Tuesday, August 28, 2012

Planning for Retirement

My idea of a yacht
Estimated Planning Time: 1 hour
Materials: Results from Creating a Budget, Employee retirement plan materials (if any)
Project Difficulty: Intermediate

Retirement means something different to me than merely staying home from work, watching TV, taking cruises, or playing golf.  All of those things might be fun, but to me the benefit of retirement (or even better, financial independence) is the ability to contribute in whatever way I am called to without concerning myself with the monetary rewards.  Readers of MrMoneyMustache or EarlyRetirementExtreme might find this definition familiar.

If money is a preferred indifferent, though, you might ask why it is important to save now rather than spend all that you make?  The short answer is that money saved and lower expenses give you options that you would not otherwise have.  For instance, if you spend 70% of your income, not only will you soon have an emergency fund but maybe you could fund your own side business.  On top of this, if your dream job comes along but it will only pay 80% of your current income you will be able to make the switch without financial difficulty.

All of those reasons are in addition to the concept that you probably don't want to work up to your death because you need the money.  So, with that in mind, here is my very basic advice on where to save your money.  First, if your employer matches any part of your 401K or 403B, contribute up to the maximum needed to max out that matching.  For instance, if they match 50% of the first 6%, this means if you contribute 6% of your salary to your retirement plan, 9% of your salary will be deposited into your account.  That extra 3% (50% of 6%) comes from your employer, and it is essentially free money to encourage you to save in your retirement plan.  The employer portion is usually subject to a vesting period, such as 5 years.  In other words, if you leave before 5 years, all or part of the employer portion could be lost.  Read your retirement plan documents carefully to understand what the rules are, and write down any questions and go over them with someone in your human resources department.

After you take advantage of any employer matching, you have a choice to make on further retirement savings.  You can max out your contribution to your employee retirement plan, or you can contribute to a Traditional or Roth IRA.  There are many factors in deciding between the three, if you have a high tax rate you might consider using a Traditional IRA or the employee plan to reduce your current taxes.  If you think you will have a higher rate in retirement, the Roth IRA is a better option.  Additionally, you should consider the fact that you can withdraw your Roth IRA funds without any tax penalties at any time under the current rules (but you cannot replace them once withdrawn).  Yet another consideration is the different types of investments that will be available under the different plans.  For instance, your employee plan might be limited to a few mutual funds.  With a Traditional or Roth IRA you could invest in ETFs, individual stocks, or mutual funds depending on the brokerage firm you use for your account.

Personally, my default advice is to utilize the matching if it exists.  If there is no matching or once you meet the matching rate, I would then contribute the maximum to a Roth IRA.  I like the flexibility of investment choices and the tax free nature of withdrawals (of contributions pre-retirement and of all funds post retirement).  After maxing out the Roth, I would then proceed to max out the employee retirement contribution.

Once you have done all this, take a look at what you can expect to be saving during the rest of your career.  Assuming different rates of return, at what point will your retirement savings be able to cover your expenses?  Twenty years?  Thirty?  What happens if you save more or less?  What are the different factors that go into the assumed rate of return?  You should think about all of these options, even though they can be uncomfortable and impossible to fully anticipate.  If you ignore your retirement savings, you risk not making choices that could have led to a more satisfying life.  The past is (as they say) past, focus on the present and plan for the future.


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