How Much Should I Contribute to Retirement?

A question I’m sure to address during employee retirement presentations is, “How Much Should I be Contributing?”.  Quick internet search led me to two popular answers.

1. Whatever you need to contribute to get the match from the employer,

2. 10-15% of your compensation.

As with most questions around financial planning, the answer should really be, “it depends”.  We all know it is important to save for retirement, but knowing how much is enough is the real issue and typically there is more work involved than saying 10-15% of your pay.

In this article, I will address some of the variables at play when coming up with your number and provide detail as to why the two answers previously mentioned are so common.

Expenses and Income Replacement

Creating a budget and tracking expenses is usually the best way to estimate what your spending needs will be in retirement.  Unfortunately, this is time-consuming and is becoming more difficult considering how easy it is to spend money these days.  Automatic payments, subscriptions, payment apps, and credit cards make it easy to purchase but also more difficult to track how much is leaving your bank accounts. 

Most financial plans we create start with the client putting together an itemized list of what they believe they spend on certain items like clothes, groceries, vacations, etc.  A copy of our expense planner template can be found here.  These are usually estimates as most people don’t track expenses in that much detail.  Since these are estimates, we will use household income, taxes, and bank/investment accounts as a check to see if expenses appear reasonable.

What do expenses have to do with contributions to your retirement account now?  Throughout your career, you receive a paycheck and use those funds to pay for the expenses you have.  At some point, you no longer have the paycheck but still have the expenses.  Most retirees will have access to social security and others may have a pension, but rarely does that income cover all your expenses.  This means that the shortfall often comes from retirement accounts and other savings.

Not taking taxes, inflation, or investment gains into account, if your expenses are $50,000 per year and Social Security income is $25,000 a year, that is a $25,000 shortfall.  20 years of retirement times a $25,000 shortfall means $500,000 you’d need saved to fund retirement.  Once we have an estimate of the coveted “What’s My Number?” question, we can create a savings plan to try and achieve that goal.

Cash Flow

As we age, some of the larger expenses we have in life go away.  Student loan debt, mortgages, and children are among those expenses that stop at some point in most people’s lives.  At the same time, your income is usually higher due to experience and raises throughout your career.  As expenses potentially go down and income is higher, there may be cash flow that frees up allowing people to save more for retirement.  The ability to save more as we get older means the contribution target amount may also change over time.

Timing of Contributions

Over time, the interest that compounds in retirement accounts often makes up most of the overall balance. 

For example, if you contribute $2,000 a year for 30 years into a retirement account, you will end up saving $60,000.  If you were able to earn an annual return of 6%, the ending balance after 30 years would be approximately $158,000.  $60,000 of contributions and $98,000 of earnings.

The sooner the contributions are in an account, the sooner interest can start compounding.  This means, that even though retirement saving is more cash flow friendly as we age, it is still important to start saving early.

Contribute Enough to Receive the Full Employer Match

Knowing the details of your company’s retirement plan is important.  Most employers that sponsor a retirement plan make contributions to eligible employees on their behalf.  These contributions often come in the form of “Non-Elective” or “Matching”.

Non-Elective – Contributions that will be made to eligible employees whether employees are contributing to the plan or not.  These types of contributions are beneficial because if a participant is not able to save for retirement from their own paycheck, the company will still contribute.  That being said, the contribution amount made by the employer, on its own, is usually not enough to achieve the level of savings needed for retirement.  Adding some personal savings in addition to the employer contribution is recommended.

Matching – Employers will contribute on behalf of the employee if the employee is contributing to the plan as well.  This means if the employee is contributing $0 to the retirement plan, the company will not contribute.  The amount of matching varies by company, so knowing “Match Formula” is important to determine how much to contribute.  For example, if the matching formula is “100% of compensation up to 4% of pay”, that means the employer will contribute a dollar-for-dollar match until they contribute 4% of your compensation.  Below is an example of an employee making $50,000 with the 4% matching contribution at different contribution rates.

As you can see, this employee could be eligible for a $2,000 contribution from the employer, if they were to save at least 4% of their pay.  That is a 100% return on your money that the company is providing.

Any contribution less than 4%, the employee would not be taking advantage of the employer contribution available to them.  I’m not a fan of the term “free money”, but that is often the reasoning behind the “Contribute Enough to Receive the Full Employer Match” response.

10%-15% of Your Compensation

As said previously, how much you should be contributing to your retirement depends on several factors and can be different for everyone.  10%-15% over a long-term period is often a contribution rate that can provide sufficient retirement savings.  Math below…

Assumptions

Age: 25

Retirement Age: 65

Current Income: $30,000

Annual Raises: 2%

Social Security @ 65: $25,000

Annualized Return: 6%

Step 1: Estimate the Target Balance to Accumulate by 65

On average, people will need an estimated 90% of their income for early retirement spending.  As we age, spending typically decreases because people are unable to do a lot of the activities we typically spend money on (i.e. travel).  For this exercise, we will assume a 65-year-old will need 80% of their income throughout retirement.

Present Salary - $30,000

Future Value After 40 Years of 2% Raises - $65,000

80% of Future Compensation - $52,000

$52,000 – income needed to replace

$25,000 – social security @ 65

$27,000 – amount needed from savings

X       20 – years of retirement (Age 85 - life expectancy)

$540,000 – target balance for retirement account

Step 2: Savings Rate Needed to Achieve $540,000 Target Balance

40 years of a 10% annual savings rate earning 6% interest per year, this person could have an estimated balance of $605,000.  $181,000 of contributions and $424,000 of compounded interest.

I hope this has helped provide a basic understanding of how you can determine an appropriate savings rate for yourself.  We recommend reaching out to an advisor who can customize your plan based on your personal needs and goals.

Rob Mangold

About Rob……...

Hi, I’m Rob Mangold, Partner at Greenbush Financial Group and a contributor to the Money Smart Board blog. We created the blog to provide strategies that will help our readers personally, professionally, and financially. Our blog is meant to be a resource. If there are questions that you need answered, please feel free to join in on the discussion or contact me directly.

Can I Open A Roth IRA For My Child?

Parents will often ask us: “What type of account can I setup for my kids that will help them to get a head start financially in life"?”.  One of the most powerful wealth building tools that you can setup for your children is a Roth IRA because all of accumulation between now and when they withdrawal it in retirement will be all tax free. If your child has $10,000 in their Roth IRA today, assuming they never make another deposit to the account, and it earns 8% per year, 40 years from now the account balance would be $217,000.

Contribution Limits

The maximum contribution that an individual under that age of 50 can make to a Roth IRA in 2022 is the LESSER of:

• $6,000

• 100% of earned income

For most children between the age of 15 and 21, their Roth IRA contributions tend to be capped by the amount of their earned income. The most common sources of earned income for young adults within this age range are:

• Part-time employment

• Summer jobs

• Paid internships

• Wages from parent owned company

If they add up all of their W-2's at the end of the year and they total $3,000, the maximum contribution that you can make to their Roth IRA for that tax year is $3,000.

Roth IRA's for Minors

If you child is under the age of 18, you can still establish a Roth IRA for them. However, it will be considered a "custodial IRA". Since minors cannot enter into contracts, you as the parent serve as the custodian to their account. You will need to sign all of the forms to setup the account and select the investment allocation for the IRA. It's important to understand that even though you are listed as a custodian on the account, all contributions made to the account belong 100% to the child. Once the child turns age 18, they have full control over the account.

Age 18+

If the child is age 18 or older, they will be required to sign the forms to setup the Roth IRA and it's usually a good opportunity to introduce them to the investing world. We encourage our clients to bring their children to the meeting to establish the account so they can learn about investing, stocks, bonds, the benefits of compounded interest, and the stock market in general. It's a great learning experience.

Contribution Deadline & Tax Filing

The deadline to make a Roth IRA contribution is April 15th following the end of the calendar year. We often get the question: "Does my child need to file a tax return to make a Roth IRA contribution?" The answer is "no". If their taxable income is below the threshold that would otherwise require them to file a tax return, they are not required to file a tax return just because a Roth IRA was funded in their name.

Distribution Options

While many of parents establish Roth IRA’s for their children to give them a head start on saving for retirement, these accounts can be used to support other financial goals as well. Roth contributions are made with after tax dollars. The main benefit of having a Roth IRA is if withdrawals are made after the account has been established for 5 years and the IRA owner has obtained age 59½, there is no tax paid on the investment earnings distributed from the account.

If you distribute the investment earnings from a Roth IRA before reaching age 59½, the account owner has to pay income tax and a 10% early withdrawal penalty on the amount distributed. However, income taxes and penalties only apply to the “earnings” portion of the account. The contributions, since they were made with after tax dollar, can be withdrawal from the Roth IRA at any time without having to pay income taxes or penalties.

Example: I deposit $5,000 to my daughters Roth IRA and four years from now the account balance is $9,000. My daughter wants to buy a house but is having trouble coming up with the money for the down payment. She can withdrawal $5,000 out of her Roth IRA without having to pay taxes or penalties since that amount represents the after tax contributions that were made to the account. The $4,000 that represents the earnings portion of the account can remain in the account and continue to accumulate tax-free. Not only did I provide my daughter with a head start on her retirement savings but I was also able to help her with the purchase of her first house.

We have seen clients use this flexible withdrawal strategy to help their children pay for their wedding, pay for college, pay off student loans, and to purchase their first house.

Not Limited To Just Your Children

This wealth accumulate strategy is not limited to just your children. We have had grandparents fund Roth IRA's for their grandchildren and aunts fund Roth IRA's for their nephews. They do not have to be listed as a dependent on your tax return to establish a custodial IRA. If you are funded a Roth IRA for a minor or a college student that is not your child, you may have to obtain the total amount of wages on their W-2 form from their parents or the student because the contribution could be capped based on what they made for the year.

Business Owners

Sometime we see business owners put their kids on payroll for the sole purpose of providing them with enough income to make the $6,000 contribution to their Roth IRA. Also, the child is usually in a lower tax bracket than their parents, so the wages earned by the child are typically taxed at a lower tax rate. A special note with this strategy, you have to be able to justify the wages being paid to your kids if the IRS or DOL comes knocking at your door.

About Michael.........

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Tax Reform: Your Company May Voluntarily Terminate Your Retirement Plan

Make no mistake, your company retirement plan is at risk if the proposed tax reform is passed.  But wait…..didn’t Trump tweet on October 23, 2017 that “there will be NO change to your 401(k)”?  He did tweet that, however, while the tax reform might not directly alter the contribution limits to employer sponsored retirement plans, the new tax rates will produce a “disincentive” for companies to sponsor and make employer contributions to their plans.

What Are Pre-Tax Contributions Worth?

Remember, the main incentive of making contributions to employer sponsored retirement plans is moving income that would have been taxed now at a higher tax rate into the retirement years, when for most individuals, their income will be lower and that income will be taxed at a lower rate.   If you have a business owner or executive that is paying 45% in taxes on the upper end of the income, there is a large incentive for that business owner to sponsor a retirement plan.  They can take that income off of the table now and then realize that income in retirement at a lower rate.

This situation also benefits the employees of these companies.  Due to non-discrimination rules, if the owner or executives are receiving contributions from the company to their retirement accounts, the company is required to make employer contributions to the rest of the employees to pass testing. This is why safe harbor plans have become so popular in the 401(k) market.

But what happens if the tax reform is passed and the business owners tax rate drops from 45% to 25%?  You would have to make the case that when the business owner retires 5+ years from now that their tax rate will be below 25%.  That is a very difficult case to make.

An Incentive NOT To Contribute To Retirement Plans

This creates an incentive for business owners NOT to contribution to employer sponsored retirement plans.  Just doing the simple math, it would make sense for the business owner to stop contributing to their company sponsored retirement plan, pay tax on the income at a lower rate, and then accumulate those assets in a taxable account.  When they withdraw the money from that taxable account in retirement, they will realize most of that income as long term capital gains which are more favorable than ordinary income tax rates. 

If the owner is not contributing to the plan, here are the questions they are going to ask themselves: 

• Why am I paying to sponsor this plan for the company if I’m not using it?

• Why make an employer contribution to the plan if I don’t have to?

This does not just impact 401(k) plans. This impacts all employer sponsored retirement plans: Simple IRA’s, SEP IRA’s, Solo(k) Plans, Pension Plans, 457 Plans, etc.

Where Does That Leave Employees?

For these reasons, as soon as tax reform is passed, in a very short time period, you will most likely see companies terminate their retirement plans or at a minimum, lower or stop the employer contributions to the plan.  That leaves the employees in a boat, in the middle of the ocean, without a paddle.  Without a 401(k) plan, how are employees expected to save enough to retire?  They would be forced to use IRA’s which have much lower contribution limits and IRA’s don’t have employer contributions.

Employees all over the United States will become the unintended victim of tax reform.  While the tax reform may not specifically place limitations on 401(k) plans, I’m sure they are aware that just by lowering the corporate tax rate from 35% to 20% and allowing all pass through business income to be taxes at a flat 25% tax rate, the pre-tax contributions to retirement plans will automatically go down dramatically by creating an environment that deters high income earners from deferring income into retirement plans.   This is a complete bomb in the making for the middle class.

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

How Does A Simple IRA Plan Work?

Not every company with employees should have a 401(k) plan. In many cases, a Simple IRA plan may be the best fit for a small business. These plans carry the following benefits

• No TPA fees

• Easy to setup & operate

• Employee attraction and retention tool

• Pre-tax contributions for the owners to lower their tax liability

Your company

To be eligible to sponsor a Simple IRA, your company must have less than 100 employees. The contribution limits to these plans are about half that of a 401(k) plan but it still may be the right fit for you company. Here are some of the most common statements that we hear from the owners of the business that would lead you to considering a Simple IRA plan over a 401(k) plan:

"I want to put a retirement plans in place for my employees that has very low fees and is easy to operate."

"We are a start-up, we don't have a lot of money to contribute to the plan as the owners, but we want to put a plan in place to attract and retain employees."

"I plan on contributing $15,000 per year to the plan, even if I sponsored a plan that allowed me to contribute more I wouldn't because I'm socking all of the profits back into the business"

"I have a SEP IRA now but I just hired my first employee. I need to setup a different type of plan since SEP IRA's are 100% employer funded"

Establishment Deadline

The deadline to establish a Simple IRA plan is October 1st. Once you have cross over that date, you would have to wait until the following calendar year to set the plan.

Eligibility

The eligibility requirements for a Simple IRA are different than a SEP IRA or 401(k) plans. Unlike these other plan "1 Year of Service" = $5,000 of compensation earned in a calendar year. If you want to only cover "full-time" employees with your retirement plan, you may need to consider a 401(k) plan which has the 1 year and 1000 hours requirement to obtain a year of service. The most restrictive "wait time" that you can put into place is 2 years. Meaning an employee must obtain 2 years of service before they are eligible to start contributing to the plan. You can also be more lenient that 2 years, such as immediate entry or a 1-year wait, but 2 years is the most restrictive it can be.

Types of Contributions

Like a 401(k) plan, Simple IRA have both employee deferral contributions and employer contributions.

Employee Deferrals

Eligible employees are allowed to make pre-tax contributions to their Simple IRA accounts. The contribution limits are less than a traditional 401(k). Below is a tale comparing the 2021 contribution limits of a Simple IRA vs a 401(k) Plan:

There are not Roth deferrals allows in Simple IRA plans.

Employer Contributions

Unlike other employer sponsored retirement plans, employer contributions are mandatory each year to a Simple IRA plan. The company must choose between two pre-set employer contribution formulas:

• 2% Non-elective

• 3$ Matching contribution

With the 2% non-elective contribution, the company must contribute 2% of each eligible employee’s compensation to the plan whether they contribute to the plan or not.

For the 3% matching contribution, it’s a dollar for dollar match up to 3% of compensation that they employee contributes to the plan. The match formula is more popular than the 2% non-elective contribution because the company only must contribute if the employee contributes.

Special 1% Rule

With the employer matching contribution there is also a special rule. In 2 out of any 5 consecutive years, the company can lower the employer match to as low as 1% of pay. We will often see start-up company's take advantage of this rule by putting a 1% employer match in place for the first 2 years of the plan to minimize costs and then they are committed to making the 3% match for years 3, 4, and 5.

100% Vesting

All employer contributions to Simple IRA plans are 100% vested. The company is not allowed to attach a "vesting schedule" to the contributions.

Important Compliance Requirements

Make sure you have a 5304 Simple Form in your files for each year you sponsor the Simple IRA plan. If you are audited by the IRS or DOL, they will ask for these forms. You need to distribute this form to all of your employee each year between Nov 1st and Dec 1st for the upcoming plan year. The documents notifies your employees that:

• A retirement plan exists

• Plan eligibility requirement

• Employer contribution formula

• Who they submit their deferral elections to within the company

If you do not have this form on file, the IRS will assume that you have immediate eligibility for your Simple IRA plan, meaning that all of your employees are due employer contributions since day one of employment. Even employee that used to work for you and have since terminated employment. It’s an ugly situation.

Make sure the company is timely when submitting the employee deferrals to the Simple IRA plan. Since you are withholding money from employees pay for the salary deferrals the IRS want you to send that money to their Simple IRA accounts “as soon as administratively feasible”. The suggested time phrase is within a week of the deduction in payroll. But you must be consistent with the timing of your remittances to your Simple IRA plan. If you typically submit contributions to your Simple IRA provider 5 days after a payroll run but one week you randomly submit it 2 days after the payroll run, 2 days just became the rule and all of the other deferral remittances are “late”. The company will be assessed penalties for all of the late deferral remittances. So be consistent.

Cannot Terminate Mid-Year

Unlike other retirement plans, you cannot terminate a Simple IRA plan mid-year. Simple IRA plan termination are most common when a company started with a Simple IRA, has grown in employee head count, and now wishes to put a 401(k) plan in place. You must wait until after December 31st to terminate the Simple IRA plan and implement the new 401(k) plan.

Special 2 Year Rule

If you replace your Simple IRA with a 401(k) plan, the balances in the Simple IRA can usually be rolled over into the new 401(k) if the employee elects to do so. However, be very careful of the special Simple IRA 2 Year Distribution Rule. If you process any type of distribution from a Simple IRA, within a two-year period of the employee depositing their first dollar to the account, and the employee is under 59½, they are hit with a 25% IRS penalty. THIS ALSO APPLIES TO DIRECT ROLLOVERS. Normally when you process a direct rollover from one retirement plan to another, no taxes or penalties are assessed. That is not the case in Simple IRA plan so be care of this rule. If you decide to switch from a Simple IRA to a 401(k), make sure you run a list of all the employees that maintain a balance in the Simple IRA plan to determine which employees are subject to the 2-year withdrawal restriction.

About Michael.........

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

A New Year: Should I Make Changes To My Retirement Account?

A simple and easy answer to this question would be…..Maybe?  Not only would that answer make this article extremely short, it wouldn’t explain some important items that participants should take into consideration when making decisions about their retirement plan.Every time the calendar adds a year we get a sense of reset.  A lot of the same tasks on the to do list get added each January and hopefully this article helps you focus on matters to consider regarding your retirement plan.

Should I Consult With The Advisor On My Plan?

At our firm we make an effort to meet with participants at least annually.  Saving in company retirement plans is about longevity so many times the individual meetings are brief and no allocation changes are made.  Even if this is the result, an overview of your account, at least annually, is a good way to keep retirement savings fresh in your mind and add a sense of comfort that you’re investing appropriately based on your time horizon and risk tolerance.

These individual meetings are also a good time to discuss other financial questions you may have.  Your retirement plan is only a piece of your financial plan and we encourage participants to use the resources available to them.  Often times these meetings start off as a simple account overview but turn into lengthy conversations about various financial decisions the participant has been weighing.

How Much Should I Be Contributing This Year?

This answer is not the same for everyone because, among other things, people have different retirement goals, financial situations, and time horizon.  That being said, if the  company has a match component in their plan, the first milestone would be to contribute enough to receive the most the company is willing to give you.  For example, if the company will match 100% of your contributions up to 3% of pay, any amount you contribute less than 3% will leave you missing out on retirement savings the company is willing to provide you.

Again, the amount that should be saved is dependent on the individual but saving anywhere from 10% to 15% of your compensation is a good benchmark.  In the previous example, if the company will match 3%, that means you would have to contribute 7% to achieve the lower end of that benchmark.  This may seem like a difficult task so starting at an amount you are comfortable with and working your way to your ultimate goal is important.

Should You Be Making Allocation Changes?

The initial allocation you choose for your retirement account is important.  Selecting the   appropriate portfolio from the start based on your risk tolerance and time until retirement can satisfy your investment needs for a number of years.  The chart below shows that over longer periods of time historical annual returns tend to be less volatile.

When you have over 10 years until retirement, reviewing the account at least annually is   important as there are a number of reasons you would want to change your allocation.  Lifestyle changes, different retirement goals, or specific investment performance to name a few. Participants tend to lose out on investment return when they try to time the market and are forced to sell low and buy high.  This chart shows that even though there may be volatility in the short term, as long as you have time and an appropriate allocation from the start, you should see returns that will help you achieve your retirement goals. 

About Rob……...

Hi, I’m Rob Mangold. I’m the Chief Operating Officer at Greenbush Financial Group and a contributor to the Money Smart Board blog. We created the blog to provide strategies that will help our readers personally , professionally, and financially. Our blog is meant to be a resource. If there are questions that you need answered, pleas feel free to join in on the discussion or contact me directly.