free. The amount in an after-tax account will not be taxed again during retirement. The amount in a Traditional IRA may be taxed at your ordinary income tax rate for the year you withdraw the amount.

2. Social Security
As you might guess, social security benefits can provide just a small portion of your retirement income. The Social Security Administration (SSA) provides free estimates of your projected retirement benefits based on your historical income to date and the number of years you have worked. In order to prepare a comprehensive game plan for a comfortable retirement, you can complete a Request for Social Security Statement. You can request your personalized estimate by either calling toll-free at 1-800-772-1213; writing to the Social Security Administration at 8515-A Liberty Road, Randalstown, MD 21133; or by visiting the SSA webpage at

You may not want to include social security benefits in your retirement calculations because, as we already mentioned, the entire projected amount may not be available at retirement time. Alternatively, you may wish to include them at a portion of their value, say 50%, to be on the conservative side.

Either way, figure out what your estimated social security benefits are expected to be in today's dollars and add them to your list of retirement income sources. You won't be able to use this money to build your nest egg, but it will help to fund your living expenses when you're retired and reduce the size of nest egg you will need.

In John's example, his social security benefits were estimated to be about $1,300 per month, in today's dollars.

3. Employer-Sponsored Retirement Plan
You may or may not participate in a retirement plan through your employer. If you don't, you will need to focus on your other income sources to fund your retirement. If you do participate in an employer plan, contact your plan provider and obtain an estimate of the fund's value upon your retirement.

If you are eligible to participate in your employer-sponsored 401(k), take full advantage of this savings opportunity. Even though retirement seems a long time away, starting now will make it easier to reach your goal of a comfortable retirement.

The contributions you make to a 401(k) plan are tax-deferred. This means they are deducted from your pay before taxes are assessed. For example, assume you are in a 20% tax bracket, and you are thinking about investing $50 of every paycheck into a 401(k). If you were not investing in the 401(k), that $50 (considered part of your income) would be taxed at 20% and you would only receive $40 (20% = $10, subtracted from $50).
However, if you put the $50 into a 401(k), it is not considered part of your income for tax purposes (and lower income means lower tax). Even better, you earn tax-deferred interest on your investment in the retirement plan.

If your employer matches your contribution, you've got a windfall! You'll need to decide how important that portion of your paycheck is to your budget before deciding how much to invest in a 401(k). Don't forget that 401(k)s are specifically retirement investments, and you may pay a substantial penalty for early withdrawal. Careful planning is important to ensure the right balance between savings and retirement investments.

If you currently work, or previously worked for a company that provides an employer-paid pension, that's great news. A pension is a retirement plan entirely paid for by your employer. You may want to check with the benefits administrator and ask for an estimate of how much you will receive once you finally retire. Don't forget to periodically check the financial condition of previous employers that owe you a pension to make sure it's still a reliable source of retirement income.

Your plan provider should be able to give you an estimated value (in today's dollars) of your retirement funds in terms of a monthly allowance. Obtain this number and add it to your list of retirement income sources.

Similar to your social security benefits, the funds from your employer plan can help cover your living expenses during your retirement. However, most employer plans have rules regarding the age at which you can start receiving payments. Even if you quit working for your company at age 50, for example, your employer plan may not allow you to begin receiving payments until age 65. Or they may allow you to begin receiving payments early, but with a penalty that reduces the monthly payment you receive. Talk to your plan provider to determine what rules apply to your employer plan and consider them when you are making your retirement plan.

How to make a good use of Employer Plans? Here are some things you can do to make the best use of the benefits you do have:
  • Check on whether your employer is doing well to increase the chances of a good outlook for continued employment and continued benefits.
  • Save at least the amount matched by your employer in 401(k) plans and other defined contribution plans.
  • When investing funds, don’t put all your eggs in one basket—diversify.
  • Don't use retirement money for non-retirement purposes.
  • If you are thinking about switching jobs, remember to look at the vesting schedule where you are and stay at least that long.
  • If you are self-employed, don’t forget to save—you need retirement income too.
  • Remember that plan funds are an asset at the time of a divorce, and in the long run, might be the most important asset you have.
§         Don't retire too early, and remember that your money needs to last a lifetime. 
  • File and save all your plan information, including benefit statements and Summary Plan Descriptions.  
§         Keep track of any pensions or 401(k) account balances that you earned with prior
employers, either by saving your latest statements or by rolling over the funds into an IRA that you control.  If you lose contact with a former employer whose defined benefit pension plan covers you, the PBGC may be helpful. Their booklet “Finding A Lost Pension” is available at
  • When leaving a job before retirement, be careful about cashing out any lump sum benefit. You can avoid IRS penalties and preserve the money for retirement by taking a direct rollover to an IRA or to another employer’s plan.
4. Current Savings and Investments
Also consider what current savings and investments you have. If you already have a sizable investment portfolio, it may be sufficient to cover your retirement needs all by itself. If you have yet to begin saving for your retirement or are coming into the retirement planning game late, you will need to compensate for your lack of current savings with greater ongoing contributions.

For example, with John's retirement plan he already had a $100,000 retirement fund at age 40. Reasonably assuming this fund grows at a real rate of return of 6% per year until he is 65, John will have about $429,200 in today's dollars by the time he is 65. Depending on other sources of income he may have, this could be enough to fund his retirement so that John does not have to contribute large amounts of his ongoing employment income.

If you do have current savings and investments, be sure to include only the portion you expect to have left over by the time you have reached retirement. Don't include any portions you're planning to leave for your children or spend on other assets, such as a summer home, which will make the funds unavailable for covering your living expenses.

5. Other Sources of Funds
You may have other sources that will be available to fund your retirement needs. Perhaps you will receive an inheritance from your parents before you reach retirement age or have assets, such as real estate, that you plan to sell before retiring.

Whatever additional sources of funds you do happen to have, be sure to include them in your retirement projections only if they are certain to occur. You may be expecting to realize a large inheritance from your parents, but they may have other plans for their surplus savings, such as donating them to charity.

Other unexpected cash inflows may also come along as you build toward your retirement, such as lottery winnings, gifts, raises or bonuses, etc. When you do happen to receive these additional cash inflows, consider adding them to your retirement fund. It's also fine to include the planned sale of real estate to when you estimate your retirement funds (at a conservative price).

Adding Up Your Income Sources
After you have clearly defined all the available income sources with which to fund your retirement, make a list and add them up.

Let's continue with John's sample retirement plan. Remember, all figures are in today's dollars. John's retirement income sources are:
  • $10,000 maximum annual retirement contributions from his $45,000 after-tax earnings.
  • John has $1,300 per month in estimated social security benefits. To be on the safe side, we won't include these in our calculations.
  • John does not have a company pension plan.
  • John has $100,000 of current savings and investments. At a reasonable 6% real rate of return for 25 years, his savings should grow to $429,200.
  • John does not have any other sources of funds he can conservatively expect to add to his retirement funds. He might win the lottery, but he's not banking on it.
As we outlined earlier, John would need a nest egg of $850,000 (in today's dollars) to fully fund his retirement goals with the peace of mind that any social security shortfalls won't derail his plans.

Since his current savings and investments can realistically be expected to provide only $429,200 (in today's dollars) by the time he reaches his retirement age, John will need to rely on his other funding sources to reach his retirement goal.

This leaves him needing to build additional savings of $420,800 (in today's dollars) by the time he is 65 years old. Given his annual income, John will have to make periodic contributions to his retirement fund and build it up over the next 25 years.

To calculate this, let's track his progress over the 25-year period:
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Assuming the 6% annual growth rate and a constant annual contribution, we find that John needs to contribute $7,236 per year or about $600 per month in order to meet his retirement goal.

This is a relatively high level of ongoing contributions. While John can meet his contribution requirements given his $10,000 available annual income, he may wish to adjust his plan to leave himself more discretionary income.

John may consider revising his retirement plan so that his annual contributions are smaller. He could do this by choosing to include 50% of his estimated social security benefits, instead of our initial decision to assume no social security benefits at all. Or he may decide it's acceptable to leave only half of his retirement nest egg to his children, instead of the full $850,000. Alternatively, John could lower his required retirement income from $40,000 to, say, $35,000 and run the numbers again.

Any of these options would allow him to lower his monthly contribution amounts to a more manageable level. At the end of the day, it's important that whatever retirement plan you devise for yourself, you are able to stick to it. If your plan will require large monthly contributions, it's unlikely you'll be able to stick to it over the long term in order to make it work.

In John's case, another entirely reasonable solution to his plan would be to work part-time during his retirement years. By adding even $12,000 of annual retirement income, John's financial picture would change substantially and his required annual contributions would be lowered considerably.

The key is to remain conservative in your financial estimates (i.e., don't assume 20% annual investment returns or large inheritances from your parents) and settle on a plan that is feasible and sufficient for your needs.

Sources and Additional Information:


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