Nobody ever said planning and saving for retirement would be easy, and statistics from a recent study out of the Employee Benefits Research Institute (which we covered in April) show that quite a few people are making the same mistakes.
The EBRI's study, which surveyed approximately 2,000 people, half retired and half working, showed that close to three-fifths of respondents had $25,000 or less saved for retirement via cash and investments, including 28% who had $1,000 or less. It should be noted that the EBRI study excluded defined-savings plans such as 401(k)s, so things may be a bit better than the study portends -- but it nonetheless highlights the struggle of the average American to save for retirement.
56% of you could be doing this all wrong
But what happens to John and Jane Q. Public if they do have enough money for retirement and they hit their target retirement numbers? That was the question on the minds of researchers at Pentegra Retirement Services when they recently asked 1,530 respondents (all still working) whether or not they had plans in place to begin taking their distributions during retirement.
According to Pentegra's findings, 56% of respondents had no distribution plan for accessing their money in retirement, and one in five admitted to not even thinking about it at all. What's more, one in five didn't plan to retire, and the average respondent believed they would need $3,200 in retirement.
"Why does this matter?" you wonder? Excluding the fact that not planning for retirement because you plan to work forever is generally a bad idea (and an entirely different topic we've covered before), not having a distribution plan in place could cost retirees a lot of money -- money they may need in retirement and can't afford to pay back in taxes.
Why a distribution plan is so important
The key advantage to having a retirement distribution plan in place is tax savings. If you don't understand the ins and outs of when to begin taking your retirement distributions, you could wind up paying significantly more back to Uncle Sam than you need to, or worse, can afford to.
For example, taking a retirement distribution before turning 59 1/2 years old will almost always net you a tax penalty of 10% on top of the marginal tax you'll need to pay on your distribution based on your tax bracket. Unless you're taking care of unreimbursed medicals bills, paying for health care premiums, buying a home for the first time, or you owe the IRS money for unpaid taxes, then withdrawing money from a defined-savings plan before the age of 59 1/2 is a no-no!
But even reaching the age of 59 1/2 doesn't mean you can throw a dart or flip a coin and hit the perfect distribution strategy.
Although it would probably be enticing to leave your retirement accounts, such as your 401(k), untouched for as long as possible so compounding can continue to work in your favor, the IRS imposes some extremely harsh penalties if you don't begin taking your minimum distributions by age 70 1/2. The reason the IRS does this is to mitigate the ability of retirees to use retirement accounts as vehicles to pass money to their heirs. If you choose not to take your required minimum distribution in a calendar year, or only take a portion of it, the remaining balance that wasn't distributed will be taxed at a rate of (drumroll please...) 50%! That's a good way to kiss your hard-earned money goodbye!
Even if you aren't violating the required minimum distribution and aren't taking distributions before age 59 1/2, there are still possible pitfalls. For instance, taking out an exceptionally large sum of money could overwhelm your ability to spend your retirement money responsibly. You might think you have plenty of disposable cash, and thus burn through your savings at a faster pace than you initially intended.
A possible solution is to open an annuity, which gives the account owner guaranteed distributions throughout their expected lifetime -- but this also comes with a price. The rate of appreciation on an annuity is near a record low right now since interest rates have a strong bearing on payouts, and the fees associated with an annuity could easily eat into your retirement savings.
One smart move you should consider right now
Obviously, the first step in your distribution plan should be to target a regular withdrawal amount on a monthly basis that's very similar to what you would have earned while working. One of Pentegra's primary findings was that transitioning from work life to retired life isn't easy from a monetary perspective. Therefore, workers should consider gradually adjusting their spending and lifestyle to a "retired" level a few years before they retire so the transition is a lot smoother.
However, the one smart move that I'd strongly suggest today's workers consider is to open and/or maximize their contributions to a Roth IRA.
Unlike a Traditional IRA, which requires an account holder to begin taking distributions between age 59 1/2 and 70 1/2, a Roth IRA has no minimum age at which you need to begin taking required distributions. As long as you wait to get over the age hump of 59 1/2 years (unless you meet one of the aforementioned hardships above), you'll be allowed to keep every cent of your capital gains because they'll be free and clear of taxation.
Additionally, because Roth IRAs don't mandate a minimum annual distribution, the account holder can continue allowing compounding and time to work their magic. Plus, unlike a Traditional IRA, the account holder can make contributions to their Roth after their 70th birthday. As a refresher, the maximum contribution is $5,500 for those under age 50 and $6,500 for people aged 50 and up.
Keep in mind that Roth IRAs, just like Traditional IRAs, do have qualifying income limitations in order to contribute, but the limits are often high enough that roughly nine out of 10 working Americans will qualify.
Long story short, the only one responsible for reducing your tax bill come retirement is you! It all begins with having a distribution plan in place well before you hit your golden years and having the motivation to become educated about your choices. Take my suggestion as your motivation to begin putting your retirement distribution plan in place today.