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Retirement and Financial Planning

There is a lot of misinformation floating around about personal financial management and retirement planning, most of it generated by various media outlets and organizations that benefit from the misinformation, or would like to shape other people's lives. The reality is that personal financial management is not difficult, but it takes self-discipline and knowledge of basic rules. Otherwise, one is likely to retire at or pretty close to bankrupt.

Underneath all of the systems and buzzwords, practical financial planning boils down to avoiding unnecessary debts, consistently spending less than you earn -- which together are summed by the classic saying "live within your means" -- and saving or investing the balance. Okay, let's all say "duh!" together now. This is all obvious, common sense, but most people fail at one if not all three of these points. I did too for a long time.

I don't care about having a lot of money or a lot of things, but I do care about being able to provide a decent life for my wife and children, and would prefer not to be a devastating burden to them at the end of my life. Rather, I'd like to be able to leave them a little extra, or turn it over to charity. But there is a problem.

Time Consumes Idle Value

Unless you are very wealthy -- and that brings with it a whole host of other dangers -- it is difficult to save enough for retirement. First, immediate needs (and wants) seem much more important and we don't see the connection between what we spend now and the long term consequences. Second, even the least affluent among us are presently taxed (effectively) at nearly a 50% rate, meaning that you only get to control about half of the earnings you might otherwise control. Finally, the government actually discourages sufficient retirement savings.

The Government Discourages Retirement Savings

The individual retirement account limit of $4000 per year is ridiculous. No one can retire except at the most frugal living level on the results of saving $4000 per year. Thirty years of doing so would only leave enough money for about $1100-1200 per month, which will run out around age 78. Whether they admit it or not, the politicians and government agencies would rather that we all have mediocre lives orchestrated by and dependent upon them, than more fruitful and productive ones without dependency upon and obedience to them. Of course, they will deny this, but it is irrefutably how they have set up the tax system; they take so much from you all your life, the average person can't help but eventually become an impoverished ward of the state.

Obviously, the government doesn't prevent you from saving more, but they make it very difficult. Not only do you pay social security, medicare and other taxes (that are paid on almost all income, anyway, to the tune of about 15%), but you will also pay federal and state income taxes, plus capital gains taxes on any growth. The difference is that you won't have to pay income taxes on the future withdrawls -- you already paid capital gains taxes on them. How does this affect retirement savings? Consider two people who grossed $10,000 a year to save for retirement. Both lose social security and related taxes, reducing their deposit to ~$8500. Person A gets to deposit/invest the full $8500, and pays no more taxes until he makes his withdrawls for retirement, which he expects to be taxed at 15%. Person B paid 25% between federal and state income taxes on $9200, reducing his deposit to about $6900. Person B also pays an average of 25% in capital gains tax, but has no tax to pay on withdrawls. Otherwise, both save for the same time period, same inflation, etc. Both wish to have about $2000 per month in today's dollars when they retire.

Person A's fund has about 1.1 million at retirement, and may last until about age 86. Person B starts retirement with 717k, and may run out of money 13 years earlier, at age 73. If they both live to the average life expectancy, one person bankrupts before death, the other is able to leave something to charity or family. The only difference was how the government taxed their savings.

Taxes matter. All other things being equal, to do as well as person A, but in a taxed account, person B needs to start with about 17,400 per year instead of 10,000, almost twice what person A had to save. A serious exception to consider, however, is that person B's capital gains tax may have been significantly less, or he may have been more successful due to the options available in a non-IRA account. If so, his results could easily far-surpass the IRA investor.

A note worth adding here (as of 2008) regards Health Savings Accounts. These are basically IRA's that, when combined with a high deductible insurance policy, allow you to make withdrawls without penalty or tax when used for eligible medical expenses. The funds can be invested, and after 65 can be withdrawn and used for any purpose (like an IRA). This is a supplemental way to save for retirement yet still have funds available for medical needs. Also, some IRA plans allow withdrawl without penalty for certain emergencies.

Despite the challenges, it is vital that you find every savings advantage possible, which, if nothing else, usually means participating fully in your company's retirement plan, or setting up a personal plan. This can allow you to save as much as 10 times what you could otherwise save, tax deferred. One thing to mention here: Avoid any plan that requires you to place your funds only in your company's stock.

Next, your savings must be invested in a way that it grows faster than inflation and can be protected from serious mistakes. This is also difficult and comes down to the individual's ability to invest wisely. Anything more than a 10% return might not be a realistic expectation over the long term, and there are good reasons to suspect that number. All that is really happening here is that you are (1) working to create value which is provided to you in the form of dollars, and (2) attempting to exchange those dollars for some other commodity that will hold or gain value.

Some claim that stock market investments (index-type investing) are a sure thing over long periods, that one is almost assured a 10% return per year on average. But that just isn't true. The question to ask is "If I put $1000 into 'the market' for X years, how much will it be worth after adjusting for inflation?" The answer isn't always a happy one. If you don't account for inflation, your odds are pretty good at breaking even or better (averaging about 8% gains per year). But the picture is much less pleasant once inflation is included. Adjusted for inflation, the average DJIA growth over ten year periods dating back to 1928 is about 4% per year. On average, $1000 invested grew to ~$1500 over 10 years. But in many periods the growth was little, negative, or even resulted in a loss of over 50%. Things were a little less volatile for 20-year savings periods, but even that had a 20-year stretch from about 1954 through 1972 where $1000 invested lost net value over the following 20 years. The average gain was 3.8% per year. For a 30-year invested time window, the average gain went down to 2.3% per year, still with a ~20 year stretch of gains so small (or actual losses) that stock index investing would have been pretty painful. Since 1928 the general market has demonstrated average large cycles of about 40-years from peak to peak. If these cycles continue -- and they appear to be doing so -- we are actually entering the worst possible time for the amatuer investor to be making blind, long-term, index-based investments in the stock market. The situation may not improve significantly for the next ten years. (For this example I have not included dividends in the calculations.)

A factor rarely understood or taken into account is the devastating effect of inflation (and likewise, taxation) upon the value of one's savings and needed funds. Inflation is the devaluing of money (for the sake of our discussion). $3 might buy a gallon of milk today, but all other things being equal, at 3% inflation, that same gallon of milk will cost $6 in about 23 years. Every dollar you hoarded away lost half of its value relative to common material goods in that time. This is not a good thing for people who are trying to save for the future. One might retort that milk holds value better than dollars, and in a sense he is right. But a particular gallon of milk goes bad -- becomes worthless -- in a few weeks. However, the point made -- that different commodities hold value differently -- is the important one to recognize. And the lesson to learn is that the stock market, one of many different kinds of commodities, may not always be the best one in which to invest.

Assume that you are 30 and save the traditional IRA max per year, $4000. Let's even assume that the IRS allows this to increase in the future at 3% per year. If you average 7% growth on your investments, you'll have enough money to last about eight years (withdrawing 2000 per month in today's dollars). That is at 3% inflation. At 4%, you'll run out in about 6 years. At 5%, you'll run out in four years. That's right, 30 years of saving the maximum allowed by the government in a traditional retirement account could easily last only four years upon retirement. Retire at 60, and go back to work at 64. If inflation was 0% (or if the government allowed you to save more and taxed you less), that same savings could last until you are 100.

One more example: This may sound extreme, but a 40-year old couple saving $2000 per month towards retirement will never run out of savings if inflation stays at 3%. If it goes to 7%, they go bankrupt at 75. At 8%, they are broke a 69. All after saving well over a million dollars. These numbers may seem silly, but inflation during the Great Depression ran over 10% for several years.

Inflation is very bad for any dollar-based accounts. Taxation on capital gains has a similar effect, so it is important that you choose a long-term savings method that is protected from taxation and grows at a higher rate than inflation -- as high as possible. The problem is that, the higher the rate, the higher the risk of loss. Inflation eats your savings slowly, like rust. A loss from a bad investment is like a thief (or accelerated inflation) that simply comes in a takes a big chunk all at once.

IRA vs. Common/Other Investment Funds

IRA accounts generally must be funded from "earned income," there are strict limits on how much you can contribute per year (which can be legally circumvented with some effort), and limits on how it can be invested. Earned income is usually the highest taxed income; that, combined with the other limits makes it such that an IRA is not necessarily the best choice for everyone. If your situation meets all four of these criteria, then using an IRA will usually be in your best interest due to their being no tax on gains.

  1. You have only "earned income" -- pay from common employment or self-employment
  2. You earn less than ~$200,000 / year
  3. You intend to invest only in stocks, bonds and mutual funds
  4. You are seeking ways to reduce your income tax bill

If you are a very high income earner, get passive (non-earned) income, you intend to use margin, or invest in options, commodities, currencies, real estate, or engage in shorting, an IRA may not be your best choice. You may be able to earn much more for retirement by using a different fund of your choosing.

IRAOther

Advantages

  • No tax on gains
  • Less risk
  • Income tax deduction on deposits

Disadvantages

  • Can only deposit earned income
  • Deposited funds were heavily taxed
  • Fewer investment options
  • Pay taxes on withdrawls
  • Penalties on early withdrawls
  • Deposits are limited

Advantages

  • Wider variety of investment choices
  • Greater possibility of gains
  • No tax or penalty on withdrawls
  • No limits on deposits

Disadvantages

  • Taxes on large gains can be substantial
  • Greater risk of loss

The big difference (long term) is the tax on gains. However, the annual gains, combined with your other income, have to be quite substantial before the capital gains tax becomes a serious burden. By that time, you probably have enough funds in the account that it doesn't really matter "in the grand scheme." Let's assume that your goal is to get to a point where you are, effectively living off of the the annual gains. In an IRA account, your withdrawl -- not the gain -- is taxed. In the non-IRA, the gain -- not your withdrawl -- is taxed. Which will be better, 30-40 years from now is anyone's guess. We can plug and chug all the numbers we want; the truth is that no one knows, and any number of things could happen that turn any plan on its nose.

Tax on a long term gain is usually equal to or less than -- sometimes much less than -- the tax on equivalent earnings. It isn't until gains approach the average annual income that tax on gains becomes an issue. Until then, it is simply treated like income (or taxed less), and common exemptions and deduction will usually reduce the actual income tax to 0. However, not being earned income, you won't get some tax credits you might otherwise get; many tax credits disappear once your passive income exceeds a few thousand dollars.

Assuming you have no other income, the gain will often need to be $30k+ per year, depending on your family situation, before it gets taxed at all (due to average exemptions and deductions). That kind of an annual gain, requires a $300k - $1M stake. Once you are in those kinds of figures, it might hurt emotionally to pay capital gains taxes, but the truth is that it probably doesn't make that much difference compared to simply taxing your withdrawls. In other words, if it helps you grow your retirement fund faster because you can deposit more or wish to invest in ways no allowed by an IRA, then a non-IRA account is usually a better long term choice. But if you don't plan to deposit more than the IRA maximum per year, and wish to only do "conservative" investing, then an IRA will usually be better.

There isn't a one-size-fits-all answer to which is better. Exactly what you choose is up to you. But almost any diversified, legitimate investment does better in the long run than hiding cash in a can.

But how much do you need to save, and what rate of return is necessary? The following tool might help you answer some of these questions for yourself. You can try different combinations of figures in the following table to estimate your retirement savings needs. Obviously, this projection doesn't and can't take into account end-of-life expenses, medical or other emergencies. Also, there are obvious imprecisions in these calculations, but the future cannot be predicted precisely, anyway. This is only a rough approximation.

Current Age:
Retirement Age: -- distributions begin and deposits stop at this age
Life Expectancy:
Current Savings Balance:
Gross Monthly Contribution:
Tax on Contribution: % -- reduces the actual contribution
Annual Increase in Contributions: %
Annual Savings Growth: %
Post-Retirement Savings Growth: % -- allows for consideration of more conservative funds
Tax on Gains: None (IRA-style account)
Use table
Annual Earned Income:
Typical Exemptions/Deductions:
Income LevelRate
%
%
%
%
%
%

All of the above will be assumed to grow at the rate of inflation

Tax on Distributions: %
Annual Inflation Rate: %
Net Monthly Retirement Withdrawl: -- in today's dollars

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