FINANCING LIFE
Fall 2015
Session #5 – Financing Retirement
As you travel along your “life path,” financing current expenses and accumulating assets and liabilities, virtually
everyone reaches a point when the current income from work abruptly stops, i.e., they retire. For college students
still waiting to land that first “real” paycheck, planning for a retirement still decades away seems a remote concept
indeed. Yet the only way to live comfortably in retirement is to save some of your current income during your
working years, invest it wisely, and then manage that wealth intelligently so that it lasts at least as long as you do.
The only sure way to avoid having to finance retirement is to die young—not really the most desirable solution to
financial planning. A better strategy is to plan for a lengthy retirement. This is especially important for women
who statistically earn less, save less and live longer than men. It is not impossible or even uncommon in the
modern world to spend nearly as many years in retirement as you spend in the labor force. BE PREPARED.
“Compounding”—the magic of exponential growth
The secret to securing a comfortable retirement isn’t really a secret. Start saving for retirement early in life.
Money set aside at the beginning of a year, if invested wisely, will earn a return. Next year you earn a return
on the principle and on last year’s interest. The third year you are earning on the principle, the first year’s
earnings and the second year’s…and so on ….and so on…The more years involved the more this effect is
magnified. There are two important principles to remember about this compounding effect:
a)
b)
though in the first years there is little difference between the effects of larger and smaller
rates of return, the differences become very large as the time horizon is extended.
most of the growth in an exponential function takes place at the very end. An extra ten
years of compounding can result in a doubling or more of total wealth. Small
differences in the length of time money is invested become huge differences in the
amount at the end.
Accounting for inflation
In planning for retirement it is essential to keep in mind the effects of inflation. You can be certain that the
real value of $1 million when you retire will be significantly less than it was on the date you graduated from
college. Do your planning in terms of real rather than nominal values. (See the handout from Session #1 on
converting nominal to real values.)
Tax Sheltered Retirement Saving
There are a number of ways to save for retirement that have distinct tax advantages. Employer contributions
to retirement are “exclusions” under the IRS code and as such they are invisible when taxes are calculated.
Any supplemental contributions you make to an employer sponsored plan (401K) up to generous limits are
“adjustments”. Thus the real cost of making those contribution is reduced by your marginal tax rate. A
$1000 contribution “costs” $850 to someone in the 15% bracket and only $650 to someone in the 35%
bracket. If your employer does not offer a plan you can establish an Independent Retirement Account (IRA)
and deduct contributions to it from your Adjusted Gross Income in figuring your income taxes. You will
have to pay taxes on the funds when you withdraw them during retirement but it is likely that you will be in a
lower tax bracket then than during your peak earning years.
(There is another form of IRA, called a “Roth” account whereby you contribute after tax dollars, but all of the
earnings are forever tax exempt.)
Rollovers
If you are covered by an employer retirement plan, then under most conditions you are entitled to take those
funds with you if you leave the company… and most of us do change jobs and employers several times over
our careers. It is important to handle those accumulated retirement funds wisely. There is a temptation to treat
them as “found cash” and buy a new car. That would be a mistake. They are the foundation for later
retirement and they will already have been through the “early but unimpressive” years of compounding. They
should be rolled over into another form of retirement vehicle.
Sponsored by the Center for Women & Financial Independence
FINANCING LIFE
Fall 2015
Social Security
The federal Social Security program does provide some retirement income for most persons who work
and contribute. Social Security benefits can be a helpful portion of a retirement plan but they will never
be enough to provide real comfort or security. They can be the frosting. Don’t count on them being the
cake.
Planning for a Retirement Target
If you want to retire by age
And have a retirement fund of
65
$ 1,000,000.00
With an annual rate of return of
10.00%
The amount you will have to set aside each month
If you start at age
If you start at age
If you start at age
If you start at age
If you start at age
If you start at age
If you start at age
If you start at age
20
25
30
35
40
45
50
55
$
$
$
$
$
$
$
$
95.40
158.13
263.39
442.38
753.67
1,316.88
2,412.72
4,881.74
(In order to achieve this, starting at age 20, you would need to set aside $3.14 a day)
(If your are in the 28% tax bracket your actual cost will be only $2.86 a day)
Sponsored by the Center for Women & Financial Independence