Preparing for Your Retirement: An IRA Review

The most valuable asset of any person is their earning power.  This personal earning power is a powerful tool when used correctly.  Not many people realize that an average couple can earn 3.5 million dollars by age 65 if the total family income averages $100,000 for their entire career, without any raises.  

The future earning power is comprised of a person’s income, their spouse’s income, investment income, and other income.  In fact, a couple that is 45 years old and earns $50,000 yearly has an earning potential of $1,000,000 by age 65 if they invest wisely.

Sources of Retirement Income

Careful retirement income planning can come from a variety of sources, such as:

  • Social Security – In 2017, according to the Social Security Administration, the average retiree received an estimated $1,360 monthly benefit.  This is about 40% of the average pre-retirement income.  The percentage replaced by Social Security declines as pre-retirement income increases.
  • Employer-Sponsored Plans and IRAs – Pension income may be available at retirement if an employer offers an eligible retirement plan.  If a pension plan is not offered, many employers still offer individual retirement accounts (IRA) to supplement Social Security and vested pension payouts.
  • Home Ownership and Personal Retirement Savings – With a gap between the retirement income from Social Security and employer-sponsored plans/IRAs and a retiree’s income objectives, home equity can be used to bolster retirement security.  To bridge a retirement income gap, bank, and brokerage account along with insurance and annuity contracts, and personal retirement savings can be utilized.

One question must be answered before a potential retiree can determine if their post-retirement income will be sufficient:  Will retirement wait if funds are not available to support the standard of living or will the standard of living be reduced?

Important Facts about Social Security Retirement Benefits

With the current Social Security age at 66, many baby boomers will have to wait until age 67 to retire.  If these workers decide to retire early there will be a permanent reduction in the Social Security benefits received.  For example, if a potential retiree born in 1955 decides to retire at age 62, their Social Security benefits will be reduced by 25%.

According to the Social Security Administration, the maximum Social Security retirement benefit for a worker to receive in 2017 is $2,687 per month.  However, the average Social Security benefit for all retired workers in 2017 is $1,360.

The maximum Social Security spousal retirement benefit is limited to 50% of the retired worker’s benefit.  If the worker retires before the normal retirement age, the spousal benefit is reduced even further.

For a spouse, the maximum spousal retirement benefit is limited to 50% of the retired worker’s benefit.  This amount is reduced even further if the worker retirees before the normal retirement age.

For a source of retirement income, with baby boomers entering the retirement pool, large tax increases or benefit reductions are surely in the future.

Time is Money

Compound interest is a powerful tool in investment.  Delaying retirement savings can keep a person from realizing their earning potential and may affect their retirement dreams.  At a modest 5% annual rate of return, $100 a month saved beginning at age 20 will turn into almost $200,000 by retirement, whereas the same monthly amount decreases drastically to $81,870 for a 35-year-old.  

IRA’s Made Simple

An Individual Retirement Account (IRA) is a type of savings account that allows for substantial tax breaks.  An ideal retirement investment plan, many people mistake an IRA as the actual investment.  However, it is just the vehicle that drives the investment in stocks, bonds, mutual fund, or other assets.

To open an IRA account, certain income IRAs are opened by an individual, unlike 401 (k)s which are provided by an employee’s company.  Self-employed individuals or small business owners can also open IRAs.  However, eligibility is restricted based on income or employment status.  In addition, yearly contribution caps limit the amount of money that can be invested.  Finally, penalties are placed on funds that are withdrawn before the designated retirement age.

Early withdrawal penalties can be avoided in a few specific instances by paying for:

  • College expenses for children, grandchildren, a spouse, or self
  • Medical expenses greater than 7.5% of a person’s adjusted gross income for those older than 65 and 10% for those under 65
  • Up to $10,000 of a first-time home purchase
  • The costs of a sudden disability

The IRA Solution

There are two different types of IRAs, tax-deductible and tax-deferred.  In a traditional tax-deductible IRA, the money that is deposited into the account that otherwise would be paid in taxes.  When the money is distributed at retirement, taxes are paid.  In a tax-deductible IRA, taxes are paid on the money at the time of deposit into the Roth IRA.  Then, when distributions are received, the money is received income tax free.

Both types of IRA’s, tax-deductible and non-deductible Roth, can still yield results superior to a savings plan whose growth is taxed.  For example, at an 8% annual rate of return on a $5,500 annual contribution for a person in the 25% income tax bracket would produce well over $50,000 compared to a non-deductible savings account.

The Breakdown

Traditional tax-Deductible IRA – If the annual tax savings of $1,375 is invested in an account whose growth is taxed each year.  If the $271,826 value of the tax-deductible IRA is surrendered at the end of the 20th year, once income tax is paid, the principal amount left is $203,870.  Added to any future value of the tax savings of $53,615, the sum of the after-tax value of the IRA is $257,485.

Non-Deductible Roth IRA – When surrendered at the end of the 20th year, assuming no penalty tax is assessed, the full principal amount of $271,826 is available.  This total amount is free of income tax.

Non-Deductible Savings – If income tax is paid out of investment earnings each year, the entire principal amount of $214,460 is available free of income tax at the end of the 20th year.

With differing income brackets, interest rates, and investment plans, investing in an IRA and IRA options should be thought out and discussed with a financial expert.    

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