Financial Planning for Retirement: A Stage-by-Stage Guide

Early Financial Planning in Your 20s

The primary means of achieving adequate savings for retirement is to begin planning well before retirement is near. This period is ideally when a person is in their 20s. Financial advisors recommend setting aside 10% of gross pay each month for long-term investments. Additionally, 401(k) contributions should be at least at the employer matching limit, if not greater. Once a 401(k) account is set up, one should never borrow against it for any reason. First, the retirement savings balance will decrease. Second, early withdrawal from a 401(k) account results in steep penalty fees.

Credit card debt should also be evaluated when one is in their 20s. Many credit cards carry interest rates of 20% or higher. Over time, a concerted effort should be made to lower balances on these cards, since maintaining high balances at high interest rates delays putting money aside for retirement. Financial goals should also be shared with one's partner. It is critically important that each person is involved in the planning process and agrees on what type of lifestyle he or she envisions. Once goals are mutually agreed upon, both parties should be involved in carrying out the financial strategies necessary to achieve them. Each person should know and understand which investments to hold and why. This is a critical period to educate oneself about how to handle personal finances.

A common rule of thumb in retirement planning is that, in order to maintain one's current standard of living, a retiree will need to replace 70–80% of pre-retirement income, since overall expenses usually decline. Some financial professionals recommend aiming to replace 90–100% of pre-retirement income. While this may be an ambitious goal for many, achieving it helps retirees be prepared for nearly any circumstance that arises.

As part of one's net worth, retirement capital should be determined. This is the pool of assets beyond Social Security and any company pension that can provide income and capital during retirement. Retirement capital may include individual retirement accounts (IRAs), Keogh plans, company profit-sharing plans, personal investments and savings, and annuities.

With current expenses and net worth as a benchmark, future expenses should be projected. Housing, clothing, gasoline, and food expenses will likely decline, while medical expenses, travel, and entertainment costs will likely rise.

Financial Planning for Retirement in Your 30s

As one approaches the 30s, a retirement finance re-evaluation is in order. This is also the time to begin saving for a child's college education. Money set aside for this purpose should come only after all routine household expenses and the 401(k) contribution have been funded. It is also worthwhile to investigate potential alternative financial sources such as scholarships, financial aid, and student employment.

At this age, one should consider boosting the 401(k) contribution to 12% or 15% of gross income (Jones, 2004). This is also the period in one's life where investing in stocks and other options should be seriously considered. Diligent financial record-keeping is an important habit that will yield significant benefits over time. If the retirement portfolio loses substantial value due to a market downturn, one should not impulsively alter the investment plan or withdraw money. The retirement investing portfolio should be viewed as a long-term strategy that will endure many market swings over the course of years. A well-diversified portfolio will help limit dramatic shifts in value, however.

Financial Planning in Middle Life

When one reaches his or her 40s, 15–20% of salary should be set aside for retirement (Jones, 2004). Retirement plans that were created years or decades earlier should be updated to reflect prior experiences and changed circumstances. Financial advisors play an invaluable role at this stage. As one reaches the 50s and older and slowly approaches retirement age, less risky investments — such as bonds and real estate — should make up the majority of the portfolio. The closer one comes to retirement, the more conservative the investments should become. One may also consider selling the current home and purchasing a smaller one.

Healthcare costs should not be underestimated with advancing age. If one does not budget for private insurance, Medicare is the only option available (Silva, 2004). No one should plan retirement around this government program alone, because rising costs will almost certainly mean reduced benefits and longer waits for care (Moon, 2004).

Financial Resources for Retirement

Most likely, the financial benefits received from Social Security will not be sufficient to solely sustain a person through retirement. The higher one's income, the smaller the portion replaced by Social Security. For example, a retired couple whose annual pre-retirement income was $20,000 will have 46–62% of that income replaced by Social Security. However, Social Security will replace only 19–25% of the income of a couple who earned $80,000 before retirement, and less than 10% for a couple who earned $200,000. Additionally, for each year a person works beyond age 65, up to age 70, Social Security benefits will be larger once one begins collecting them (Smith, Toder, & Iams, 2003; Verma & Rix, 2003).

Like Social Security, employer-sponsored retirement plans typically replace only a portion of pre-retirement income for the average retired couple. Adjunctive income sources are therefore often necessary. Unlike Social Security, however, most company retirement plans are not adjusted annually for inflation.

Employer-sponsored plans typically come in two forms: defined benefit plans, in which one receives a specific monthly benefit typically based on salary; and defined contribution plans, such as the 401(k) or money-purchase plan, in which the size of the funds depends on how much the individual and the company contributed during one's working years and the rate of return earned during that time.

The 401(k) is probably the most common retirement plan, allowing employees to contribute pre-tax money to a retirement account. Many employers also provide matching funds to the employee's 401(k) as part of the benefits package. The employee often has the option of selecting specific investments for the money in their account. In addition to building retirement funds, contributing to a 401(k) reduces taxable income and helps preserve more take-home pay.

If one's employer offers a qualifying 401(k) plan and one is a full-time employee, one may participate. Generally, contributions are auto-deducted from the paycheck into a pre-determined retirement account. The balance is invested according to the specifications established at initiation of the plan. If the employer provides matching funds, this portion of the account balance may not be immediately available and will become part of the vested balance only after a set number of years.

Money in a 401(k) account is not taxed until it is withdrawn. Additionally, money grows faster through the power of tax-deferred compounding interest. Since 401(k) contributions are typically made directly from the paycheck, saving for retirement is made automatic and straightforward. However, there is a 10% penalty for early withdrawal, and one becomes liable for the deferred income taxes at that time. It is therefore advantageous on several fronts to leave this money in the account untouched until retirement.

After retirement, the decision about the form in which to receive defined-contribution benefits will have already been made and is irrevocable. If one is nearing retirement, there remains an opportunity to select the benefit distribution option. Three basic options are typically available:

Retirement accounts that are commonly utilized include IRAs, annuities, and retirement plans for the self-employed such as Keogh plans. Unlike typical company pension plans, one does not have to begin withdrawing from these accounts until as late as April 1 of the year following the year one turns 70½. One may withdraw all, some, or none from any given account in a given year, as long as the total withdrawal meets or exceeds the annual minimum withdrawal requirement based on the total assets in all qualified plans, such as 401(k) plans and IRAs.

Savings and investment accounts may also be used as a source of retirement income. Part-time work can help stretch retirement funds and ease the emotional transition into retirement as well. According to the Social Security Administration, 43% of people age 65 and older who earn $20,000 a year work part-time (Licari, 2004). One may also be able to continue contributing tax-deductible dollars to Keogh plans, IRAs, or similar tax-deferred plans until age 70½. However, one must keep in mind that earning too much income may reduce the Social Security benefits to which one is entitled.

Another option is selling one's home to free up assets for retirement. If one sells the home and moves to a less expensive residence, the after-tax sales profits can be invested for future retirement needs. An alternative home-based option is the reverse mortgage. With a reverse mortgage, the homeowner receives regular, nontaxable payments from the lender rather than making payments. The principal and interest are repaid at a later date, either when the house is sold or when the owner dies. Reverse mortgages are a relatively recent option for retirees, and terms vary widely, so any contract should be carefully reviewed before signing.