What derails retirement planning comes down to two basic things. Failing to get started (if you don’t get started, you won’t finish) and not understanding what you must know when investing for retirement. There are fundamentals that make retirement different from any other financial goal. Understanding these is key if you are to invest successfully for retirement.
There’s a mess of tax terms related to retirement. There’s pretax and post-tax. Some options are tax deductible; others are tax deferred. Many accounts do both. What’s an investor to do? What will work best for you?
Many workplace retirement accounts provide for pretax contributions. Pretax contributions are deducted prior to the calculation of federal and state taxes, and these contributions are not subject to federal or state income taxes when doing your taxes. This can be a huge advantage, as will be discussed in more detail below.
Note that Social Security taxes are calculated on wages even if they are considered pretax. There’s no escaping Social Security tax here.
Other contributions are post-tax. These are not deductible from income for tax purposes; you pay tax on the income even though it may be going into an account that has other tax advantages.
Making pretax contributions is a phenomenal advantage. If, for example, a worker is in a combined 30 percent federal and state tax marginal tax bracket, a $200-per-week contribution will cost about $140 out-of-pocket. This means that while they will have the entire $200 going into their investment account, they will see only a $140-per-week reduction in their take-home pay.
Effectively their contributions are being subsidized by tax savings.
For people in low marginal tax brackets, the effect is less dramatic. Some people have income, but not enough to pay federal taxes, and may be better off with another form of account. A Roth account is typically beneficial in this situation.
Tax Deductible vs. Tax Deferred
A tax deductible account allows the amount contributed to the account to be excluded from income. You get an upfront tax break on the amount you contribute; you don’t pay income tax on the contribution.
Tax deferred is not the same, it is deferred is an ongoing benefit. Tax deferred accounts allow you to postpone taxes on income and gains within the account. For example, if you own a stock or bond in a tax deferred account and the account gets dividends or interest from that investment, you have no tax liability because of that income. You will ultimately have to pay tax when you spend the money, most likely at a lower tax cost.
Many accounts offer both. This is how a traditional IRA generally works: You make deductible contributions, and the account grows tax deferred. People used to also make post-tax (nondeductible) contributions to IRAs when they weren’t eligible for deductible contributions. This is rarely the case today, as a Roth would generally be the way to go if you couldn’t make a deductible contribution.
Some Employers offer Matching Contributions. The most common form of matching is to offer a 50 percent match of the first 6 percent of an employee’s contributions. If, continuing our example above, the employee were contributing $200 and that had a 50 percent match, the company would contribute an additional $100 — 50 percent of the employee’s contribution, as long as the $200 wasn’t over 6 percent of an employee’s contributions.
Now our employee has $300 going into her retirement plan, but it cost her only $140 out-of-pocket due to matching and favorable tax treatment. Like magic.
The Affordability Factor
It’s no secret that most people’s retirements are underfunded. Many people struggle to get to a place where they feel they can afford to invest for retirement. Others plunge forward anyway, and may be better off for it.
One issue is that people do less than they plan. For example, someone might think they could afford at most a $50-per-week contribution into their pre-tax retirement plan. So they ask their human resources group to begin a $50-per-week contribution. But they’re shorting themselves because they can invest more than that for an out-of-pocket cost of $50 per week.
They need to gross the contribution up for taxes.
If you’re good at math, you could figure out your marginal federal, and if appropriate, state tax brackets, and come up with the amount you can contribute that will cost you your budgeted out-of-pocket amount.
If you and math have a less comfortable relationship, you might consider having your HR person or an accountant, or other financial professional, help you with it.
Along with affordability should be a plan to make an annual increase to your contributions. Even increasing your contributions by 1 percent of your pay each year will quickly build your contributions to something likely to work for you, if you’re starting young. But always do this, no matter what age you start. Having more will be better in the end.
Most people don’t appropriately consider their retirement time horizon. They are clear on the point where they plan to retire, but that isn’t the time horizon that should be driving the majority of their investment decisions. People have a tendency to get overly conservative with their investments at retirement — even though they are likely to be retired for over 30 years.
Thirty years or more is long term. Twenty years or more is long term, as is 10 years or more.
When you retire, the majority of your investment assets are not necessary to provide immediate income, but are needed for far later in retirement. You do need investments in stable positions for a few years’ worth of income.
The majority of your retirement investments should, however, still be invested for growth, unless you have more than you need. That’s not the norm. People with underfunded or marginally funded retirements cannot afford to be overly conservative. Their time horizon for most of their investments is still long term.
Becoming overly conservative with investments at retirement can cause you to run out of money during your lifetime when that did not need to happen.
The Bottom Line
Investing for retirement is different from investing for other goals. There are different options, and more types of investment accounts. There are tax considerations unique to retirement accounts, and features, such as employer matching, virtually unheard of elsewhere.
The trade-off for the benefits of retirement accounts and their favorable tax treatment is that the dollars are not up until retirement age — or else substantial penalties may apply. This shouldn’t prevent you from using the accounts; you should still be able to retire early without penalty, and do anything else you want. It just may take getting some professional advice and some proper planning. It’s also a good idea not to tie up all your investments in retirement accounts; there will likely be other goals you want to accomplish along the way.
Knowing what you must know to invest for retirement can help you make the most appropriate decisions for your unique financial situation. The key to success is twofold: getting off the sidelines and making the best decisions you can at the time. Understanding the ins and outs of investing for retirement should help you to comfortably get into the game.
Source: Centsai, Accessed 9/1/22
This article’s view is the author’s and does not reflect the opinion of any member of CentSai’s management. The author is not being paid by any financial services company nor has been paid to promote any individual product or service. The author is not a financial advisor or a broker-dealer. The content above is education-only and any reader is encouraged to seek advice from a registered financial advisor before taking any action.Back