Many people relate to 401(k) and 403(b) plans, which feature optional employer matching contributions. (There are other plan types such as the SIMPLE plan, which offers an employer match, which we are leaving out of this article.) Some employees say that if the company does not match their contribution, they simply won’t save. But a different viewpoint is in order—one that focuses on what your needs are for retirement savings.
Some people lament not having a traditional defined benefit pension plan where you simply get checks during retirement. Companies and governments that offer pensions typically hire actuaries who determine, based upon many factors, how much the company or governmental agency needs to contribute in order to make good on the promises of retirement income for its employees. You can use some similar methodologies to create your own retirement paychecks using a 401(k)-style plan.
Let’s quickly examine the dollar amounts one can save in tax-advantaged retirement savings. (These are called defined contribution plans because Congress defines how much money can be saved.) Different plans have different savings limits. The traditional IRA has a cap of $6,500. If you are over 50, you can add an additional $1,500. On the other end of the scale is the 401(k) plan. If your company sponsors one of these, you can save 19,500, or $26,000 if you are over 50 years old. However, none of these amounts indicate what you should save. After all, how can Congress define what you will need in retirement?
Many people I talk with are focused on getting the free money their employer will contribute to a 401(k) or 403(b) plan, known as the employer’s matching amount. We all like freebies. However, the freebie alone may not lead to sufficient savings. Let’s say you make $100,000 and need to save 10% of your income (i.e., $10,000) for retirement. If your employer offers to match 3% of your income and you save enough ($3,000) to earn the full match, then you will have $6,000. But that leaves you $4,000 short on what you need to save.
The carrot of the 3% match has become the focus for many. And it’s true that you want to save enough to earn your company’s matching amount. Otherwise, you’re leaving free money on the table. But if securing the match is your sole focus, it could be very painful to later discover that you have not saved enough money for your desired retirement. Then your choices become to delay retirement or to save an even higher percentage of your income in the final years of employment.
The opportunity with the 401(k)-style plan is that you can save $19,500 this year, whether your employer provides a match or not. If by chance you need to save 10% and you make $195,000, then the maximum amount you’re allowed to save ($19,500) is just right. If you need to save 20% and make $97,500, the maximum is also a perfect fit.
But how do you know if you need the maximum you’re allowed to save in your 401(k) or 403(b)plan? That will come by doing a retirement needs analysis. Let’s say that you use a calculator, software program or a certified financial planner to determine how much you need to save along with the rate of return you need to target until you reach retirement age. You will likely need to continue to have that money invested in the market postretirement so that it can keep up with, if not outplace, inflation. Don’t forget that you will also be combating future tax rates. You do so today, so why not in the future? Many of these calculators use an income replacement methodology. For example, replacing 60% of your income. If you make $100,000, would you be comfortable living on $60,000? $70,000? $80,000? This is pre-tax, remember, not after-tax.
You could use the calculators that are free from different websites, including the one from your employer-sponsored plan. However, I would be wary about trusting them. They are not guaranteeing any retirement results for you. I recommend working with a certified financial planner who has access to advanced financial planning software. It may even be a good idea to get different opinions from different software packages, though not necessarily from different certified financial planners. The key with any analysis is in the assumptions that are being made. Some may use historical returns versus projected returns. Some may use 2% inflation while others may use 4% inflation. These two variables alone can provide widely varying results. It may be a good idea for you to run a couple of scenarios—one that is best case and one that is worst case.
If you do decide to go down the DIY route, look for a program that considers at least these factors from Retire Ready Solutions, a provider of software to select financial advisors:
· Current account balance
· Income per paycheck
· Amount of annual raises
· Retirement income replacement ratio, such as 60 or 80%
· Retirement date
· Life expectancy
· Social Security initial benefit
· Social Security inflation
· Rate of return attained before retirement
· Rate of return attained during retirement
· Tax rates during retirement
After you’ve done your retirement savings calculation, let’s say that you need to save $5,000. If your employer doesn’t match, and you’re not phased out of contributing into a tax deductible IRA, because of your income, you could forego the plan and save that amount in a traditional IRA. Otherwise you would need to save in your employer’s 401(k)-style plan. Employer plans don’t restrict eligibility based on income. This assumes that you want to benefit from the tax deferral of growth from 401(k)-style plans. If you elect the traditional savings, you also get to make contributions that are tax-deductible with tax deferral on your gains. Taxes will be due when you withdraw the money.
If you need to save from $10,000 to $19,500, you benefit from a 401(k)-style plan. The defined contribution savings limits allow you to save all of that on your own. If your employer matched your savings, you could potentially reduce how much you save accordingly. That may be a good idea if you have student loan debt which needs to get paid off or you need to find money to establish an emergency fund.
You will owe taxes on matching contributions along with any profit sharing paid out through the retirement plan when withdrawn. When you reach age 72, you will have to make required minimum distributions (RMDs) from your retirement plans (except for Roth accounts). That RMD amount will be added to whatever you get from pensions and Social Security, and you will pay at least Federal marginal taxes. If you elect Roth contributions, you will not face future taxation after the holding period and reaching 59 ½. If you have a Roth account in either your 401(k) or an IRA, you will have some interesting tax decisions to make down the road, but that’s a topic for a different article.
You should also periodically check your progress to see how things are going. You may find yourself with an increase in income or a change in marital status or a host of other factors that may require revising your assumptions. You should focus primarily on maintaining the savings rate you need, as that is the variable you have the most control over.
The next thing to focus on is your investment returns. Rather than focus on a single average return number, however, you should look at the range of returns around that number. Without doing any advanced calculations, you could look at the most recent 10 years. While mutual funds post returns, how have the returns varied? While not perfect, this should give some sense of how the returns vary around the average. (If you work with an investment advisor representative, he or she should be able to provide more advanced calculations.) If your returns are in the range of expectations, you may not need to change how much you save. But if they are higher or lower, you may need to reconsider your portfolio allocation.
If this seems a little daunting, get help from a certified financial planner. Whatever you do, don’t let feeling daunted make you delay. Saving more sooner is always better than saving more later. Two workers making the same wage, saving the same amount, getting the same return, retiring at the same age, will have significantly different accumulated values if one starts at age 21 and the other starts at 50.
I hope this gets you focused not on saving to get a match or to meet Congress’s maximum savings amount but on saving according to the rate required to meet your retirement paycheck goals.