By Nathan gage
One of the highlights of my role as a retirement plan advisor is also one of the most challenging—helping to make sense of the very abstract retirement planning process.
There is a seemingly endless list of obstacles standing in the way of figuring out if you are on the path to retirement readiness. When will you retire? How long will your retirement last? What will your monthly budget in retirement be? How will your tax rate in retirement compare to today? How will your investments fair over the next couple of months, years, or decades?
The list of unknown variables could go on and, if you are not careful, may stand in the way of making wise decisions. In fact, for some, the uncertainty can lead to the worst possible decision—inaction.
Realizing that complexity can be paralyzing, simplifying the retirement planning process encourages savers to take the steps needed to get on the right track.
One way to help frame the process is in terms of the three main decision points that savers face as they save for retirement. First is how much to save. Next is how to make those contributions, choosing between pre-tax and Roth. The final decision is how to invest their retirement savings. Armed with an understanding of the key questions, we can take a closer look at the main decision points.
How much should you save for retirement? On the surface, this seems like a simple question. In practice, though, getting an accurate answer to this question is quite complex. There are some widely used rules of thumb. One is to set aside 15% of your pay for retirement.
Another centers around current balances rather than savings rates, for example stating that you should have four times your salary saved by the time you reach age 45. In reality, the best answer to that question comes with an analysis of your household’s unique financial picture. Most advisors have access to some robust planning tools that will help to create this customized answer.
With information like when you plan to retire, how much your household has in dedicated retirement savings, pension income (if any), current savings rates, and current investment allocations, a household’s estimated monthly retirement income can be projected and potential shortfalls identified. Although this takes some effort, in the end it is well worth it. Savers who understand where they stand are more likely to achieve retirement readiness than those who do not.
Considering how much to contribute first is no accident; it is the most important decision that savers make. In order to reach retirement income goals, it is critical to save consistently and take advantage of opportunities to increase that savings rate over time.
The contribution decision is not simply a matter of how much to save, but also how to make those savings. The choice between pre-tax and Roth will determine when you pay federal tax on your retirement contributions. Most workplace retirement plans already offer Roth and, thanks to the passage of some Roth-friendly rule changes included in the recent SECURE 2.0 legislation, Roth is poised to be even more widely available going forward.
When deciding between pre-tax and Roth, there are some standard rules of thumb involving age and current income to consider. The younger you are, the more Roth may make sense. One of the benefits of Roth is the potential for tax-free investment earnings.
The more time those invested assets have to grow, the more powerful that benefit becomes. Current income also plays a role in the decision as high standard deduction amounts and the progressive federal tax structure mean that households on the lower end of the income spectrum pay federal taxes at a relatively low rate.
If that is the case now, why not take care of paying the tax bill now, while at that lower rate. Children claimed on a household’s tax return can also influence the decision as the child tax credit helps to further reduce the effective tax rate, making the argument for Roth even more compelling.
Aside from those more conventional considerations, tax diversification is something else to keep in mind. Thinking ahead to retirement, what are your household’s sources of income? Social Security? Most of that will be taxable. Pension income? Taxable. Pre-tax contributions to traditional IRAs and retirement plans? Taxable.
Employer contributions made to retirement plans over the years? All taxable. For many households, no matter where they turn to meet their retirement income needs, there is a tax bill to worry about. Not only does having a Roth balance available give the ability to control taxable income in a given year, it also helps to hedge against the possibility that the tax rates themselves may shift in an unfavorable direction in retirement.
One other possibility that is worth considering is that of a large one-time expense, such as getting debt paid down or purchasing a retirement property. If the only available funds are pre-tax dollars, not only will the withdrawal be taxable, but it may actually push you into a higher income tax bracket. For those reasons, Roth may appeal to a broader group than the traditional thinking suggests.
Finally there is the decision that many view as the most daunting and anxiety inducing – how to invest retirement savings. When investing retirement assets, there are some guidelines to keep in mind. Diversification is key; investors should avoid putting all of their eggs in one basket. One way to diversify is at the broad asset class level between stock investments (on the high end of both the short-term risk and long-term return spectrum), cash (at the other end of those spectrums), and bonds (in the middle).
Digging a little deeper, it is important to further differentiate the stock portion of your portfolio to include holdings across different industries, locations, company size etc.
On the bond side, savers can diversify with different types of issuers, diverse credit profiles and different terms.
Time is another important factor. The more time to go until the finish line, the more short-term risk savers can take now. Those who are further from the date when they plan to start using their funds can build a portfolio more heavily weighted toward the stock side. As that time horizon grows shorter, adding bonds and cash in greater proportions help to reduce the portfolio’s volatility.
Managing both diversification and the overall risk level of the portfolio are key to managing retirement assets. Saying that is one thing; putting that concept into practice is quite another. Building a diversified portfolio with an appropriate risk level can be a non-starter for the average person.
The list of available investment options is often very long and confusing. When forced to make this decision on their own, some savers may shut down and choose not to save at all. The good news is that, most savers will not need to do this alone and they may not need to do it at all, depending on the available investment options.
An advisor will be able to take into account your time horizon, risk tolerance, and other factors to help build an appropriate investment allocation for your portfolio, and then adjust that over time.
If your retirement account(s) offer target date funds or risk-based asset allocation models, the work of diversification is done for you. Asset allocation models allow you to adjust your risk thermostat as you see fit, selecting a model that creates a diversified portfolio at a particular level of risk and adjusting that thermostat as needed over time.