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Retirement Savings 101: My Grandfather Taught Me This Lesson

When meeting with clients to discuss saving for retirement, I often note that two of the most critical elements to building wealth for use in retirement are 1. starting early and 2. saving as much as possible. After all, the goal is to develop sources of income for use in retirement as a replacement for a paycheck. Understanding that fact is step one, in my opinion, to beginning to develop a plan. Sources of income in retirement can include Social Security, retirement accounts like 401(k) or IRA accounts, rental property, etc.

In the world of investing and, in particular, investing for retirement, you might easily become confused or frustrated by what seems a daunting task complicated by industry jargon. Frustration might arise because the goal of financial security seems unachievable. Concepts such as retirement readiness (an often used term for saving enough to retire) might create confusion. Further, assessing the potential types of retirement accounts to use could lead to indecision.

Lately, I have read that States are beginning to require that businesses provide access to some form of retirement savings account for their employees even if it is not a 401(k) Plan. Illinois, California, Oregon, Connecticut and Maryland, with Oregon leading the pack, have initiated legislation to do just such a thing. The interesting thing is that the current plans appear to be to mandate businesses to automatically sign up workers for Roth Individual Retirement Accounts (IRA). Workers can opt out, but must take a pro-active step to do so. Presumably, those that choose to contribute can select investments from a menu. Those that don’t opt out are automatically enrolled and if they do not select an investment option will, most likely, be invested into a default investment option, like a Target Retirement Date Fund.

This process of enrollment, which has proved successful in the 401(k) arena, works much like 401(k) plans with automatic enrollment. However, contributing to a Roth IRA is done after paying income taxes, whereas a traditional IRA is funded with tax-deductible contributions. Often 401(k) plans allow you to choose between saving with pre-tax or after-tax dollars. Both Roth and traditional IRAs enjoy growth that is not taxed. However, at the time of withdrawal, while distributions of the Roth IRA are not taxed as income, the traditional IRAs are taxed like a paycheck.

One other big difference between a 401(k) Plan and an IRA is the maximum amount an investor may contribute. For calendar year 2017, the IRS allows an individual to contribute $5,500 plus an additional $1,000 if that individual is over 50 years of age. The IRS allows an individual to contribute a maximum of $18,000 to a 401(k) Plan with an additional $6,000 for those over age 50. I do not understand the IRS’ logic behind this differentiation, but the rules are the rules.

These States are taking positive steps to encourage workers to save for retirement. I am sure that we will see much debate going forward about what vehicle to use, IRA or 401(k) plan, but this is movement in the right direction. However, as you may have heard me say before, we don’t necessarily need the government to convince us to save.

Perhaps saving for retirement is not as difficult or daunting as you might expect. As an example, I like to apply simple compounding investment growth with an average annual return of 6% per year over an investment horizon equivalent to a person’s career. By saving the maximum under an IRA of $5,500 per year from age 23 to age 50 and then saving $6,500 per year from age 50 to 65, you will have put away $252,500 in savings. The compounded growth at 6% will have contributed approximately $836,000 for a total account value of over $1 million.

Of course, this analysis uses straight-line growth, which isn’t always the way the markets behave. However, the point is clear that the power of compounding investment growth can generate a substantial nest egg. So, take advantage of whatever savings vehicle is available to you to save for retirement and don’t wait for the government to mandate that you do so.