In general, most people don’t 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 householder aged 55-64 “had only about $104,000 in retirement savings.”
Gone are the days when you could receive pension checks during your golden years due to defined benefit plans offered by employers. Today, most private companies offer some type of defined contribution plan, including a 401(k), which has put the burden of saving and managing your money for retirement on 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 at all.
It feels good to have a 401(k) plan. However, as soon as she examines the high costs and limited amount of funds available in his plan, she realizes that building retirement savings is more of a dream than a 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 tax than she expected.
Here are five ways to check the financial health and vital signs of your plan.
1. A retirement plan is only as good as its funds. If your plan offers a limited number of mutual funds, your chances of building a large diversified portfolio decrease. Some plans offer just 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 great deal 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 management 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. Higher cost simply means lower performance for your plan.
3. Not all funds are created equal. If you decide to absorb the usual high cost associated with the mutual funds in 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 performance does not reveal the risk assumed to produce the performance. 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 performance and the fund manager’s ability to create performance. R Squared measures how close or far a fund has performed compared to its benchmark. Financial websites like Yahoo and Morningstar tools 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 contribution from your employer to your plan, there is no need to invest in the plan. By investing in a restricted plan, you end up paying too much without benefits from your employer. We encourage you to look for a better tax-deferred alternative for your 401(k) plan.
5. Extended award schedule. If your plan has a long vesting schedule, when you leave your current job, you may have to give up 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 lackluster 401(k), you have several ways 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 an open 401(k) 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 a few 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 defers taxes into the future. Whereas for 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 to your traditional and Roth IRAs up to $5,500 (for 2014 and 2015), 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’re single or head of household with 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 qualified widow(er) with 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 married) are covered by a retirement plan at work and your income exceeds certain levels.
You can only contribute to an IRA or Roth IRA if you have income from work. According to the IRC, the following are qualified for earned income; wages, salaries and tips, union strike benefits, long-term disability benefits received before minimum retirement age, and net earnings from self-employment.
However, if you’re not working, but married to someone who is, you can open a spousal IRA that could be funded by your working spouse for retirement.
Annuities
To secure 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 a stream of income for a period of time or for life. Annuities can be immediate or deferred. An immediate annuity begins its payment stream as soon as it is opened. In contrast, payment of a deferred annuity 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 some now and add more in future periods.
Annuities are divided into three main types; Fixed Income, Indexed Variable Income and Variable. 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 index annuities that guarantee principal, a variable annuity contains a subaccount that could lose principal by investing in stocks, mutual funds, bonds, real estate, commodities, and other assets. Variable annuities seek a higher return by investing in a wide range of risky assets.
Common Characteristics of Annuities
There are different types of annuities (i.e. fixed, deferred, variable), however they mostly share the following common features:
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 declining fees for early withdrawal known as surrender charges. It is usually the heaviest in the early years; An annuity may charge 7% withdrawal in the first year, 6% in the second year, and drops 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 allowed amount. 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 for retirement as much as you want. An annuity contract can provide you with income for life depending on the payment options you choose. Some may guarantee an income for the rest of your life (or single life), or you and your spouse’s life, also known as joint life. If earning income is one of your investment goals, you should consider annuities for your retirement portfolio.
Annuities come with some drawbacks like fees, expenses, and commissions. Gains and withdrawals are taxed as ordinary income compared to lower rates for long-term capital gains. Your money is locked. Although you can withdraw your funds early, your withdrawals are subject to early redemption charges. 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 provided 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 that need to be reviewed before making a decision on annuities as a viable asset for your retirement portfolio.
If your current 401(k) plan is lousy with high costs 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.
