A quick plan overview!
If you have jumped ahead to this page, I highly recommend that you go back and review the rest of this website so that you can completely understand what we are about to discuss!
When should you start planning for retirement?
The starting age in the first column of this example is sort of upside down, so letís look at what this table is saying. In our previous example of the growth of the S&P since 1950, its average annual growth rate, including inflation, was 8.82% and inflation was 3.5%, so, to be a little conservative in this example we used an inflation rate of 2.5% and a Stock Market Rate of Return of 7.5%.
Year 1 starts out with you putting $10 a week into your 401K with a 100% company match. Then we show you the annual growth of your 401K for the first 5 years, before we switch to every 5 year so the chart does not get huge.
The Retirement Age column is the primary purpose of the table. Assuming that you want to retire at age 67, how much will you have in your 401K depending on the age that you started to save for your retirement? If you started your savings at age 22, the first line of the table, and continued saving for 45 years, the second column, you should have almost a half a million dollars in your 401K / IRA when you retire.
If you waited until you were 32 to start saving for retirement, you only saved for 35 years, you would have less than of half that amount, only about $220 thousand!
I canít start to tell you how many of my friends have asked the question in their late 40ís or early 50ís, how do I START saving for retirement?
Look at the Total Savings next to the Start at Age 52 entry. Saving $10 a week, COLA adjusted, for 15 years only gives you $32,598. If you need a million to retire, you need more than 30 times that amount, so you would have to start savings $300 a week, $15,600 a year to reach your million dollar goal, and this only works if your company will match that entire amount. If you could retire on half a million you could start at $150 a week, and so forth!
Bottom line, you have to start saving early! And, I highly recommend that your minimum savings should be whatever your company will match. Why would you want to give away free money?
Phase 2: Guaranteed Income in your Sweet Spot
If you started your retirement savings at a reasonable level at an early enough age, you should be able to see the light at the end of the tunnel by your early 50ís. Now it is time to double check to make sure that light is not an on coming train!
Right now it is time to go back to your childhood, it is time to play make believe! Make believe that you are retired and fill out your tax return. Some of the numbers you use will be close to reality, and they will get even closer to reality every year that you play this game. Keep getting yearly estimates from Social Security and talk with your HR department at work for the estimates on what your Pension income might be.
The way you win this game is to concentrate on the Market Risk section of your planned retirement income. The third segment under the Market Risk banner is the money that you can withdraw from your Roth account which will be Tax Free income that doesn't interfere with your Maximum Taxable Income during retirement. This is the income level that defines Your Personal Sweet Spot!
It is also extremely important to note that your Guaranteed Annuities are located next to the IRA & Roth segments at each end of the Market Risk section. Annuities can be purchase in either your Traditional or Roth IRA account and their guaranteed income is then taxed accordingly.
Phase 3: Taxable income to Tax Free income
Let me repeat what I said on the Roth Annuity page: The key to the profitability of a Roth Conversion is the marginal tax rate you pay at the time you make the conversion vs your marginal tax rate when you use the funds.
If you did a Roth Conversion prior to 2018 at the 25% Federal Tax level, your taxes would have been a little higher than the 22.2% pre-hump rate of today, but that was not the purpose of doing the conversions. You did them to avoid the pre-2018 46.25% and 55.5% tax humps which are now the 40.7% and 49.95% tax humps that you could face during todayís retirement, which is still a positive reason.
The tax issue that you should be more concerned with is your State and Local taxes. If you do your conversions while living in a high tax state and then retire in a zero tax state, the cost could be substantial. You might want to consider waiting until you have moved to the zero tax state before doing your conversions. Paying an extra 2% to the Federal Government is better than paying 10% to your state, but the next Federal bracket is 32% which is 10% higher than 22%!
Whatever you decide, just remember the 5-year rule. The 5-year rule for Roth IRA distributions stipulates that 5 years must have passed since the tax year of your first Roth IRA contribution before you can withdraw the earnings in the account tax-free. So the answer is simple! Since the other Roth withdraw rule state that you must be at least 59 Ĺ before you can withdraw contributions and earnings, tax and penalty free; you should open your Roth IRA account and make your first contribution before you turn 54 Ĺ!
That said, in general, Tax Free income is always better than Taxable income. Try to do as many Roth Conversions as you can each year at the 22% tax bracket, maybe even the 24% bracket, and always use the Back Door Roth Contributions when you can afford to pay the taxes from non-IRA funds so that the entire amount of the conversion ends up in your Roth account, not just the after tax amount.
And don't forget MAGI! Each of your Medicare premiums will be based on your Modified Adjusted Gross Income two years before each premium is calculated. Medicare starts at age 65, so your first premium will be based on your MAGI for the year you turn 63. Your age 66 premium will be based on the year you turn 64, etc. Bottom line, try to do any major Roth Conversion before you turn 62!
Phase 4: Guaranteed income for life!
The shift from Pensions to 401Ks has introduced a high level of risk into our retirement income dreams. I am not an Annuity salesman and I donít want to push them, but they are the only source of Guaranteed Retirement Income that I personally know of. If you also take that path, do a lot of research on your salesmen and the contracts that they will are selling!
It is never Too Late to start planning for your retirement, but the earlier you start, the more you will accomplish!
Let's recap some of the things we've talked about!
When Social Security was established in 1935, the normal retirement age was 65 and average life expectancy was only 61. Since then we have raised the full retirement age to 66 and now to 67 and our current average life expectancy is 79.
40 years ago normal retirement planning was based on Social Security and your Pension. Todayís Pensions are being replaced by 401Ks and IRAs. Guaranteed Lifetime Income is being replaced by Stock Market Risk!
The Social Security benefits that you receive are Tax Delayed income. As your other taxable income crosses a certain level, your benefits are slowly taxed at the same time, and this double taxation creates Marginal Tax Rates as high as 40.7% and 49.95% during retirement at relatively low Gross income levels. The distribution of these Marginal Tax Rates create income Sweet Spots where your tax rates are relatively low, before they become huge!
The key to a safe and rewarding retirement depends on your understanding of where your Personal Sweet Spot is and then balancing your income between taxable Traditional IRAs and non-taxable Roth IRAs while also dividing your savings between Guaranteed Contractual Income and Stock Market Risk.
There are considerable penalties if you try to take money out of your IRA or 401K before the age of 59 ½, but these penalties do not exist when you do Roth Conversions, with or without Backdoor Roth Contributions, to convert your retirement savings from Taxable Income to Tax Free Income. These penalties are also non-existent when you purchase Insurance and/or Annuities within these accounts.
Stock Market Risk!
Stock Market Risk is a huge problem during retirement. The NASDAQ index for technology broke 1,000 in July 1995 and started the dot com boom. By March of 2000 the index was up over 500% to about 5050. Then the crash started! The index dropped 66% in the next 13 months down to the 1720 level. OK, donít sell low, its time to invest when the market is low, WRONG! Over the next 17 month it dropped another 33.7% down to its final low point of 1140 by the end of September 2002. The overall drop was from 5050 to 1140 totalled a 77.4% crash. Can you afford to lose 77.4% of your retirement savings?
Maybe the better move was REITs, Real Estate Investment Trusts. During the same time period the Federal Government declared that everyone deserves to own a home. They dropped the required down payments from 20% to 10% to 5% to 3% and finally, no money down. The demand for homes exploded and the national average median home price grew from $123,200 in 2000 to $195,400 in 2005, a 58.5% increase. REITs were paying huge dividends and a lot of retirees were advised to invest heavily in them by their financial advisors who got nice commissions for selling REITs.
During this time period a substantial number of the new home buyers who had never learned how to save money for a down payment were furnishing their new homes and living the high life with credit cards. All they had to do was refinance their home with no money down to get the extra cash they needed to pay off their debts and do it all again. Then came 2006. Home builders had caught up with the new demand and the national average home price did not jump that year, it actually dropped 1.6%. The new home owners couldnít refinance to pay off their credit card debt and they started to default on their mortgage payments. This led to a huge drop off in the demand for homes and the national average home price dropped another 11.5% in 2007 and a historic drop of 21.2% in 2008.
Investors found out that their REITs were not CONTRACTS. There was no guarantee that the income would continue or that they would get your original investment back.
Guaranteed Retirement Income
This is why the loss of our Guaranteed Contractual Lifetime Pensions is such a big deal. One way to compensate for this loss is to basically purchase your own Pension, an Annuity! There are a lot of different types of Annuities and you have to be careful and do a lot of background checking on your sales person and their company.
A lot of the information you read about Annuities is based on the not so great rate of return on Annuities that you purchase and start immediately. On our Roth/Annuity page we show you an example of this. If you purchase an Annuity for $100,000 at the age of 62 and start it immediately you will receive only $5,400 a year for the rest of your life which is $450 a month. If you had purchased that Annuity when you were 50 and waited until you were 62 to start the payments you would get $12,648 a year or $1,054 a month for the rest of your life!
Tax Free is always better than Taxable!
Tax Rates and Bracket are not constants. They could change with the will of whoever was just elected. The concept of paying your taxes at todayís tax rates instead of whatever they will be in five, ten, or twenty years is at best a gamble, but it is a gamble worth taking.
The concept of paying 22% or even 24% Federal Tax today instead of paying a 22.2% Marginal Tax Rate when you are retired is hardly worth thinking about, but if that means avoiding a 40.7% or 49.95% Marginal Tax Rate it is definitely the thing to do.
We talked about Annuities, and the important thing to remember here is that an Annuity can be purchased in a Roth account resulting in annual payment that are completely Tax Free.
The Bottom Line
We hope your take away from this website will be the knowledge that everyoneís taxes are different during retirement, and that your personal tax rates can include some extremely high marginal tax rates.
Find out what your tax rates will be and take them into consideration while planning for and living in retirement.
Also be aware of the tax situation that your spouse will be facing when you pass away first and take the steps necessary to make things easier on them.
At least now you know that these tax situations exist, I hope that you take the proper steps to give yourself a great retirement.
Now that we have discussed some possible retirement income sources and some possible ways to create them, it's time to download the spreadsheet that is designed to convert your personal income sources into Your Personal Marginal Tax Rates and Your Personal Sweet Spots.