The 4 Essential Elements of a Retirement Plan
To ensure you have enough money to live happily after you stop working, you need to have a retirement plan in place. The essential elements of any plan are: Maximize your contributions, diversify your savings, keep track of all your assets (and understand how different income sources can affect your Social Security benefits) and make a schedule for post-retirement distributions that makes the most of each account's earning potential.
“It is very important to have multiple types of accounts or ‘buckets’ when planning for retirement,” says Michael Windle, financial advisor at C. Curtis Financial Group in Plymouth, Mich. “Being able to pull income from both taxable and non-taxable accounts can not only help you pay the least amount of taxes required, but it can make your retirement last!”
Start by maximizing your contributions to your personal or employer-sponsored retirement savings plan. If you participate in a 401(k) or other qualified plan, be sure to defer as much as you can reasonably afford from each paycheck. If your employer offers a matching contribution, try to make contributions that can maximize the value of your employer's match. If your employer matches up to 6% of your annual salary, for example, try to defer at least 6% of each paycheck to get the most bang for your buck.
“Do not save anywhere else until you have maxed out your company match within the 401(k),” says David S. Hunter, CFP®, president of Horizons Wealth Management, Inc., in Greenville, S.C. “It is akin to ‘hustling backwards’ if you do not get the free-100% return on your contribution.”
For 2016, the maximum annual employee contribution to a 401(k) plan is $18,000, with a maximum total contribution limit, including employer match, of $53,000. If you are over age 50, you can contribute an additional $6,000 each year for a total contribution limit of $59,000. (For additional insights, see How 401(k) Matching Works.)
If you have an individual retirement account (IRA), your annual contribution limit is $5,500 per year, or $6,500 if you are over 50.
Spread the Wealth
While most long-term employers offer some type of retirement savings plan, don't rely solely on these programs if you don't have to. If you don't already have an IRA, consider opening one in addition to your employer-sponsored account so that you can increase the amount of money you save each year. If you have a 401(k) and an IRA, you can contribute an annual maximum of $23,500 in 2016, or $30,500 if you're over 50.
If your tax burden isn't too high, consider opting for a Roth IRA to take advantage of tax-free earnings on your contributions when you take withdrawals after age 59½. (For more, see our tutorial: Roth IRAs.)
“Be careful not to put all your retirement eggs in the pre-tax basket because you could be setting yourself up for a higher tax bracket once you retire,” says Windle. “If all your assets are in a pre-tax account, that means when you retire and need that money as income you will have to pay tax on everything you put in and every penny of growth.”
“Tax diversification is just as important as investment diversification,” notes Marguerita Cheng, CEO of Blue Ocean Global Wealth in Rockville, Md. “It's helpful to have taxable, tax-deferred and tax-free assets.”
If you hold both a 401(k) and an IRA, do your best to contribute to both. Focus on maximizing your contributions to employer-sponsored plans first to take advantage of employer matching.
Know Your Assets
Depending on which type of plan your employer offers, you may be able to opt for a self-managed plan or one in which your contributions are automatically invested in accordance with the plan's goals. In either case, educate yourself about the different investment options available to you and the expenses associated with each option. Many 401(k) plans carry hefty administrative fees or only provide access to mutual fund investments with high expense ratios. Keep track of your own account and make sure you fully understand your options so you can avoid losing money to unnecessary fees (see How to Know If Your 401(k) Plan Fees Are Too High).
Also keep track of the Social Security benefits that will be available to you at retirement (see Types of Social Security Benefits for more), as well as other income you are likely to receive from retirement accounts or pensions. Your income may affect how much you pay for Medicare (The High Net Worth Guide to Medicare explains how) and whether you are taxed on your Social Security benefits, so factor in all your various income sources when planning for retirement.
Make a Schedule
Even if you intend to work well into your twilight years, remember that most retirement savings plans include minimum distribution requirements and may carry heavy penalties for participants who neglect to begin withdrawals by a certain age. Roth IRAs often do not carry such requirements, which is yet another benefit of Roth accounts. However, most other plans set the age of required minimum distribution (RMD) at age 70½. Similarly, you are required to begin taking Social Security benefits by age 70.
If you have multiple sources of retirement income, be sure to make a schedule for when you will begin to take withdrawals from each account. If you have a Roth IRA, for example, put off taking withdrawals until you have exhausted funds from accounts that carry RMD requirements. In addition to being an efficient way to spread out your savings, this type of scheduling allows your Roth account to continue to accrue tax-free earnings while you collect from other accounts.
The Bottom Line
Following these four essential steps – maximizing your contributions so that you are saving at least 10-15% of your income; diversifying your savings into tax-deferred, tax-free and taxable accounts; knowing your assets and the fees associated with them (as well as their impact on Social Security); and making sure you have a schedule of withdrawals in your post-work years – will help ensure you have the funds you need for a comfortable retirement.