It’s Not Too Late

How Much Money Will I Need to Retire?
It depends. That’s the answer to the age-old question, how much money will I need to retire? Some people can live happily on half of their preretirement income while others require 100% or more to maintain, or even enhance, their lifestyles. For many people, 70% to 80% of the amount earned during their working years is a realistic income replacement percentage; these figures are commonly quoted in financial publications.

When it comes to retirement planning, there is no “one size fits all” answer. A lot depends on your goals (such as traveling and pursuing hobbies) and lifestyle decisions (such as where you choose to live), as well as available resources such as an employer pension and/or free or low-cost retiree health insurance. Other important factors to consider are age at retirement, expected life span, health status, family responsibilities (caring for aging parents or grandchildren, for example), and inflation.

Michael Stein, author of The Prosperous Retirement, notes three distinct phases of retirement: active (go-go), passive (slow-go), and final (no-go). Expenses during the early years (active phase) of retirement can equal or exceed those during the years before. Often, expenses decrease in later years but may increase during the final phase due to medical and/or long-term care costs.

To determine your retirement savings needs, a group of researchers, Tacchino and Saltzman, suggests using a “blended income replacement rate” to adjust for decreased expenses as retirees get older. Illustrated in Table 1, a blended income replacement rate uses an average of different income replacement percentages to reflect different spending levels throughout retirement. For example, Stan and Sue Olek, both age 50, have a preretirement income of $50,000. They plan an initial retirement income replacement ratio of 80% ($40,000), but believe that they will spend less as they get older. Their blended income replacement ratio, for a 30-year retirement period, would be 69.3% as shown in the following table (or $34,650), which accounts for different spending levels throughout retirement.

Table 1
Blended Income Replacement Ratios

• Commuting costs and business travel
• Union dues and/or professional dues
• 401(k) plan contributions and Social Security tax deductions
• Business clothing
• Work-related social expenses
• Automobile expenses
• Income taxes
• Mortgage payments
• Child-rearing expenses

In addition, perhaps your mortgage will be paid off by the time you retire and you will have launched your children successfully into adulthood.

Also, consider expenses that are likely to begin or increase during retirement, including:

• Travel, entertainment, and hobbies
• Medical and dental expenses
• Medigap health insurance premiums and/or long-term care insurance
• Gifts to children and/or grandchildren
• Volunteer expenses (for example, commuting and contributions)
• Care of elderly parents

Also, inflation may increase expenses over time. Thus, factor a reasonable annual inflation rate (3% to 5%) into retirement savings calculations. You may also want to maintain a cash reserve large enough to cover several years worth of expenses so you can avoid selling investments at a loss during extended market downturns.

Ideally, your retirement savings analysis should be accurate enough that you don’t save a lot more money than you need — nor do you need to drastically lower your standard of living. Five key variables in a retirement savings analysis are:

Age at Retirement: Retiring before age 65 has been an increasing trend in recent years, but the downside is that early retirees have fewer years to save, fewer years for their savings to grow, and a longer time period to sustain themselves on invested assets. A major factor affecting when you retire is the availability and cost of health insurance.

Amount of Annual Income Needed: To figure this, use the income replacement ratio in Table 1. A recent study of the spending patterns of people in two different retirement phases (age 65 to 74 and 75 and over) found that, in the first phase of retirement, individuals spent 71% of preretirement income. In the second phase, however, spending decreased sharply to only 50%.

Growth Rate on Savings: A savings analysis should reflect the average rates of return actually earned on all investments. While stocks have averaged about 10% annually since 1926, it is generally not prudent to invest in stocks alone due to the increased investment risk. In addition, only half of Americans invest in stock or growth mutual funds at all. More than $1 trillion is placed in low-yield savings accounts, often earning less than the rate of inflation. Make sure you use a realistic rate of return based on your portfolio mix. If you have 50% of your assets in stocks or stock mutual funds, and 50% in bonds or Certificates of Deposit (CDs), use a blended rate of return. (A blended rate of return is an average of the different returns on different types of assets—the blended rate is often 6% to 7%.)

Life Expectancy: In just one century — from 1900 to 2000 — our average life expectancy has increased by about 30 years. Many people are living into their 80s and 90s. Since nobody has a crystal ball, the next best thing is to start with the average life expectancy figures for your gender and current age, and then make adjustments for factors such as good health and longevity of family members (for example, add five to 10 years). You don’t want to run out of money because you estimated your needs to age 85, but then live to 92!

Amount of Money Currently Saved: Obviously, the more you have already saved for retirement in accounts such as IRAs and other tax-deferred saving vehicles, the less you’ll need to save in the future. In addition, the longer money is maintained in tax-deferred accounts before mandatory withdrawals are required at age 70-1/2, the longer it will last.

Retirement Planning Worksheets
Hundreds, if not thousands, of retirement planning worksheets and calculators are available in print and online. Some keep calculations simple by making assumptions about one or more of the key variables mentioned previously. Others allow you to make your own assumptions. To interpret the output correctly, you will need to understand all of the assumptions used in an analysis.

A simple way to get a general idea of how much you need to save is to use the American Savings Education Council’s "Ballpark Estimate" worksheet. In its calculation, life expectancy is assumed to be age 87 with an investment return of 3% after inflation. Complete one online at www.asec.org or www.choosetosave.org.

To complete a realistic retirement savings analysis, you need to know how much you will receive from Social Security and/or employer pension plans. Each year, the Social Security Administration sends workers a retirement benefit estimate statement that shows what they’ll receive at ages 62, full retirement age, and 70, in today’s dollars, based on prior earnings. If you do not have this statement, contact the SSA at 1-800-772-1213 and request form SSA-7004 (or download a copy from www.ssa.gov). For a rough estimate of the amount you will get from Social Security, use the Benefit Calculator at www.socialsecurity.gov.

To make sure you include all possible income in your analysis, make a list of employers you have worked for and identify those that had a pension, 401(k), or other savings plan in which you are vested. Vesting means that you have worked for an employer long enough to earn the right to receive retirement benefits if you resign or are dismissed. Contact these employers and request a pension benefit estimate. You can also search for information about pensions through the Pension Benefit Guaranty Corporation Web site at www.pbgc.gov.

Be conservative and realistic when including other sources of income in your retirement savings calculation. Returns on certain investments, such as stocks, are unpredictable. If you plan to sell your home at a profit, subtract the cost of a new house or condo, plus moving expenses. If you plan to work after retirement, consider that you may only be able to do so for a certain number of years. In addition, you may need to plan around limits on the amount Social Security recipients age 62 to 64 can earn without affecting their benefits.

Retirement Catch-Up Strategies
Compound interest is the interest you receive on both reinvested interest and on the original amount invested. Unfortunately, compound interest is not retroactive. In other words, it is impossible to earn interest on money that was never saved years before. That’s the bad news.

The good news is that late savers have more than a dozen different ways to make up for lost time. All of these methods fall into one of two basic strategies:

• Take action before retirement to increase retirement savings.
• Take action after retirement to decrease the amount of savings required to live on.

Fortunately, even if you haven’t saved a dime, time is still on your side with both of these strategies. For example, if you’re 50 years old and your savings from today forward earn an 8% return, your money, simply left to accumulate, will double every nine years at ages 59, 68, and 77 — and possibly even at ages 86 and 95 — according to the Rule of 72.

The Rule of 72 is a quick way to figure out how long it takes a sum of money to double with compound interest. Simply divide 72 by the interest rate you’re earning (for example, 72 ÷ 8% = 9 years). Or, divide 72 by the time frame in which you want to double your money and solve for the required interest rate (example: 72 ÷ 10 years = 7.2%). In either case, the growth of money after several rounds of earlier doubling is impressive.

Like many decisions in life, catch-up retirement planning requires trade-offs. For example, you might spend less now in order to save more in a tax-deferred plan or delay retirement in order to earn additional retirement benefits and/or save more money. The retirement planning process proves the cliché that “there is no such thing as a free lunch.” All decisions do have their costs.

Although various catch-up strategies are explained individually, keep in mind that you can easily combine two or more of them. For example, you might (1) invest more in a 401(k) and move to a less expensive location, or (2) moonlight for additional income and delay retirement.

The bottom line is that it’s not too late to get started. Catch-up savers who are just beginning to plan for the future still have many options. By using the strategies on this Web site, financial “late bloomers” may afford to retire comfortably and have their money last as long as they do.

Tax Incentives to Make Up for Lost Time
If there was ever a good time to be a late saver, this is it. Thanks to the 2001 tax law, American workers, especially those born in 1952 or earlier, have at least nine years (from 2002 to 2010) to save more money than ever before in tax-advantaged accounts. Increased retirement plan contribution amounts, coupled with extra “catch-up” savings and the power of compound interest, can greatly enhance your future financial security.

These tax law changes are extremely important to late savers but may not last beyond 2010, so take advantage of them now. (These tax laws have a “sunset” provision, meaning they will end if not renewed.) As they say in farming, it’s time to “make hay while the sun shines.” A 50-year-old worker making the maximum contribution allowed each year to both an IRA and a tax-deferred plan—as much as $26,000 when the 2001 tax law is fully phased in—and earning an 8% average annual return, could amass $500,000 by age 65.

Higher Contribution Limits
Starting in 2002, escalating annual contribution limits apply to both Roth and Traditional individual retirement accounts (IRAs). IRAs are tax-deferred retirement savings plans available to all workers with earned income (wages and self-employment earnings), subject to certain adjusted gross income limits.

Escalating maximum annual contribution limits also apply to tax-deferred retirement savings plans available through employment: 401(k)s for employees of private corporations; 403(b)s for employees of schools, colleges, and nonprofit organizations; and Section 457 deferred compensation plans for state and local government workers. In addition, a catch-up provision exists for people age 50 and older for both IRAs and tax-deferred employer plans. Contribution limits and catch-up amounts are both escalating gradually from 2002 through 2010.

Table 2 shows the maximum contribution that all workers and those age 50 or older can make to IRAs and tax-deferred employer retirement plans:

Table 2
Maximum Retirement Plan Contribution Limits

Note: Contribution limits will revert to 2001 amounts and the catch-up amounts will be eliminated in 2011 if the 2001 tax law is not extended by Congress.

Workers who take advantage of the higher contribution limits for 401(k)s, 403(b)s, and 457 plans will save $30,500 more between 2002 and 2010 than they would have under the previous tax law. Older workers, who are also eligible for the catch-up provision, can contribute an additional $35,000. The grand total is $65,000 of tax-deferred savings, plus the earnings on that money and possible additional employer matching.

Tax Credit for Retirement Plan Contributions
The 2001 tax law provides an income tax credit of up to $1,000 for lower-income workers to save for retirement through IRAs or employer plans. Like the earned income tax credit and child credit, this credit is subtracted dollar for dollar from the amount of income tax a taxpayer owes.

The tax credit is available to single taxpayers with an adjusted gross income (AGI) up to $25,000 and couples with an AGI of up to $50,000. Workers under age 18, full-time students, and persons who are claimed as dependents are ineligible. The amount of the credit decreases from 50% to 20% and then to 10%, as taxpayers’ income increases as shown in Table 3.

A tax credit is much more valuable than a tax deduction, so try to make the most of it. Retirement plan contributions do not have to be made all at once—you can save the money gradually as you earn it, on your own, or via payroll deduction.

Table 3
Tax Credit for Retirement Plan Contributions

Note: The income levels listed above are for adjusted gross income—gross income minus certain allowable expenses such as alimony and contributions to retirement plans.

Savings Opportunities for Small Business Owners
The 2001 tax law increased the amount small business owners and their employees can contribute to tax-deferred retirement savings plans. The maximum contribution to Savings Incentive Match Plan for Employees (SIMPLE) is $7,000 in 2002 and will increase $1,000 each year (to $8,000 in 2003 and $9,000 in 2004) until it reaches $10,000 in 2005. After that, the limit will be indexed for inflation. Maximum annual contribution limits also increased in 2002 for Simplified Employee Pension (SEP) and Keogh retirement savings plans.

Other Savings Opportunities
Another beneficial 2001 tax law change is that when funding a tax-deferred plan, you are no longer limited to 25% of your gross income. Low-income workers who can afford it (for example, those with another major earner in their household) can contribute 100% of their earnings up to the maximum dollar limit allowed annually by law.

Since 2002, rollovers between different types of employer-sponsored retirement plans are now more flexible. This makes it easier to transfer retirement plan savings when you change jobs and keep your savings growing tax-deferred.

Note: At the time that the “Guidebook to Help Late Savers Prepare for Retirement” was finalized, legislation was being considered to provide additional opportunities to augment retirement savings.