About the author: Lamar Watson, CFP®, is a Fee-Only Financial Advisor in the Washington, D.C. area that works with clients virtually across the country. Lamar's work with his clients focuses on budgeting, employee benefits, paying down debt, buying their first home, and investing. Lamar is the Founder of Dream Financial Planning, a virtual Fiduciary Financial Planning firm specifically designed to help young professionals and minorities take control of their finances and fulfill their dreams. Feel free to schedule a complimentary consultation to learn how we use the DREAM Financial Planning Process ™ to help our clients achieve their goals.
The economic impact of COVID-19 has been felt around the world. And, unfortunately for many pre-retirees, it could potentially impact your Social Security benefits as well. A new 2021 report indicates that Social Security benefits will be cut to 78 percent of promised benefits by 2034 if Congress takes no action to address funding.1 While Social Security long-term funding has been a concern for a while now, it appears that a snowball effect caused by the Covid-19 pandemic has shortened the timeline. Covid-19 served as the catalyst for an economic recession in early 2020, with a plunge in employment rates - meaning a drop in payroll taxes as well.
In December 2020, the average monthly benefit for a retired individual receiving Social Security was $1,544.2 Even with benefits at full funding, you may not be able to meet your financial needs in retirement on Social Security alone. For those who have the opportunity to plan and prepare, Social Security doesn't have to be their only source of retirement income. There are a few options to consider when preparing to supplement the difference between what you earn in Social Security benefits and what you need to thrive in retirement.
Option #1: Individual Retirement Accounts
There are two types of Individual Retirement Accounts, or IRAs, to choose from - traditional IRAs and Roth IRAs. If you’ve had these accounts set up for some time and made contributions regularly, then the potential growth of these accounts could make up for Social Security reductions. However, there are a few things about your IRAs to consider toward retirement.
Contributions you make to a traditional IRA may be fully or partially deductible, depending on your individual circumstances. In most cases, once you reach age 72 you must begin taking required minimum distributions from your IRA. Withdrawals from traditional IRAs are taxed as ordinary income and, if taken before age 59 1/2, may be subject to a 10 percent federal income tax penalty.3 You may continue to contribute to a traditional IRA past age 70 1/2 as long as you meet the earned-income requirement.4
Roth IRAs differ from traditional IRAs because contributions are made with after-tax dollars. This means that Roth IRA contributions do not lower your yearly taxable income, but withdrawals made in retirement are tax-free.
To qualify for the tax-free and penalty-free withdrawal of earnings, Roth IRA distributions must meet a five-year holding requirement and occur after age 59 1/2. Tax-free and penalty-free withdrawals also can be taken under certain other circumstances, such as a result of the owner’s death. The original Roth IRA owner is not required to take minimum annual withdrawals. Lastly, high-income taxpayers may have a lower contribution cap, or cannot contribute to a Roth IRA at all, depending on their yearly income and tax-filing status.5
Option #2: Defined Contribution Plans
If your employer offers a defined contribution plan, such as a 401(k), 403(b), or 457 plan, the accumulated income in these accounts could supplement Social Security, especially if this amount has had time to grow.
Be aware that distributions from a defined contribution plan are taxed as ordinary income unless they are Roth 401(k) or 403(b) accounts. Individuals are required to take minimum distributions at age 72, and any distributions before age 59 1/2 are subject to a 10 percent tax penalty.
Option #3: Defined Benefit Plans
Though not as common as they used to be, pensions are a common type of defined benefit plan. Benefits established by an employer take into account work history and salary to determine benefits.
Option #4: Personal Savings
Your personal savings could be used to help make up the difference in Social Security benefits. Funds tucked away in a savings account may be used to purchase more long-term options, such as an annuity. What works best for each individual will depend on their situation. If your savings will become your main source of Social Security supplementation, then consider consulting a financial advisor who can help you determine a long-term, more sustainable solution.
Option #5: Continued Employment
Unfortunately for some retirees and pre-retirees, if Social Security does not help make ends meet, and the above options are not available or don’t provide enough benefits, then it may be time to consider postponing your retirement. The good news though, is that working while collecting Social Security could potentially increase your benefit amount.6
Having multiple sources of income in retirement is important. But if Social Security is your primary source of income, then a reduction in benefits will certainly be challenging. Using the list above, one can consider their options to prepare appropriately. Remember to consult a financial advisor for more guidance and to receive an approach tailored to your financial situation.
Dream Financial Planning Process ™
Whether you're managing student loan debt, starting a family, or considering buying your first home, the DREAM Financial Planning Process™ is tailored to the unique needs of busy professionals in their 30s and 40s. This process focuses more on short-term goals while you grow and evolve in your personal and professional life. So if you're looking for guidance on Financial Planning, optimizing employee benefits, budgeting, student loans, and managing your 401k or investments, we can help.
With uncertainty surrounding the economic stability of our country, it's okay to have fears and anxieties surrounding your own savings and investments. The most productive course of action from here is to reach out to Dream Financial Planning (or whoever your trusted advisor might be) and discuss your options. It's easy to have knee-jerk reactions when it feels like the bottom is falling out, but it is imperative to make decisions using research-backed data and a level head. If you'd like a Complimentary Review and risk assessment of your investment portfolio, feel free to send me an e-mail.
In the August Newsletter, I explore how you should invest money for your short-term goals after you've established an emergency fund. I also discuss how a Financial Advisor can help you avoid emotional decision-making with U.S. News and World Report and how to know if your Financial Advisor is the right fit for you. There are also blog posts where I outline how to complete a mid-year financial check-up and 5 college planning mistakes to avoid.
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