It is never too late to begin planning for retirement, but starting early has tremendous advantages.
Consider the story of two small typical small business owners. Each takes a salary of about $60,000 a year. One, a florist, began saving for her retirement at age 35. The other, a computer consultant, began saving for retirement at age 45. Each contributed $2,000 per year to an Individual Retirement Account. Each earned an average of 8% interest over time. When florist reached 65, her IRA was worth $244,692. When the computer consultant reached 65, his IRA was worth $98,846. They each contributed the same amount of money every month, but by starting at 35 instead of 45, the florist wound up roughly $150,000 ahead. And if you begin saving and investing for retirement even earlier, you will find even larger nest egg waiting for you when your retirement years begin.
How Much Is Enough?
How much is enough for a comfortable retirement? To maintain your current lifestyle, many experts believe that you will need about 75% of your pre-retirement take-home pay.
But you might want to shoot for a more expensive lifestyle after retirement, and budget for a return to school, the launch of a second career, or extensive travel.
On the other hand, you might be among the fortunate few whose expenses will be significantly lower in retirement. Some major expenses, like your children’s education, or a mortgage on your home, might end just as your retirement begins.
So you’ll have to make some choices today about what you expect your lifestyle will be like years from now, when you retire. If you want to maintain your standard of living, shoot for 75% of current income. If you want to live a bit more lavishly, you might want to plan for 100% or even 125%. If you expect a more modest retirement, 50% might serve you very well.
How Will You Get There?
Once you have a clear income goal, take a careful look at any sources of retirement income that you already have in place. These might include a pension or 401(k) plan from a past employer, or a tax-deferred retirement savings account tailored to small business owners.
With these assets in mind, you should be able to find the shortfall between what you have now and what you will need once you retire. As a rule of thumb, you should plan to save enough that you will be able to live off the interest and not the principal once you retire. That probably means putting aside a good bit of principal.
The good news is that the government is ready to help you do that, through tax-deferred retirement savings plans that accrue and reinvest interest and investment gains without any taxes being taken out. The compound growth of earnings is a dramatic advantage to these accounts over traditional savings and investment plans. Some tax-deferred plans also allow you to put off paying taxes on much of the income you invest in them until after you retire and withdraw the money. That is a huge advantage – the government is essentially lending you money to invest (in the form of the income taxes you defer) and letting you keep whatever the investment returns.
Most people also find that they fall into a lower tax bracket after they retire – and tax-deferred retirement savings are taxed when you withdraw the funds, at the rate you pay then, not the rate you paid when you put the money aside.
The following retirement-savings accounts are the most important tools most business owners have in planning for their retirements.
IRA’s and Keoghs
An Individual Retirement Account, or IRA, is a tax-deferred personal savings plan that lets you set aside funds for your retirement, using pretax dollars, entirely independent of any employer. Once you deposit money into your IRA, you can control the specific assets that the IRA holds – moving the money from stocks to mutual funds, for example – though there are some limits to the kinds of investments that you can purchase with your IRA. There are also limits to how much you can contribute every year.
If you are self-employed, you can qualify to make larger IRA investments using a Simplified Employee Pension Plan, also know as a SEP-IRA. You can purchase an IRA directly from a bank, a broker, or a mutual fund company.
Keep in mind that you can still deduct your full IRA investment from your 1996 taxes even if you purchase the IRA as late as April 15, 1997.
Keogh plans work much like SEP-IRAs, though they involve more paperwork, and place obligations on business owners with employers to offer similar tax-deferred savings plans for them as well.
Annuities are contracts between investors and insurance companies. When you invest for your retirement, you will be interested in deferred annuities, which shelter the interest you earn on your investment much as an IRA does. Unlike IRA’s, though, you generally can’t buy annuities with pre-tax money. Still, there is one advantage of this: you face no maximum investment in deferred annuities; you can invest as much of your money as you wish, and continue to benefit from the tax-deferred growth of the initial investment.
There are two kinds of deferred annuities, fixed annuities and variable annuities. Fixed annuities credit your account with interest based on a fixed rate that you agree to when you open your account. Variable annuities contain investment pools much like mutual funds. You choose which of the funds within your annuity your money goes to, and you earn interest based on the performance of the funds.
One of the most vexing issues in retirement planning is Social Security. Many people don’t have a clear picture of how much income they are eligible for from Social Security, and when they should apply for it. Others have little confidence in the Social Security system and predict its imminent failure.
There are, in fact, a number of uncertainties present in the system. Congress may well change the level of benefits that future Social Security recipients will receive. And taxes on benefits might change, as well – they might go up, or down. People with incomes above a certain limit might see lower pay-outs, or pay higher taxes. Still, it seems unlikely that any of the more dramatic predictions about Social Security will come true. Modifications to the program are far more likely than any kind of catastrophic development. You are certainly better off if you can live the kind of retirement life you want to without relying on Social Security payments, but most of us aren’t that lucky.
By far, your best bet is to start an automatic deduction from your paycheck, or an automatic deduction from your bank account, to fund a tax-deferred retirement savings plan. It’s far easier to resist spending the money if it never gets into your hands in the first place. And like the florist, you will benefit greatly if you start saving today, no matter how far from retirement you are.
Content copyright Enterprise Interactive