Although congressional actions are constantly being scrutinized, we should be thankful to this organization for allowing us to have retirement plans.
Whether it’s a 401(k) plan, 403(b) plan, traditional IRA, Roth IRA, SEP-IRA, etc., these plans allow employers, employees, and, in some cases, employees’ spouses, to set aside funds earmarked for retirement.
While there are different eligibility rules, contribution limits, income tax incentives, and compliance requirements associated with each type of plan, all of them provide us with a tax-favored way to accumulate funds for retirement that we might not do otherwise.
That’s the good news. The bad news is, retirement plans, in and of themselves, generally aren’t sufficient to meet most individual’s financial needs for the duration of their retirement years. Projected longer life expectancies don’t make this situation any easier. While Social Security helps soften the blow, it doesn’t solve the problem in most cases.
So why aren’t retirement plans typically an all-encompassing solution to see us through our retirement years?
Here are 10 reasons :
1. Most plans aren’t designed to provide sustainable retirement income
There’s a major disconnect when it comes to IRS-blessed retirement plan choices and our retirement funding needs. During our working years, we pay our expenses from employment income. When we retire, we still require a dependable, sustainable source of income to cover our expenses. Unfortunately, with the exception of one type of plan, that is, a defined benefit plan, the majority of retirement plan types today aren’t designed to provide us with lifetime income.
Other than the defined-benefit plan and hybrid plans which have a defined benefit element, both of which are rarely offered in the workplace today, all other retirement plans are defined contribution plans. With this type of plan, the amount of the annual maximum allowable contribution is specified by IRS without regard to the benefit amount that a participant will ultimately receive. These plans include 401(k), 403(b) (public education organizations and some nonprofit employers), 457 (governmental and certain nongovernmental employers), SIMPLE, SEP-IRA, traditional IRA, and Roth IRA plans.
2. Unable to count on a specific amount of income
Given the fact that fewer and fewer individuals are participants in defined-benefit plans, it’s become the norm that most people are unable to count on a specific amount of income they will receive from their retirement plans.
As a retirement income planner, I can run income projections for a client’s 401(k) plan until I’m blue in the face; however, the fact of the matter is that the resulting amounts are projections, and not actual amounts, of income that my client will receive. There are too many variables that will affect the future value of a 401(k) plan and the associated amount of sustainable income that my client will ultimately receive from his/her plan. These variables include continued employment, annual salary and bonuses, IRS-defined annual contribution limits, employee contribution percentages or amounts, employer matching contributions, investment choices, investment performance, loans, loan repayments, and potential transfers from other 401(k) and IRA plans.
3. Lack of uniform contribution amounts
Assuming that you’re a participant in a defined contribution plan, there’s no uniform allowable annual contribution amount. The amount of contribution that your employer or you may make to your plan is dependent upon the type of plan.
SEP-IRA, 401(k), and 403(b) plans enjoy the highest employer contribution limits. Employers may contribute up to 25% of participant’s compensation, or $51,000, whichever is less, with 401(k) and 403(b) plan contributions reduced by employee contributions. Employees may contribute up to $17,500 or $23,000 if age 50 or older to 401(k), 403(b), and 457 plans, and up to $5,500 or $6,500 if age 50 or older to SEP-IRA’s.
IRA’s fall on the opposite end of the spectrum, with a contribution limit of $5,500 or $6,500 if age 50 or older. These limits apply to contributory and Roth IRA’s. SIMPLE plans, which aren’t common, fall in the middle, with a maximum allowable contribution of $12,000 or $14,500 if age 50 or older.
4. Limited allowable contribution amounts
In addition to lack of uniformity, your ability to fund your retirement solely with defined contribution plans is further constrained by the contribution limits of the type of plan(s) in which you participate. If you’re not self-employed or if your employer doesn’t offer a 401(k), 403(b), 457, or SIMPLE plan, your default retirement plan choice is a traditional IRA unless your income is less than specified levels ($112,000 if single or $178,000 if married filing joint), then you may choose instead to contribute to a Roth IRA.
Even if you make maximum contributions to a retirement plan year after year, it can be difficult to accumulate a sufficient nest egg to cover your retirement needs. With current contribution limits of $5,500 or $6,500 if age 50 or older for both traditional and Roth IRA’s, you will be challenged to accumulate sufficient funds to match your expense needs for the duration of your retirement if this is your only retirement plan option during your working years.
5. Real value of retirement plans is insufficient to cover retirement expenses
When doing retirement income planning, you need to calculate the real value of your projected assets. This is especially important when it comes to retirement plans. The real value of an asset is its nominal or stated value, reduced by income taxes and inflation. The best way to illustrate this concept is with an example.
Let’s assume that your employer doesn’t offer a 401(k) plan. You decide to invest in a traditional IRA. In a best-case scenario, assuming that you’re 25 years old today, you make maximum allowable contributions on Jan. 1 each year until age 65, contribution limits increase by $500 every five years, and your IRA earns 4% each year, it will be worth approximately $700,000 at age 65. Assuming a 20% combined federal and state tax bracket, which is on the low side, the after-tax value of your IRA would be $560,000. Factor in 3% annual inflation and the after-tax value of your IRA in today’s dollars shrinks to a real value of approximately $167,000. How far will this plus Social Security take you?
6. Most people don’t contribute enough
Despite the fact that savings in qualified accounts likely won’t be enough to cover retirement even with maximum allowable contributions — most people don’t contribute enough in any event.
They either don’t make contributions every year and/or don’t approach maximum allowable contribution limits.
7. Most people don’t start early enough
Retirement planning isn’t a priority for most people in their 20s and 30s. This is the time when other financial goals take precedence, including buying a first house and saving for children’s education. Consequently, even when 401(k) plans are offered, many younger employees make minimal contributions or choose not to participate. This is common despite the tax deduction available for non-Roth 401(k) plan contributions.
8. Number of funding vs. retirement years
Many individuals are going to be spending as many, if not more, years in retirement than the number of years that they will contribute to retirement plans. Given the fact that retirement may last 30 or more years, there’s a good possibility that the number of years you spend in retirement will equal or exceed the number of years that you fund your retirement.
While the example in reason No. 5 assumed 41 years of contribution funding, this isn’t the norm. In order to achieve this milestone, there are several hurdles that you must overcome. For starters, you need to be employed for 41 years. If you’re an employee, your employer needs to offer a retirement plan or you need to open a traditional or Roth IRA account. If you’re self-employed, you need to open a SEP-IRA, traditional IRA, or Roth IRA account. Finally, contributions must be made to your plan each and every year.
9. Retirement plan investing is disrupted in down markets
As is well-known and well-documented, our emotions override logic when it comes to investing. People get scared in down markets and do the opposite of what they should be doing. Retirement plan investing is no exception. Even though the stock market is on sale in a bear market, it isn’t unusual for investors to do two things that disrupt their retirement planning.
The first thing is reducing or suspending retirement plan contributions. The second thing many retirement plan investors do in down markets is changing their standard investment allocation by transferring funds and/or changing future allocations from equities to fixed income and money-market funds.
Both events typically result in less retirement funds than if neither of these two actions were taken and instead the status quo was maintained.
10. Premature withdrawals
Retirement plan funds are sacred. With their tax-deferred or tax-free status in the case of Roth IRA’s, they’re generally, although not always, the last source of funds that should be tapped. Any time that funds are withdrawn from retirement plans when there are other assets available is a potential lost opportunity to further grow those assets on a tax-deferred or tax-free basis. This is true unless the withdrawal must be made as is the case with a required minimum distribution, or “RMD,” or if the withdrawal can be made without incurring any, or minimal, income tax liability.
To the extent that the withdrawal is made before age 59 1/2, with some exceptions, an IRS premature withdrawal penalty of 10% will be assessed on either the value of the funds withdrawn or the earnings, depending upon the availability of a tax deduction for contributions to the plan.
Another type of premature withdrawal, although it isn’t usually thought of as such, is an outstanding loan from a 401(k) plan upon termination of employment. Let’s suppose that you borrow $40,000 from your 401(k) plan and two years later your employment is terminated when there’s a loan balance of $25,000. This amount will be reported to you as taxable income in the year you leave your company. Had you remained with your company, you would have continued to repay your loan and your 401(k) plan assets would continue growing by the repaid amount. Since this wasn’t the case, you will end up with less retirement funds in addition to a potential tax liability on your unpaid loan amount.
As you can see, although retirement plans are a wonderful thing, there are numerous obstacles preventing them from being an all-encompassing solution to see us through our retirement years in most situations. Retirement plans typically need to be supplemented by other sources of income, including, but not limited to, Social Security, immediate and deferred income annuities, and nonretirement investments.
Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the sole proprietor of Robert Klein, CPA. Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions based on each client’s needs and personality.