Notes on Saving for Retirement
Published On: April 29, 2019
Written by: Ben Atwater and Matt Malick
As our series on retirement continues, we turn our attention today to saving for retirement. Whether you are forty years from retirement or five years from retirement, saving should be a priority. The adage to “pay yourself first” is a good one. But, how best to “pay yourself first”? This essay addresses the hierarchy of saving for most individuals.
Abraham Maslow created a theory in 1943 to rank humans’ basic needs in life. Maslow’s “Hierarchy of Needs” is typically presented as a pyramid, with primitive needs for survival at the bottom. Upon satisfying each level, one can move up the pyramid and fulfill more complex needs. For example, once a person has air, water and food, he can seek out shelter, followed by more abstract desires such as love, self-esteem and creativity.
Achieving long-term financial goals requires a plan for saving and investing that can be sorted into a similar pyramidal structure. While we are not the first financial advisors to create a “financial hierarchy of needs,” this iteration focuses exclusively on saving.
Most Americans have access to the same basic investment vehicles, including workplace retirement accounts such as 401(k) and 403(b) plans, traditional and Roth IRAs, 529 plans, brokerage accounts, etc. While every client’s personal situation is unique, this basic “hierarchy of saving” can serve as a guide for most investors to prioritize saving in different types of accounts.
It’s worth noting that many clients invest outside of financial assets, most commonly in real estate. In some cases, this can be highly profitable, especially in owner-occupied commercial properties or when an investor acquires numerous commercial or residential properties with the scale and expertise in real estate to succeed. However, we’ve also seen many situations where one-off rental properties or vacation homes become low-returning investments or even a financial burden.
For clients considering a real estate investment, we urge you to contact us to review financial projections for the investment. For others, we believe the following “hierarchy of saving” can provide the means for a prosperous retirement.
An emergency fund, which is typically just a bank account that can be tapped in the event of lost income, home/auto repair, health problems, etc., should be the foundation of any personal balance sheet. Most financial advisors recommend enough to cover 3-6 months of expenses but the exact amount depends on your personal situation and comfort level. For instance, if your wages are variable (e.g. sales commissions) or if your job is not secure, a larger emergency fund may be appropriate.
Emergency funds should be stashed in cash; we often recommend high-yielding online savings or money market accounts. Bankrate.com is a good source to find the best rates.
Workplace Retirement Plan
Qualified retirement plans, such as 401(k)s and 403(b)s, are offered by employers to encourage retirement saving and they come with several advantages. First, contributions are tax-deductible (more and more plans now offer a post-tax Roth option as well). For wager-earners, this tax deduction is highly valuable. Income taxes are deferred until funds are withdrawn in retirement, when most retirees are in a lower tax bracket.
Second, many plans include an employer “match.” For example, if you contribute at least 4%, an employer may contribute a “matching” 4%. In this example, an investor earns an immediate 100% return on investment.
Third, most plans allow participants to defer up to the IRS limit each year. For 2019, this limit is $19,000 for participants under age 50 with a $6,000 catch-up contribution for those age 50 and above. Some workers, typically at smaller companies or self-employed, can participate in SIMPLE IRAs or SEP IRAs and these plans also carry relatively high contribution limits.
How workplace retirement plans should be invested should depend entirely on your time horizon and risk tolerance. But we almost always recommend maximizing contributions as a first step toward planning for retirement because of their tax-deferral, potential employer match and high contribution limits.
Traditional and Roth IRAs
After you max-out contributions to workplace retirement plans, or if you don’t have access to them, then individual retirement accounts (IRAs) should be next on the savings pyramid. Traditional IRAs, where contributions are made pre-tax but future withdrawals are taxed, and Roth IRAs, where contributions are post-tax but future withdrawals are tax-free, come with much lower contribution limits of $6,000 for people under age 50 and $7,000 for those 50 and above in 2019.
If you are covered by a retirement plan at work, then traditional IRA contributions also begin to lose their tax deductibility for taxpayers earning an adjusted gross income (AGI) over $64,000 (single) or $103,000 (married filing jointly). If you are not covered by a workplace retirement plan but your spouse is, then the phaseout begins at an AGI of $193,000. Once these contributions lose their deductibility, they become less appealing and investors may want to consider “moving up” the savings pyramid.
Roth contributions also have phaseouts, which begin at AGI of $122,000 (single) or $193,000 (married filing jointly). In the case of Roth IRAs, the IRS disallows contributions entirely above the phaseout limits.
For investors with young children, 529 plans are often the best tool to save for education. They offer tax-free growth if the funds are used for education expenses and sometimes come with a state income tax deduction on contributions. Most plans offer age-based investment options that start aggressive (stock-heavy) and become more conservative (bond and cash-heavy) as a child approaches college age.
However, we rarely recommend saving for children’s education until an adequate amount is contributed toward retirement. Most young people can borrow for college and have a lifetime to pay it back. But you only get one chance at saving for retirement and we have yet to find a financial institution willing to offer “retirement loans” to those who neglected to save. And if you ultimately find that you’ve saved enough for retirement, you can always help adult children repay school loans.
A valuable, yet often overlooked, savings vehicle is a simple, taxable brokerage account.
Brokerage accounts don’t come with any immediate tax benefits like 401(k) and IRA accounts. Each year, the account holder receives a tax form 1099 to report taxable interest, dividends and capital gains to the IRS. But brokerage accounts can be surprisingly tax-efficient if invested appropriately.
On the equity side, our low-turnover strategy leads to modest capital gains in most tax years. And both long-term capital gains and qualified stock dividends are taxed at favorable rates: 0%, 15% or 20%, plus a 3.8% Medicare surtax in certain situations. All these rates would be lower than that taxpayer’s marginal federal income tax rate.
On the fixed income side, coupon (interest) payments are generally taxable as ordinary income, although municipal bonds can be utilized for high earners, generating tax-free income.
Most importantly, a brokerage account gives you the flexibility to draw from your investments without triggering the ordinary income taxes that result from IRA and 401(k) withdrawals in retirement. For clients hoping to retire early, particularly before Medicare kicks in at age 65, a taxable brokerage account can provide tremendous flexibility to help fund private health insurance premiums and ordinary retirement expenses. To review your overall savings plan, please contact us. As always, we appreciate your support.