Retirement planning is the process of determining retirement income goals and the actions and decisions necessary to achieve those goals. Retirement planning includes identifying sources of income, estimating expenses, implementing a savings program, and managing assets and risk. Future cash flows are estimated to determine if the retirement income goal will be achieved. Some retirement plans change depending on whether you're in, say, the United States, or Canada.
Retirement planning is ideally a life-long process. You can start at any time, but it works best if you factor it into your financial planning from the beginning. That's the best way to ensure a safe, secure—and fun—retirement. The fun part is why it makes sense to pay attention to the serious and perhaps boring part: planning how you'll get there.
Understanding Retirement Planning
In the simplest sense, retirement planning is the planning one does to be prepared for life after paid work ends, not just financially but in all aspects of life. The non-financial aspects include lifestyle choices such as how to spend time in retirement, where to live, when to completely quit working, etc. A holistic approach to retirement planning considers all these areas.
The emphasis one puts on retirement planning changes throughout different life stages. Early in a person's working life, retirement planning is about setting aside enough money for retirement. During the middle of your career, it might also include setting specific income or asset targets and taking the steps to achieve them. Once you reach retirement age, you go from accumulating assets to what planners call the distribution phase. You’re no longer paying in; instead, your decades of saving are paying out.
Retirement Planning Goals
Remember that retirement planning starts long before you retire -- the sooner, the better. Your “magic number,” the amount you need to retire comfortably, is highly personalized, but there are numerous rules of thumb that can give you an idea of how much to save.
People used to say that you need around $1 million to retire comfortably. Other professionals use the 80% rule, i.e., you need enough to live on 80% of your income at retirement. If you made $100,000 per year, you would need savings that could produce $80,000 per year for roughly 20 years, or $1.6 million. Others say most retirees aren't saving anywhere near enough to meet those benchmarks and should adjust their lifestyle to live on what they have.
Whatever method you, and possibly a financial planner, use to calculate your retirement savings needs, start as early as you can.
Stages of Retirement Planning
Below are some guidelines for successful retirement planning at different stages of your life.
Young adulthood (ages 21-35)
Those embarking on adult life may not have a lot of money free to invest, but they do have time to let investments mature, which is a critical and valuable piece of retirement savings. This is because of the principle of compound interest. Compound interest allows interest to earn interest, and the more time you have, the more interest you will earn. Even if you can only put aside $50 a month, it will be worth three times more if you invest it at age 25 than if you wait to start investing at age 45, thanks to the joys of compounding. You might be able to invest more money in the future, but you’ll never be able to make up for the lost time.
Young adults should take advantage of employer-sponsored 401(k) or 403(b) plans. An upfront benefit of these qualified retirement plans is that your employer has the option to match what you invest, up to a certain amount. For example, if you contribute 3% of your annual income to your plan account, your employer may match that, depositing the equivalent sum into your retirement account, essentially giving you a 3% bonus that grows over the years. However, you can and should contribute more than the amount that will earn the employer match if you are able to; some experts recommend upwards of 10%. For the 2020 tax year, participants under 50 can contribute up to $1,500 of their earnings to a 401(k), some of which may be additionally matched by an employer.
Additional advantages of 401(k) plans include earning a higher rate of return than a savings account (although the investments are not risk-free). The funds within the account are also not subject to income tax until you withdraw them. Since your contributions are taken off your gross income, this will give you an immediate income-tax break. Those who are on the cusp of a higher tax bracket might consider contributing enough to lower their tax liability.
Other tax-advantaged retirement savings accounts include the IRA and Roth IRA. A Roth IRA can be an excellent tool for young adults, as it is funded with post-tax dollars. This eliminates the immediate tax deduction, but it avoids a bigger income-tax bite when the money is withdrawn at retirement. Starting a Roth IRA early can pay off big time in the long run, even if you don’t have a lot of money to invest at first. Remember, the longer the money sits in a retirement account, the more tax-free interest is earned.
Roth IRAs have some limitations. Single filers can only contribute fully (up to $6,000 a year) to a Roth IRA if you make $124,000 or less annually, as of the 2020 tax year. After that, you can invest to a lesser degree, up to an annual income of $139,000 (the income limits are higher for married couples filing jointly).
Like a 401(k), a Roth IRA has some penalties associated with taking money out before you hit retirement age. But there are a few notable exceptions that may be very useful for younger people or in case of emergency. First, you can always withdraw the initial capital you invested without paying a penalty. Second, you can withdraw funds for certain educational expenses, a first-time home purchase, health care expenses, and disability costs.
Once you set up a retirement account, the question becomes how to direct the funds. For those intimidated by the stock market, consider investing in an index fund that requires little maintenance, as it simply mirrors a stock market index like the Standard & Poor's 500. There are also target-date funds designed to automatically alter and diversify assets over time based on your goal retirement age. Keep in mind that certain federal agencies and uniformed services offer thrift savings plans.
Early midlife (36-50)
Early midlife tends to bring a number of financial strains, including mortgages, student loans, insurance premiums, and credit card debt. However, it’s critical to continue saving at this stage of retirement planning. The combination of earning more money and the time you still have to invest and earn interest makes these years some of the best for aggressive savings.
People at this stage of retirement planning should continue to take advantage of any 401(k) matching programs their employers offer. They should also try to max out contributions to a 401(k) and/or Roth IRA (you can have both at the same time). For those ineligible for a Roth IRA, consider a traditional IRA. As with your 401(k), this is funded with pre-tax dollars, and the assets within it grow tax-deferred.
Finally, don't neglect life insurance and disability insurance. You want to ensure your family could survive financially without pulling from retirement savings should something happen to you.
Later midlife (50-65)
As you age, your investment accounts should become more conservative. While time is running out to save for people at this stage of retirement planning, there are a few advantages. Higher wages and potentially having some of the aforementioned expenses (mortgages, student loans, credit card debt, etc.) paid off by this time can leave you with more disposable income to invest.
And it's never too late to set up and contribute to a 401(k) or an IRA. One benefit of this retirement planning stage is catch-up contributions. From age 50 on, you can contribute an additional $1,000 a year to your traditional or Roth IRA, and an additional $6,000 a year to your 401(k).
For those who have maxed out tax-incentivized retirement-savings options, consider other forms of investment to supplement your retirement savings. CDs, blue-chip stocks, or certain real estate investments (like a vacation home you rent out) may be reasonably safe ways to add to your nest egg.
You can also begin to get a sense of what your Social Security benefits will be, and at what age it makes sense to start taking them. Eligibility for early benefits begins at age 62, but the retirement age for full benefits is 66. The Social Security Administration offers a calculator here.
This is also the time to look into long-term care insurance, which will help cover the costs of a nursing home or home care should you need it in your advanced years. Such health-related expenses can decimate your savings if not properly planned for.
This article was written and published by Investopedia.com. Baffilk Financial Consulting does not own this article, it has been shared for information and education purposes only.