3.6 Retirement Planning
Personal Finance. Provided by: Saylor Academy. Located at: https://saylordotorg.github.io/text_personal-finance. License: CC BY-NC-SA: Attribution-NonCommercial-ShareAlike
Retirement planning involves the same steps as any other personal planning: figure out where you’d like to be and then figure out how to get there from where you are. More formally, the first step is to define your goals, even if they are no more specific than “I want to be able to afford a nice life after I stop getting a paycheck.” But what is a “nice life,” and how will you pay for it?
It may seem impossible or futile to try to project your retirement needs so far from retirement given that there are so many uncertainties in life and retirement may be far away. But that shouldn’t keep you from saving. You can try to save as much as possible for now, with the idea that your plans will clarify as you get closer to your retirement, so whatever money you have saved will give you a head start.
Chris and Sam were young urban professionals until their children were born. Tired of pushing strollers through the subways, they bought a home in the suburbs. They are happy to provide a more idyllic lifestyle for their kids but miss the “buzz” and convenience of their urban lifestyle. When their children are on their own and Chris and Sam are ready to retire, they would like to sell their home and move back into the city.
Chris and Sam are planning to use the value of their house to finance a condo in the city, but they also know that real estate prices are often higher in the more desirable urban areas and that living expenses may be higher in the future. Now in their midthirties, Chris and Sam are planning to retire in thirty years.
Chris and Sam need to project how much money they will need to have saved by the time they wish to retire. To do that, they need to project both their future capital needs (to buy the condo) and their future living expense in retirement. They also need to project how long they may live after retirement, or how many years’ worth of living expenses they will need, so that they won’t outlive their savings.
To estimate required savings, in other words, you need to estimate the following:
- Expenses in retirement
- The duration of retirement
- The return on savings in retirement
As difficult as these estimations seem, because it is a long time until retirement and a lot can happen in the meantime, you can start by using what you know about the present.
The amount you need at retirement varies with the expected rate of return on your savings. While you are retired, you will be drawing income from your savings, but your remaining savings will still be earning a return. The more return your savings can earn while you are retired, the less you have to have saved by retirement. The less return your savings can earn in retirement, the more you need to have saved before retirement.
Estimating the Annual Savings for Retirement
In the example above, if you make regular annual deposits into your retirement account for the next thirty years, each deposit would have to be $23,936, assuming that your account will earn 5 percent for in thirty years. If the rate of return for your savings is less, you would have to save more to have more at retirement. If your retirement savings can earn only 2 percent, for example, you would have to deposit $60,229 per year to have $2,443,361 when you retire. Your retirement account grows through your contributions and through its own earnings. The more your account can earn before you retire, the less you will have to contribute to it. On the other hand, the more you can contribute to it, the less it has to earn.
Let’s try one together…
You are currently 20 and plan to retire when you are 60. You want to have $3 million saved. You are depositing your money in a mutual fund that, over the long-run, earns 5% per year. How much do you need to contribute each month? How does this number change if you start saving at 30? 40? 50?
Answers: $1,966; $3,605; $7,299; $19,320
The longer the time you have to save, the sooner you start saving, and the less you need to save each year. Chris and Sam are already in their thirties, so they figure they have thirty years to save for retirement. Had they started in their twenties and had forty years until retirement, they would not have to save so much each year. If they wait until they are around fifty, they will have to save a lot more each year. The more you have to save, the less disposable income you will have to spend on current living expenses, making it harder to save. Clearly, saving early and regularly is the superior strategy.
When you make these calculations, be aware that you are using estimates to figure the money you’ll need at retirement. You use the expected inflation rate, based on its historic average, to estimate annual expenses, historical statistics on life expectancy to estimate the duration of your retirement, and an estimate of future savings returns. Estimates must be adjusted because things change. As you progress toward retirement, you’ll want to reevaluate these numbers at least annually to be sure you are still saving enough.
The Motley Fool: How Much do I need to Retire (all rights reserved)
Wills
Since you won’t be here, you will need to leave a written document outlining your instructions regarding your estate. That is your will[2], your legal request for the distribution of your estate, that is, assets that remain after your debts have been satisfied. If you die intestate[3], or without a will, the laws of your state of legal residence will dictate the distribution of your estate.
You can write your own will so long as you are a legal adult and mentally competent. The document has to be witnessed by two or three people who are not inheriting anything under the terms of the will, and it must be dated and signed and, in some states, notarized. A holographic will[4] is handwritten; it may be more difficult to validate. A statutory will[5] is a preprinted will that you can buy from a store or in a software package. Consider, however, that a will is a legal document. Having yours drawn up by a lawyer may better insure its completeness and validity in court.
Probate[6] is the legal process of validating a will and administering the payment of debts and the distribution of assets by a probate court. Probate courts also distribute property in the absence of a will. Probate is not required in every case, however. Probate is not required if the deceased
- owned assets of little value, allowing for transfer without court supervision;
- owned assets jointly with or “payable on death” to another person;
- owned assets naming another person as beneficiary;
- held all assets in a living trust (a legal entity for managing assets on behalf of beneficiaries).
Besides the details of “who gets what,” a will should name an executor[7], the person or persons who will administer the payment of your debts and the distribution of your remaining assets, according to your wishes as expressed in your will. If you have legal dependents, your will should name a guardian for them. You may also include a “letter of last instruction” stating the location of important documents, safe deposit keys, and bank accounts and specifying your funeral arrangements.
You may change or rewrite your will at any time, but you should definitely do so as your life circumstances change, especially with events such as marriage or divorce, the birth of a child, and the acquisition of significant assets, such as a house. If the changes in your circumstances are substantial, you should create a new will.
It is possible that you will become mentally or physically disabled before you die and unable to direct management of your assets. To prepare for this possibility, you may create a living will[11] with instructions for your care in that event. You may appoint someone—usually a spouse, child, or sibling—who would have power of attorney[12], that is, the right to act on your behalf, especially as regards financial and legal decisions. That power may be limited or unlimited (such as a “durable power of attorney”) and is restricted to certain acts or dependent on certain circumstances.
Along with granting power of attorney, your living will may include a health care proxy, requesting that medical personnel follow the instructions of a designated family member who expresses your wishes concerning your end-of-life treatment. Many people request, for example, that they not be revived or sustained if they cannot experience some quality of life. Be sure to update your living will, however, as over time your views may change and as medical and technological advances change our notions of “quality of life.”
Trusts and Gifts
A trust[13] is a legal entity created by a trustor, or grantor, who owns assets managed by a trustee or trustees for the benefit of a beneficiary or beneficiaries. A testamentary trust[14] may be established by a will so that beneficiaries who are unable to manage assets (minor children or disabled dependents) can benefit from the assets but have them managed for them. A living trust[15] is established while the grantor is alive. Unlike a will, it does not become a matter of public record upon your death.
Another way to avoid probate and estate taxes is to gift assets to your beneficiaries while you are alive. Ownership of the assets passes to the beneficiaries at the time of the gift, so the assets are no longer included in your estate. The federal government and many state governments levy a gift tax for gifts exceeding certain limits. In 2009, the annual exclusion from federal tax was $13,000 per recipient, for example. Also, the federal government does not tax gifts to spouses and to pay others’ medical bills or tuitions.
There are limits to this kind of tax-free distribution of funds, however. For example, the federal government considers any “gift” you make within three years prior to your death as part of your taxable estate. Gifting nevertheless is a way to reduce the value of an estate. Some parents also prefer to make funds available or to gift them to their children when the children need them more—for example, earlier in their adult lives when they may not have accrued enough wealth to make a down payment on a house.
Most trusts, whether testamentary or living, revocable or irrevocable, are created to avoid either the probate process or estate taxes or both. The probate process can be long and costly and therefore a burden for your executor, your beneficiaries (who may have to wait for their distributions), and your estate.
Hadi Harp: Introduction to Wills and Trusts (all rights reserved)
