Retirement – Pension in the US!

For some reason people all over the world think that Americans retire rich. It’s true to a degree but to a much lesser extent. The truth is that not everyone in the US is making six figure income and working in the office. The roads are not paved with gold in the US and hundred-dollar bills don’t fall from the sky. However, if you can be discipling you too can retire as a millionaire, it’s really not that hard. Of course, you need to have a constant stream of income and systemically set aside funds into your pension accounts. Another reason for comfortable retirement are diversified streams of income. 

In our countries there is no culture of personal contributions to the pension accounts, we rely on the government to provide us with retirement income and as a result are dependent on politicians who run the government. In the US its quite different and during your retirement you might be getting income from multiple sources: 

  1. Social Security Income
  2. Company Sponsored Pension Fund
  3. 401K Plan
  4. IRA
  5. Annuities
  6. Reverse Mortgage
  7. Downsizing
  8. Personal Savings

Let’s cover now individual items in more details. Furthermore, let’s calculate what you can look into at retirement when you retire. Let’s assume you are 30 years old and make $60,000 per year and are single and will die at an age of 85. For simplicity let’s assume your salary will not increase in 30 years and the prices will stay the same. Disclaimer: this is only for illustrative purposes, if you need to evaluate your situation you will need to hire professional. 

Social Security Income

Social Security Income is a federal government run program that provides you with income when you retire or cannot work due to disability. Unlike retirement programs run by other countries, it provides coverage after you pass away to your eligible family. 

In the US, your retirement age depends on the year you were born. If you were born after 1960 your retirement age is 67 but you can start receiving retirement income from 62. If you delay receiving your Social Security Income till your full retirement age, you will be getting much more than if you claim it at earlier age.  

So how does this program work. Throughout your career you and your employer pay Social Security Taxes (we covered this in previous topics). The government accumulates this money in special funds and then distributes it to the eligible recipients. 

To be eligible for Social Security Income you have to work in the US at least 10 years and get at least 40 work credits. You are eligible to 4 work credits per year at maximum. To get work credit you need to have at least $1,300 qualified earnings to get 1 work credit. Remember you can get maximum of 4 work credits per year. 

So, if you start claiming your income at an age of 62, how much can you get? You can get approximately $1,900 per month. This is a gross amount and depending on your situation you might need to pay a tax. 

Company Sponsored Pension Plan

If your employer offers Company Sponsored Pension Plan, you might be getting additional income when you retire from your employer. You are not paying anything for this, your employer pays for it. 

Now, despite the fact that your company is offering this now, they might change in future or default on their payment or even freeze their payment. For our purposes we will not consider this income. If you get it when you retire great, if not you are not alone. 

401K

401K is an employer opened account which allows you to set aside pretax money for your retirement. Your employer usually contributes as well. Contribution limits (amount you can set aside every year) are defined by IRS. For 2020 if you are single, you can set aside $19,500 a year. You are required to take a distribution after you hit 59 ½. 

So how does it work. It’s simple you tell your employer how much from your paycheck you want to set aside. Remember its pre tax money, so the more you set aside the lesser taxes you will pay. Your employer also contributes something. These funds are invested in the investment vehicle of your choice. Let’s assume that you chose to invest into a fund that mimics S&P500 growth. 

For our example let’s assume that you set aside $600 per month of your pretax income. So, the total for the year will be $7,200. Now let’s assume that your employer matches your contributions up to 4% of your annual income. So your employers contribution will be $2,400. Hence your total contribution a year to your 401K is $9,600. 

Now let’s say you invested your money in S&P500 index fund. Historically, the S&P500 has returned roughly 7-8%. Let’s take 7% as an average. So investing $9,600 a year for next 30 years will result in $980,000 when you hit your 60 year milestone. So assuming you will live till 85, and assuming your 401k through your retirement age will continue to earn 7%, you will be able to withdraw monthly $4,975 till you die. Not bad and you are almost a millionaire. Of course you will need to pay taxes on this amount. 

IRA

Traditional IRA stands for Individual Retirement Account. It allows you to set aside money up to $5,500 in your post tax contributions and deduct from your personal taxes at the time of filing if you are making less than $75,000 a year (please check with your accountant). 

So let’s assume that you set aside $200 a month in your post taxes in your IRA account and invest in the same fund where you have your 401K. By age 60 you will have $242,000 in your IRA account. Remember, even though your contributions are post tax, meaning that you have paid taxes already, you will need to pay taxes on the interest during withdrawal. Now, keeping the same assumptions we had for 401K this means that you will be able to withdraw $1,600 a month till you die. 

Annuities

Annuities are financial products that allow you to make lump sum or monthly payments in exchange for guaranteed retirement income during your retirement. E.g. you might pay annuity $X now for a stream of income of Y per month in future after certain number of years.  

But let’s be realistic. Most likely we will not have a large lump sum lying around. Too many expenses to take care of. But if you can afford investing couple of thousands that could be well worth it. E.g. if you invest $5,000 at age 30 at an age of 60 assuming that you will have a guaranteed return of 7% you will have a lump sum of $40,000. 

Being realistic we will exclude this from our calculations for now and assume that we did not make any annuity investments. 

Reverse Mortgage

Reverse mortgage is opposite of a traditional mortgage and offers you an ability to take out an equity in your house once you reach an age of 62. It can be a lump sum or monthly withdrawals. You don’t have a payment schedule and will pay when you move out from your house. Now, you would not consider this as a retirement income, but if you want to splurge in retirement and have no one to leave your property to, why not. 

Let’s assume you bought a home for $250,000 when you were 30 and by the age of 62 have fully paid it off. After years of appreciation you house if worth $350,000 today. This would make you eligible for $153,000 as a lump sum. Another calculation shows that you can have a monthly withdrawal of $650-$700. This is a tax-free income for you and you can treat this as an additional source of retirement income. Furthermore, because IRS considers reverse mortgage as a regular mortgage you can actually write off the interest during from your personal taxes. 

Reverse mortgages are not simple products and you need to understand them well before you make a decision as they have fees, insurance, special conditions and limitations. 

Downsizing

If you need a lump sum you can consider downsizing your current home and move into an apartment or smaller home to save on the taxes and other expenses. This will free up certain amount for you that you can invest for additional stream of income. For now, we will assume that you prefer to live in your house. 

Personal Savings

This is a personal saving that you have amassed in your life. There are numerous scenarios here, so we will skip this step. Whatever you saved is yours J.

Conclusion

You need to plan for your retirement. The best thing you can do is to start saving money as early as possible. It would not hurt to hire professionals to plan your finances. 

But based on our example your monthly retirement income could look like: 

Social Security – $1,900

401K – $4,975

IRA – $1,600

Total Taxable Income: $8,475

Reverse Mortgage – $650

Not bad right? Even though you will need to pay taxes on some of the amounts above, you can still live pretty comfortable on what is left, provided you are in good health. And you can afford to travel as well. 

Once again, all of the numbers above are approximate and don’t consider a lot of factors and things that could go wrong. Please consult your accountant or financial planner. 

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