Let us assume we are retired, living in Florida and dining at every early bird special. We have no problem spending money. The question is what are the sources of income during retirement. We will address the following sources of retirement income:
- Social Security Benefits
- Employer Pension Benefits
- Tax Deferred Retirement Benefits (IRA's, 401-k's)
- Individual Savings
Social Security Benefits
We work all our lives and every paycheck we receive has FICA (Social Security) taxes withheld. We are contributing to a fund that pays retirement, disability, survivor and death benefits to individuals currently entitled to receive these benefits. In theory, future workers will pay for the benefits of current workers when they are entitled to receive these benefits. Social Security Benefits can be a significant source of income during your retirement, depending on your level of retirement needs. Single low income workers ($30,000 or less) can expect Social Security benefits to provide 42% of retirement needs. A married low income worker with a same age non working spouse can expect Social Security to provide 63% of retirement needs. In contrast, a single high income worker ($100,000 or more) can expect Social Security to provide 13.5% of retirement needs. A married high income worker with a same age non working spouse can expect Social Security benefits to provide 20.25% of retirement income needs. The reason for this disparity is that there is a limit at which workers do not continue to pay Social Security taxes (1996 - $62,700) and the calculation of the retirement benefit is based on a decreasing percentage as your AIME (Average Indexed Monthly Earnings) increases.
Essentially, the more you earn the more you need to provide for your own retirement needs. You can find out what are your expected Social Security benefits are by accessing the Social Security Administration web site at http://www.ssa.gov/ and submitting a request for a Form SSA-7004. Once you submit this form, you will receive a detailed statement listing all of your earnings and your expected benefits.
Employer Pension Benefits
Your employer may have established a retirement plan that will pay you a monthly amount over your life or over you and your spouse's joint life expectancy. There are many different types of pension plans. A typical plan is one that is based on a percentage times your years of service with your employer and your compensation. For example, assume a retirement plan that provides a retirement benefit equal to 1.5% times the number of years of service times the average of your three highest years of consecutive compensation. If an individual worked for an employer for 30 years and the average of his three highest years of consecutive compensation was $50,000, then his annual retirement benefit would be $22,500 (1.5% X 30 X $50,000) or $1,875 per month. Retirement plans vary in design so it is important to understand how your particular benefits are calculated when planning for your own retirement.
Retirement plans that promise to pay a benefit during retirement are known as Defined Benefit plans. The employer typically is responsible for the investment and actuarial funding of the retirement plan. Other plans place the responsibility on the employee for investment of the funds. The employer only specifies the amount that is to be contributed to the retirement plan. These types of plans are known as defined contribution plans. The source of income during retirement depends on the employer contributions, if any, and the tax deferred earnings on the balance in the investment account. A defined contribution plan offers no guarantee as to the balance in the employee's account. Inadequate funding, bad investing and poor earnings performance can have a detrimental effect on the amount available for retirement.
Tax Deferred Retirement Benefits (IRA's, 401(k)’s, 403(b)’s)
We have talked about retirement sources of income that are provided to the employee or worker. Individuals can also fund their own retirement through tax deferred retirement plans that are funded by contributions or salary reductions. Employers may offer employees a 401(k) plan, also known as a CODA (Cash or Deferred Arrangement). This is an increasingly popular retirement savings vehicle because employees can contribute more to a 401(k) plan (1996 - $9,500) than to a regular IRA and employers will sometimes match employee contributions up to a certain percentage. Contributions to a 401(k) plan are tax deferred and any investment earnings are tax deferred. This is a significant advantage over personal after-tax savings. Employees are responsible for selecting the investment vehicle and there is no guarantee as to the savings accumulation in the account. Certain tax-exempt private organizations, public schools, and colleges may offer a variation of the 401(k), known as a 403(b). These type of plans are similar in concept to a 401(k) plan.
IRA’s are generally available to individuals who are not participants in an employer sponsored plan. The amounts that individuals can contribute to an IRA is lower (1996 - $2,000) than most other types of retirement plans. Individuals are also excluded from contributing to an IRA if they are participants in an employer sponsored plan and have earnings in excess of $50,000 for a married couple ($35,000 for a single individual).
Individual Savings
Another source of retirement funds is the individual savings amounts that are accumulated after tax. This is generally the most difficult way to accumulate retirement savings because there is no tax deduction or tax deferral on earnings and, as individuals, we tend to spend all of our available funds (take home pay). However, if you have excess funds on a periodic basis and you are disciplined enough to "pay yourself first" (i.e. transfer money before you see it in your checking account), then this may be a significant source of retirement savings.
