In general, most people do not have enough money saved to last them into retirement. A recent Boston College study as reported by the NY Times (5/3/2015, Section B1) said the average 55-64 year old householder “had only about $104,000 in retirement savings.”
Gone are the days when you could receive pension checks during your golden years because of defined benefit plans offered by employers. Today, most private companies offer some type of defined contribution plan, including a 401(k), which has shifted the burden of saving and managing your money for retirement to you. To encourage you, for example, your employer can contribute up to 50% of your contribution, if you invest at least 6% of your annual salary. Some may contribute less or even none.
It feels good to have a 401(k) plan. However, as soon as she inspects the high costs and limited amount of funds available in his plan, she realizes that building retirement savings is more dream than reality. Plus, she’s happy to defer her taxes now, since they may be lower at retirement. However, the current trend of tax growth indicates that she may end up paying more in taxes than she expected.
Here are five ways to check your plan’s financial health and vital signs.
1. A retirement plan is only as good as your funds. If your plan offers a limited number of mutual funds, your chances of building a large, diversified portfolio are diminished. Some plans offer only a handful of mutual funds, while others offer a better variety of funds, including exchange-traded funds (ETFs) with much lower cost and greater diversification. You may spend a significant amount of time creating a sound and appropriate investment policy. However, without adequate funds in your 401(k) plan, it would be difficult to mitigate portfolio risk and achieve your financial goals.
2. Cost is a major factor that could make or break your future savings. Mutual funds generally have a high administration fee. Actively managed mutual funds have much higher fees than passively managed market indices. In addition to commissions and administration fees, your plan may impose an annual low balance maintenance fee. A higher cost simply means a lower return for your plan.
3. Not all funds are created equal. If you decide to absorb the usual high cost associated with mutual funds into your plan, you should consider their risk-adjusted return. A Sharpe ratio measures a fund’s return relative to its risk. Comparing different funds by their performance does not reveal the risk taken to produce the return. In addition to a Sharpe ratio, you can use other risk measures like Alpha and R Squared to assess the funds in your plan. Alpha measures the performance and ability of the fund manager to create the return. R Squared measures how closely or far a fund has performed compared to its benchmark. Financial websites like Yahoo tools and Morningstar should help you choose the funds available in your plan based on different measures of risk.
4. Your employer does not contribute to your 401(k). When there is no employer contribution to your plan, there is no need to invest in the plan. By investing in a restricted plan, you end up paying too much with no benefits from your employer. We encourage you to look for a better tax-deferred alternative to your 401(k) plan.
5. Long award schedule. If your plan has a long vesting schedule, when you leave your current job, you may have to waive some or all of your employer contributions. Some plans may have a vesting schedule which means that unless you are employed for a specific number of years, you are not entitled to your employer’s contributions.
If you find that you have a mediocre 401(k), you have several options to consider saving for retirement.
IRA or Roth IRA
The Individual Retirement Account (IRA) is a tax-deferred retirement account available to people with earned income. Unlike a 401(k) set up and provided by your employer, you open your own IRA or Roth IRA with a financial institution or custodian. Within your IRA or Roth IRA, you can invest in stocks, mutual funds, ETFs, and some other assets. An IRA or Roth IRA helps people save and invest money for retirement. With a traditional IRA, the contribution is generally tax deductible since it is tax deferred for the future. Whereas for the Roth IRA, you pay taxes now and your withdrawals are tax-free at retirement. For the Roth IRA, there are some eligibility requirements.
You can contribute up to $5,500 (for 2014 and 2015) to your traditional and Roth IRAs, or $6,500 if you’re age 50 or older at the end of the year; or your taxable compensation for the year. Under the Internal Revenue Code (IRC), if you are single or head of household with a Modified Adjusted Gross Income (AGI) of $61,000 or less, you can contribute to your IRA up to the contribution limit. Or, if you’re married filing jointly or a qualifying widow(er) with a modified AGI of $98,000 or less, you can contribute up to your contribution limit. Your deduction may be limited if you (or your spouse, if you’re married) are covered by a retirement plan at work and your income is above certain levels.
You can only contribute to an IRA or Roth IRA if you have earned income. According to the IRC, the following are qualified for earned income; wages, salaries and tips, union strike benefits, long-term disability benefits received before the minimum retirement age, and net earnings from self-employment.
However, if you are not working, but are married to someone who is, you may be able to open a spousal IRA that could be funded by your working spouse for your retirement.
annuities
To ensure a better retirement fund, an annuity is a valuable asset to consider in your retirement portfolio. An Annuity is a contract issued by an insurance company that pays out a stream of income for a period of time or for a lifetime. Annuities can be immediate or deferred. An immediate annuity begins its payment stream as soon as it is opened. By contrast, a deferred annuity payment does not begin until a later date in the future. You can fund your annuity contract with a lump sum payment when you open it, called a Single Premium Annuity, or you can pay something now and add more in future periods.
Annuities are divided into three main types; Fixed Income, Variable Indexed and Variable Income. A fixed income annuity pays you income based on a fixed interest for the life of your fund. It works like a CD, money market, or bond. An equity-indexed annuity, like a fixed annuity, provides a guaranteed minimum return while offering upside potential when investing in the stock market.
Unlike fixed annuities and indexed annuities that guarantee principal, a variable annuity contains a sub-account that could lose principal when investing in stocks, mutual funds, bonds, real estate, commodities, and other assets. Variable annuities seek higher returns by investing in a wide range of risky assets.
Common Annuity Features
There are different types of annuities (i.e. fixed, deferred, variable), however they mostly share the following common characteristics:
Life annuities are financial assets. You can buy them as a separate investment vehicle or within your IRA and any type of qualified retirement plan like a 401(k) plan. Since they are tax-deferred vehicles, an early withdrawal before age 59½ would incur a 10% penalty from the IRS. However, insurance companies generally allow 10-20% of the principal to be withdrawn each year without penalty. An annuity has a schedule of decreasing fees for early withdrawal known as surrender charges. It is usually the heaviest in the early years; An annuity may charge 7% for withdrawal in the first year, 6% in the second year, and reduces to zero percent in year 7, as an example.
You can invest as much as you want in annuities unless it’s part of your IRA or 401(k) plan, which is restricted to the amount allowed. Some insurance companies may limit your annuity investment to a large amount, such as $5 million.
Advantages and Disadvantages of Annuities
Among the advantages of annuities is their tax-deferred feature that helps you save as much for retirement as you want. An annuity contract can provide you with a lifetime income depending on the payment options you choose. Some can guarantee an income for the rest of your life (or single life), or your life and the life of your spouse, also known as a joint life. If income is one of your investment goals, you should consider an annuity for your retirement portfolio.
Annuities come with some disadvantages such as fees, expenses, and commissions. Gains and withdrawals are taxed as ordinary income compared to lower rates for long-term capital gains. Your money is blocked. Although you can withdraw your funds early, your withdrawals are subject to early surrender fees. Also, like any other retirement plan, you must pay a 10% penalty to the IRS before age 59½. Also, annuities are not guaranteed by the FDIC. Therefore, the financial guarantee given by an insurance company is backed by the creditworthiness and financial strength of the insurer.
Annuities could improve your retirement portfolio. However, there are more details to review before making a decision about annuities as a viable asset for your retirement portfolio.
If your current 401(k) plan is lousy with high cost and limited funds that doesn’t meet your investment goals and needs, you should seek help from professional financial advisors. The stakes are too high to manage your retirement plan as a do-it-yourself project.