This week we moved on to Baby Steps Four and Five, which are saving for retirement and saving for your kids’ college education. Baby step four was on deck first, which is to save 15% of your household income in tax-advantaged plans. Dave points out that, at the time this class was filmed, 53% of all workers had less than $25,000 in retirement vehicles. Further, when asked how they plan for retirement, 44% said that they guess at the amount they’ll need and the investment products to use. Those are some scary numbers. Most people figure retirement’s too far away or they’re too busy living for today that they “forget” to take care of their future. Big mistake. Since pensions are almost a thing of the past and Social Security cannot be counted on, most of these people are going to have a hard time making ends meet in retirement.
Dave spends the first part of the lesson discussing the most popular retirement products, including the 401(k), IRA, SEPP, and other speciality plans like 403(b)’s and 457′s. The most commonly used are the 401(k) and the IRA (and it’s cousin, the Roth IRA). The point of any of these plans is to use tax-favored money to save for your retirement. You’re either putting in pre-tax money and allowing it to grow tax free (IRA, 401(k)), or you’re using post-tax dollars that will grow tax free and not be taxed when you withdraw the money (Roth IRA).
Dave strongly advocates for the Roth IRA. In a Roth IRA, you invest after-tax money but your earnings grow tax free and you are not taxed on any withdrawals when you retire. There’s also a little more flexibility with a Roth in terms of early withdrawals without penalty. Dave argues that you have more investment choices with a Roth, also. That’s probably true when compared to a 401(k) that offers only a few funds, but you can open a traditional IRA at any brokerage and have access to thousands of funds and stocks, just like with a Roth. The ability to withdraw money tax free after you retire is the big draw. If you’ve saved a lot of money, you’ll likely be in a higher tax bracket when you retire since most of your deductions will be gone and you may be pulling in more per year than you did when you were employed. If that’s the case, tax free withdrawals are great news.
I have nothing against the Roth, but I don’t believe in it as strongly as Dave does. I just cannot imagine that in the thirty years I have until retirement that the government will not find some way to tax those withdrawals. I cannot see them letting that large pool of money remain untouched. I think it will be at a low rate, but I think it will be taxed. There was a time when Social Security earnings were tax free and that is no longer the case, so the government has proven to go back on its promises. I prefer to hedge my bets and use a regular IRA. Yes, I’ll have to pay taxes when I withdraw the money, but at least for now I’m able to reduce my taxable income each year. Since I hover right on the brink of a higher bracket, that reduction in taxes now is worth more to me than a promise that might not be honored by the time I’m retirement age. You might consider using both types of IRA’s and taking some deductions now, while hoping for tax free withdrawals later.
After discussing the types of retirement plans, Dave offers a reminder to roll your retirement money directly into another qualified plan if you leave your job. Never touch that money or you’ll have to pay taxes and penalties on it. You want it to roll seamlessly into another plan. He also counsels us to never borrow against retirement money. Not only do you lose out on the compound interest, but any loans must be repaid within 60 days of leaving your job. If you can’t repay it, you’ll be taxed and penalized on that money.
As far as what to do with the 15% of your income that you’re saving, Dave suggests this order:
1. Fund your 401(k) or other work plan up to the amount that your company will match.
2. Above the matched amount, or if the company does not match at all, fund Roth IRA’s up to the amount you’re allowed by the tax code.
3. If you still haven’t hit 15% of your income yet, go back and put the remainder into your employer’s plan.
His plan isn’t a bad one. It gives you a good distribution of your assets in plans that use both pre- and post-tax dollars and which have different tax structures for the withdrawals. If you don’t have a plan at work, I would suggest putting some money into a regular IRA and some into a Roth. That way you get the same type of tax structure.
Dave then moves on to saving for college. This part of the lesson is very short. He advocates using an Education Savings Account (ESA which is like an IRA for education. You invest pre-tax money into the account and the money is taxed when it’s withdrawn. If you can’t use an ESA, then Dave recommends a 529 plan. Just make sure that you stick with one that gives you complete control over the money and does not make any type of automatic adjustments based on the child’s age. Dave does not recommend using any other savings products including insurance, savings bonds, or pre-paid college tuition plans. Most of these simply don’t make the returns you’ll need to adequately grow your money. Some are also ripe for scammers.
You should do Baby Steps 4 and 5 concurrently, which is why Dave caps the retirement savings at 15% of your income. Ideally that leaves you with some left over to put away for college. Dave does not say this, but I will. If you are older and need to really catch up on your retirement savings, I say skip the college savings and put as much as you can into your retirement. Kids can find work, scholarships, and financial aid to pay for college. You can’t find aid to pay for retirement. Similarly, if you don’t have kids and don’t plan to, go ahead and funnel as much extra as you can into retirement. Don’t just accept the 15% cap. The more you can save, the better off you’ll be.
In small group we talked a little bit about our fears for retirement. We have several people in our group who are in their late forties and fifties, so this is a topic that scares them. Several of them admitted to being below even the reported average of $25,000 in retirement, with no pensions to pick up the slack. A couple of them admitted that they just never gave it much thought until now. They were so busy raising kids, working, and building a life that they let time slip away. They are like the people Dave brought up in the beginning of class who just live for today without much conscious thought for the future. They’re worried now that they won’t be able to retire or, if they can, that they won’t be able to have any fun. They mentioned that, having gone through this class, they are committed to saving from this time forward, but they worry that time has run out and that they’ll never be able to save the kind of money that will give them a good retirement.
From there we talked about what motivates you to get serous about retirement. Every single person in the room listed total fear as their primary motivator. Fear of having to work at Wal-Mart until they die, fear of living on state assistance, fear of not getting the health care that they need, fear of eating Alpo in their old age, and fear of not being able to do anything that they want to do. Fear is a powerful motivator, no doubt. Now that many people in the class are considering this seriously for the first time they are realizing just how far behind they are and how the safety nets they assumed would be there (pensions, Social Security) just aren’t going to be there. It’s scary stuff. Our group leader suggested we try to think of some positive motivators for planning for retirement, just so that terror isn’t the only reason. We came up with wanting to have fun, wanting to give to good causes, wanting to be able to help grandchildren, and wanting to leave a life changing amount of money to our heirs.
We also talked about why it’s a bad idea to borrow from or cash out a retirement vehicle to pay off debt, no matter how much you may want to be out of debt. One man in our class took out a 401(k) loan and used it basically as a debt consolidation tool. He paid off all his credit cards and high interest loans with it to the tune of about $40,000. This worked well until, two months later, he was laid off from his job. That loan was due within 60 days or he was going to have to pay the taxes and penalties on about $38,000. Ouch. He tried all he could to raise the money, but given that he was already living on the financial edge, he couldn’t do it. That 38K was considered income by the IRS and he had to pay the tax bill, plus the penalties for early withdrawal. He ended up losing a big chunk of his money, not to mention the amount of compound interest he lost by moving the money out of the account in the first place. It was an expensive lesson to learn; one from which he is still trying to recover.
As most of the people in the class are older with grown kids or no kids, we didn’t talk much about the college saving aspect of the lesson. However, we did wonder about the amount of guilt people feel if they don’t save for college. Many people put college savings before retirement because they feel so bad about it. But we talked about how a kid can work through school, or get loans or scholarships, whereas a parent has to fund his or her own retirement with no help from outside sources. The parents have to take care of themselves, first.
If you remember, last week we had to do the worksheet that showed how much money debt is robbing from retirement (or other long term goals). The results came up in group and they were eye opening. A quick calculation (using Dave’s charts) of the average in my class showed that debt has cost each person in that room about $2 million dollars in retirement money. The numbers will continue to grow until all of the debt is paid off so the total in the end will be much higher, assuming that it takes most of them several years to get out of debt. One woman said that this exercise motivated her to get out of debt more than anything else in the class so far. She’s probably in her mid-forties, so retirement isn’t that far off. once she saw how much she’d lost over the years, she got very scared and then very serious about paying off debt. Good for her!
This was one of those weeks where we had a really good discussion. Retirement is one of those things that everyone has an opinion on. It’s also something that scares and intimidates many people. I think this weeks’ discussion ended up being like a therapy session for many. It gave them a chance to air their fears and talk with others who are in the same boat. Maybe it made it seem a little less scary.
Homework roundup: This week we have to complete the monthly retirement and college planning forms to determine how much money we should be saving towards these goals. This is to give us a definite number to shoot for instead of just guessing, which is most people’s method of calculation. I don’t have kids so I skipped the college funding worksheet.
The first step in this exercise is to determine what sort of annual income you want to generate in retirement. I shot high and said $100,000. I’d like to travel a lot and I know that medical care and inflation are going to eat away at any income I have, so I aimed high. I doubt I’ll really need that much but I’d rather aim higher than lower.
We then divide that number by .08. The .08 comes from the idea that you are saving at a 12% return, but inflation is 4%, giving you a net gain of 8%. (As I said last week, I think his returns are high, but since this is homework I’m using his numbers.) Using this formula, my target number is $1,250,000.
To figure out your monthly savings amount, Dave has you multiply your target number ($1,250,000) by an 8% factor that matches your age (he provides a table that lists the factors at every five years of age, starting with age 25). Since my age falls slap in between two factors, I did this calculation twice. I need to be saving between $838 and $1,313.75 per month to reach my target number. The higher figure assumes the older age, while the smaller figure assumes the smaller age. Turns out that, according to Dave’s formula, I’m right on target. I currently save $1,227 per month in tax-advantaged accounts (the maximum I’m allowed by law based on my compensation) and another $300 per month in regular investment accounts for long term savings. So I’m at just over $1,500 per month or ahead of Dave’s calculation.
This is a series of posts about what you will find in Dave Ramsey’s Financial Peace University course. You can find the previous posts here: week one — week two — week three — week four — week five — week six — week seven — week eight — week nine