Welcome to the first post of a new series I’m calling “Five-Dollar Words.” We all hear a lot of big fancy words get thrown around a lot, and sometimes we just go along pretending like we understand the concept completely. These posts aim to explain stuff we know we *should* know about, but don’t want to ask. Disclaimer: I am not a professional of any finance-related things whatsoever, I’m just a handsome guy with a sweet blog. The information in these posts is intended to inform and entertain. For advice specific to your situation, please meet with a professional financial advisor. If you’ve got an idea for a future Five-Dollar Word, shoot me an email at email@example.com!
What Exactly Is “Retirement?”
Duh. Obviously, it’s when you quit working, throw a pair of sweatpants on for the rest of your life, and settle into your oversized armchair with a bag of Cheetos and a DVR full of The Price Is Right reruns. You know, back from the good old days with Bob Barker. But, that doesn’t sound like it costs a whole lot, so why do we have all these scary articles about how Millennials need almost two million dollars in order to do it right? And why is “retirement planning” such a big issue? I could plan that day in about five seconds! The answer is because we don’t agree on what retirement is. Personal finance is personal, after all, so there’s no one right situation that works for everyone. Some people want to travel the world drinking elephant poop coffee, and others are perfectly content to sit at home and eat bon-bons for the entirety of their golden years. For the sake of this post, I’m going to define Retirement as: “The point in life where you no longer have to work in order to support your day-to-day obligations.” Notice I said “have to.” I’m a firm believer that work is good for you, and that you should continue doing some sort of service to other people for as long as you’re physically able to do so. But the day that you theoretically could live out the rest of your days without stepping foot in the office again is the day you’re retired.
How Much Do I Need To Retire?
Again, that’s a super vague question. What do you plan on doing? How much, if anything, do you want to leave to your children? Are you going to stay in your giant house and host family reunions every weekend, or are you selling it to fund RV life for the rest of your time? Now you’re starting to see why this question has so many different answers, depending on who you talk to. The simplest way to get a ballpark idea of how much money you’ll need is to work backwards. Figure out how what kind of lifestyle you want to live, how much per year it’ll take to fund that lifestyle, and then estimate the number of years you think you’ll live beyond the point of retirement. Kinda morbid, huh? Math is cold, but it’s not super difficult. You can use a calculator, like this one from Vanguard, to do the heavy lifting for you. Again, take any number you get anywhere with a grain of salt, because there are just so many factors that go into retirement planning that a ten-second analysis is never going to be right. The best way to get the most accurate number possible is to meet face-to-face with a financial planner and walk through all of your assets and plans with them.
How Do I Get There?
Let’s say you’ve crunched those crunchy numbers, and you’ve landed on a big one: $1,000,000. A big, chunky million will let you do all the stuff you want to do in retirement, and might even leave something behind for your kids to fight over. But what if your prospects at being an NFL quarterback aren’t so great? You can still do it. Yes, a million dollars is a big mountain to climb, but as that old piece of wisdom tells us, the best way to eat an elephant is one bite at a time. You’ll need to make changes in your financial lifestyle to allow for consistent savings over a long time. Lucky you, the mathy part is mostly done for you in the form of retirement accounts. In order to take full advantage of these accounts, you have to sign up for them. I know that sounds like a no-brainer, but you’d be surprised at the number of people who think they can get away with doing nothing and retirement will just sort of happen when they get there. The more money you can put away and the longer you can let it sit, the better off you’ll be. I’ll do a future FDW post about investing where I’ll go into more detail, but let’s just go over the different types of retirement accounts for now. I promise it won’t be painful. Ready for some alphabet soup?
Yeah, there we go. I started in with the numbers and letters, and your brain just shut off, didn’t it? Well, wake it back up, because you’re gonna learn some stuff today! Don’t be intimidated, it’s literally just called that because that’s the section and paragraph of the Internal Revenue Code it’s outlined in. Nobody’s ever accused Congress of being too creative. So, what is it? Basically, a 401(k) is an account with money that you agree not to touch until you’re 59.5 years old. That money comes out of your paychecks before taxes come out, which has a side effect of lowering your taxable income every year. As an incentive to get you to part with your money for so long, most employers offer to match at least some of what you put in with their own money. This is what people mean when they say you’re “leaving money on the table” if you’re not putting money in a 401(k), because when you go to withdraw your money after you retire, you get everything you put in AND everything they put in.
Traditional Individual Retirement Account (IRA)
Your employer doesn’t offer a 401(k)? No worries, you can set up an IRA and do the same type of planning, just without the match. With an IRA, the money comes out of your take-home pay (after taxes), but the amount you put in comes back as a tax credit at the end of the year. You also don’t have to pay taxes on the amount earned on your investments (returns) until you withdraw it after you retire. The biggest downside to an IRA is that there’s a limit to how much you can contribute per year; the 2017 limit is $5,500 if you’re under the age of 50, and $6,500 if you’re over.
If you’re closer to my age, you’ve probably heard people talk about Roth all the things. So what’s that mean? The “Roth” name comes from one of the guys who proposed it in 1989, Senator William Roth from Delaware. Seriously, Congress must have been the place where things like the toaster, the walkie-talkie, and slippers were all named. The technical difference between traditional and Roth accounts lies in when the money is taxed. With the traditional 401(k) and IRA, you get a break on your taxes now and pay them when you withdraw the money later. With the Roth, you pay tax on the money you put in now, and when you withdraw the money later, it’s tax-free (because you’ve already paid the tax). Read that again. When you contribute to a Roth retirement account, you use after-tax money now, and effectively don’t have to pay income tax during retirement. That includes all your investment returns over the years! That’s a pretty sweet deal, especially if you plan on being in a higher tax bracket (i.e., making more money) when you’re older.
While increasingly rare, pensions are still around. The most benevolent of all the retirement plans, pensions are where your employer completely funds an account for you, without having to make any contributions yourself other than years of your life. After you retire, you are paid a certain amount based on your length of service with the company and sometimes the level of income you earned while you were there. The major downside to pensions is that if the company disappears, so does your pension. Even government pensions, of which American Social Security is a sort, are subject to dissolution if budget crunches force them to use the money elsewhere. Be grateful if you have a pension, but don’t count on it as your sole source of retirement income.
I threw that last one in there for funsies. If you’re employed as a government worker, teacher, member of the military, small business owner, or some other special case, you have quite the list of acronyms to choose from in terms of retirement accounts offered. Most are set up to be as close to 401(k) and IRA accounts as possible in terms of the mechanics that make them work, but you’ll need to talk to the plan provider to get specifics.
How Do I Choose?
Gotcha! I can’t answer that for you. Just as there’s no one right answer for how much you need for retirement, or even what the right conditions for retirement are, there’s no one right account that’s best for everyone. If you’d like to talk more about how to start saving more towards retirement, you should get with a local financial advisor who can help you with your specific needs. If your company offers a retirement plan, you can also ask for the number to call to speak with the people that manage the plans. They’ll have advisors that can help you with the different options available to you.
Alright, now that you’re feeling like this, I think that about does it. If you have any questions about something I didn’t quite cover enough, feel free to ask in the comments!