In this article I will explain some of the basic principles that underlie intelligent retirement planning. There is no rocket science here, I just want to be sure that everyone starts off on the same page.
Compound interest
One of the most important, yet misunderstood financial planning concepts is that of the power of compound interest. Compounding of interest merely means that you receive interest on top of interest.
For example, if you are 20 years old and invest $5,000 per year for 45 years, you will have invested $225,000. However, if you earn an average of 6% per year compounded annually, you will end up with $1,127,541 after those 45 years. If you wait until age 40, in order to have over $1 million by age 65 (same 6% compounded annually) you would have to invest $20,000 per year for 25 years, for a total investment of $500,000. You would end up with $ 1,163,128.
This assumes that you invest the money on the first of each year. There is a link to download an excel spreadsheet with the calculations at the end of this post. You can change the amount invested each year and/or the interest rate to adjust to your own situation.
Now, all we have to do is figure out how to explain this to a 20-year-old!
Qualified versus nonqualified plans
In 1974, Congress passed a law known as ERISA (Employee Retirement Income Security Act). This law protects employees by requiring employers to meet certain criteria. If the criteria are met, the amounts paid in by the employer are deductible to him and not taxable to the employee. In addition, interest on the amounts invested grow on a tax-deferred basis, which means that the employee does not have to pay tax until he starts receiving the money after retirement. In order to qualify under ERISA, the plan must not discriminate in favor of key employees. It must also comply with a list of requirements which address such issues as vesting, contribution amounts, distribution amounts, reporting requirements, fiduciary responsibilities, etc. They include defined benefit plans, defined contribution plans, 401(k) plans, 403(b) plans, SEP (Simplified Employee Pension) plans, etc.
An employer may decide to institute a nonqualified plan. This would normally be used in the instance where he wants to reward key employees only. They include such things as deferred compensation plans and key employee bonus plans. The contributions are not deductible to the employer and are also taxable to the employee. However, the employee still receives the benefits of tax-deferred growth. They are much more flexible because they do not have to comply with the requirements of ERISA.
Pre-tax vs after-tax income
This is an important concept when you are talking about the IRA. Contributions made to a Traditional IRA are deductible when you calculate your taxes for the year to which the contribution applies. Because you have not paid tax on this money, it is referred to as “pre-tax” income. You must pay taxes on these contributions when they’re withdrawn in retirement.
When you contribute to a Roth IRA, you did not deduct the amount of contributions when calculating your tax for that year. This means that you must pay tax on the money that you contribute to a Roth IRA. Because you have paid tax on this money, it is referred to as after-tax income. Since you’ve already paid taxes on this money, you do not have to pay tax when you withdraw it in retirement.
There are other applications of this concept, however this is the most common for most individuals.
Benefits of tax-deferred income
It does not take a genius to know that it is better to pay later rather than sooner. But you may not realize how advantageous it is to be able to defer taxes on your income. The reason for this is that the money paying taxes could be working for you rather than for the government. If you earn $25,000 per year and have a tax rate of 40%, you pay $10,000 per year in taxes. Assume for a minute that you don’t have to pay tax on the $25.000 and can get 6% return on that $10,000 that you save in tax each year. Over. 20 years, that $10,000 per year investment, assuming the investment is made at the end of each year in years 1 – 19 (total investment of $190,000) will grow to almost $330,000 (There is a link to download the excel file I created that shows the calculations at the end of this post).
Present Value
This is a concept that is known all to well to anyone who has won, say, $1 million in the lottery and ends up with a check of about $250,000 before taxes. Let’s see where that number came from…
When you win a lottery drawing, you usually have 2 choices…take the money and run or receive annual payments. For this example I will say that the payments are over 20 years ($50,000 per year). But, the state doesn’t have to have $ 1 million on hand in order to pay the winner each year. They have to have enough that, when invested at interest, will yield $50,000 per year for 20 years. The amount they have to have on hand varies by the interest rate they expect to be able to earn.
Let’s say that the interest rate the state can earn is 5%. The state would have to have almost $654,300 on hand, invested at 5% per year, to make the payments. I created a spreadsheet that shows the annual payments and adds in the interest each year. There is a link at the end of this post that includes this spreadsheet.
This amount, the $654,300, is the present value of 20 annual payments of $ 50,000 at a rate of 5%.
Another place we see this in everyday life is in a home mortgage. The balance of the mortgage is the present value and is much less than the total of the payments the homeowner makes over the life of the mortgage. You may take out a mortgage of $ 100,000 to buy a home but over the course of the 15, 20, 30 years that you are paying, you could pay 3 times that amount in payments. The present value of the $300,000 in payments, in this case, would be $100,000.
This will be explained in more detail when we talk about buying notes as investments in your IRA.
Types of Retirement Plans
The major types of qualified retirement plans. These include:
- IRA (Individual Retirement Arrangements) Traditional and Roth
- SIMPLE IRA Plans (Savings Incentive Match Plans for Employees)
- SEP Plans (Simplified Employee Pension)
- SARSEP Plans (Salary Reduction Simplified Employee Pension)
- Profit-Sharing Plans
- Defined Benefit Plans
- Money Purchase Plans
- Employee Stock Ownership Plans (ESOPs)
What is “Financial Freedom”?
Most people believe that in order to attain “financial freedom” they have to amass a certain net worth, then invest it so as to throw off enough cash each month to afford them the lifestyle to which they would like to become accustomed. This can be true, but if you are 40+ and haven’t started saving yet, the idea of stashing a few million aside in order to retire by age 65 is just too daunting.
Financial freedom really is all about the income, not the asset. For example, if you have $2 million in assets, and have it invested at 5% (AAA corp bonds are now paying about half that so you may have a tough time) you would have an income of $100,000 per year (before taxes), or about $8,333 per month.
What if you could find a way to generate that without having to save $2 million first? There are ways to do it, by investing in assets that throw off a greater income. How to do that? We will be addressing that in future articles, so stay tuned. It just takes a slight shift in your mindset and a little extra effort…
These are some of the basic concepts you must understand in order to get the most out of your retirement planning. In the next article we will discuss some alternative investments for your self-directed retirement plan.
You can download the excel files I mention in this article by clicking here
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