Most Americans don’t save nearly enough money to retire comfortably. And it’s no wonder. It’s not easy setting aside money for the future, especially if you’re living on a shoestring.
As a result, Americans save only about 4% of their income. Only a few decades ago, in the 1970s, Americans were saving 9% to 15%.
Indeed, more than half of Americans have $5,000 or less saved for retirement. More than one-fifth have nothing saved at all. That means most Americans will be dependent on Social Security benefits averaging about $1,400/month. What’s more, Medicare premiums can reduce these benefits substantially, since they’re automatically withdrawn.
Can you live well on $1,400/month?
And in reality, Social Security will probably be less than that. The Social Security system is rapidly running out of money. The Congressional Budget Office predicts the system will be insolvent by 2029, only 11 years from now. You’ll still receive a Social Security payment each month, but the amount could be considerably less than what you’ve been promised.
Still, Social Security is in much better shape than the rest of the federal government. Our national debt now exceeds $20 trillion. And the “fiscal gap” – the deficiency in financing for unfunded mandates like federal and military pensions and interest on our national debt – now exceeds $200 trillion.
Traditional pensions are in no better shape, especially those for employees of state and local governments. The official unfunded liabilities reported by state pension systems stand at $1.4 trillion. But the actual shortfall is much higher. Liabilities of most state and local government pension plans are calculated based on the assumption that their investment portfolios will generate an average annual return between 7% and 8%. That might have been realistic in the 1970s when the economy was growing faster than it is now. But it’s wildly optimistic with today’s slower economic growth and lower interest rates. A calculation using the actual investment returns these pensions have achieved – a bit less than 3% annually – results in a shortfall of $3.8 trillion.
All of these trends point to one inescapable conclusion: it’s extremely unlikely you’ll receive the Social Security or pension benefits you’ve been promised. And the younger you are, the less you’ll get.
That means you need to save as much money as you can before you retire.
One option is to make traditional (or less traditional) investments, which I discussed here. Another option is to create a part-time business you can run once you retire, which I wrote about in this article.
But most investments and businesses have to pay income tax to Uncle Sam. And those annual tax payments can substantially reduce how much of your hard-earned money you get to keep.
Fortunately, there is a solution. Congress has created an assortment of retirement options you can use to defer a substantial (sometimes very substantial) amount of tax. But there’s a catch: in most cases, you can’t withdraw any money from these plans until you are at least 59½ years old.
I look at that limitation not as a threat but as an opportunity, especially for younger people. For instance, if you’re now 25 years old, you have at least 35 years to build a nest egg on a tax-deferred basis. And if you’re a parent, grandparent, uncle, or aunt, it’s time to have a frank conversation with the young people you care about. They need to understand that the time to start socking away money for retirement is now.
Here’s an example of the power of this strategy. Let’s say you’re 25 and can scrape together $100 each month to contribute to a Roth IRA. You invest very conservatively in two-year Treasury bonds yielding 2.6% (and rising). In 35 years, you will have accumulated more than $68,000 that you can spend tax-free once you reach 59½. That’s hardly a fortune, but it’s a lot more than most Americans have.
Since your time horizon is so long, you might decide to put that $100 into a stock index fund that mirrors the S&P 500. Yes, stocks are volatile, but 35 years is enough time horizon to even out the bumps. And the long-term annualized return on the S&P is 9.8%. If that persists over the next 35 years, you’d wind up with a tax-free nest egg of more than $360,000. Again, not a fortune, but it will go a long way toward bridging the fiscal gap when you’re ready to retire.
You can contribute no more than $5,500 annually to an IRA ($5,500 if you’re over 50). And if you make more than $120,000 annually or $189,000 filing jointly with your spouse, your eligibility to make a Roth IRA contribution starts to phase out. All these numbers are adjusted annually for inflation.
There are no income limits to making contributions to a traditional IRA, although contributions aren’t deductible if you or your spouse are covered by an employer-sponsored retirement plan and your income exceeds certain limits. Plus, you’ll need to pay tax when you start receiving distributions. (For the nitty-gritty details, check out this link.)
If you work for an employer that offers a 401(k) plan, you have another option to save some money. You decide how much money the employer can deduct from your paycheck to contribute to your 401(k), up to a maximum of $18,500 annually ($24,500 if you’re over 50). Many employers will match your contribution up to a specified limit. However, many employees fail to max out this contribution limit. Indeed, a 2015 study found that on average employees fail to match funds of $1,336 annually.
Simply by saving an additional $100 monthly, a 25-year-old could build up a substantial tax-deferred nest egg. The math is the same as in the Roth IRA example I just presented, although with a traditional 401(k), you’ll need to pay income tax when you start receiving payments from the plan.
If your employer doesn’t offer a 401(k) plan, you can start your own business and create one for yourself. It’s called a “solo 401(k)” strategy, and it’s a great way for entrepreneurs to build up a substantial nest egg for retirement. If you own your own business and have no employees other than yourself and your spouse, you qualify for this type of plan.
What’s fantastic about this type of plan is that the contribution limits are much higher than IRAs or even a regular 401(k). That’s because you’re both the employee and employer. As an employee, you can defer up to $18,500 of your salary annually, just like an employer-sponsored 401(k). But as an employer, you can contribute up to 25% of your salary to your solo 401(k). The maximum combined contribution you can make as both employee and employer comes to a whopping $55,000 annually ($61,000 if you’re over 50).
There are, of course, some caveats to these strategies. Employer-sponsored 401(k) plans, for instance, enjoy stronger asset protection than IRAs or solo 401(k)s. And if you opt for a self-directed IRA or solo 401(k), there are numerous “prohibited transactions” you need to avoid. We discussed the ins and outs of prohibited transactions in a recent Nestmann Inner Circle Alert. (Members can read the Alert here.)
Finally, there’s always a risk that Uncle Sam might decide to change the rules to help pay the bills. Indeed, one of the top concerns of our clients is that a future US president will find a way to confiscate the money in their IRAs or 401(k) plans.
That’s not going to happen. More than 11 million Americans have IRAs. And more than 50 million Americans have 401(k) plans. And while the government could legally change the rules to confiscate these funds, I don’t think it will. It would be political suicide to do so.
What will happen is that the rules will change. Income limits to make tax-deductible contributions will be decreased. Maximum contributions will be reduced. Limits will be imposed on how large an IRA or 401(k) plan you can have. And the IRS could become much more aggressive in policing prohibited transactions. You can read my thoughts on this subject at this link.
One thing is for certain. Uncle Sam isn’t in a financial position to pay for your retirement. Only you can do that…and the time to start saving for it is now.