Survey Says: 80% of Americans Lack Retirement Planning Knowledge. Here's What to Start Doing Differently Right Now

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. 

You work your entire life and save diligently in order to enjoy your retirement. It sounds simple enough, but the realities of preparing for retirement can be much more complicated and overwhelming for some people. In fact, a recent survey found that 80 percent of Americans have expressed anxiety that they have not saved enough to be financially independent in retirement.¹ 

If you’re concerned about your own prospects for retirement, here are six things to start doing differently right now.

Change #1: Better Understand Your Retirement Needs

The average person spends about 20 years in retirement. This is a significant amount of time to be financially independent, which means it’s important to plan accordingly. The Department of Labor recommends that retirees prepare to live on 70 to 90 percent of their pre-retirement income in order to maintain their usual standard of living.² Because of this, it is important to start planning early. If you are living comfortably now, ask yourself if you have saved enough to continue living this way once you have retired.

Change #2: Contribute to a 401(k)

In 2018, almost 30 percent of private industry workers had access to a defined contribution plan at their job but still did not participate.² If your employer offers a retirement plan, such as a 401(k), seriously consider making monthly contributions. Younger employees find it easier to justify putting this off. But the truth of the matter is, it’s never too early to start.

Compound interest accumulates steadily over time. This means that the earlier you start saving, the more your money will grow toward retirement. Plus, money contributed to a traditional 401(k) or IRA is tax-deferred, which makes it an appealing option for those looking to lower their tax obligation right away.

Overview of 401(k) Plans

Most of the following discussion is based on traditional 401k plans, which most employers offer. A Traditional 401k is a retirement plan where you make contributions on a pre-tax basis. The contribution limit is $19,500 for 2021 or $26,000 if you are age 50 or older. 

Two benefits of a 401(k) plan include tax-deductible and tax-deferred contributions. This means that you'll not only save on taxes but that you also won't have to pay any taxes until you withdraw your money. However, you can only take advantage of these benefits if you follow specific 401(k) plan rules.

In most cases, any 401(k) withdrawal you make is going to be taxable as ordinary income; With most 401(k) plans, you're not expected to withdraw these funds until you are at least 59½. If you make an early withdrawal, you'll incur a 10 percent early distribution penalty on top of paying ordinary income tax on the amount you take out. And that's only one of the many disadvantages of withdrawing from your 401(k) plan early.

Roth 401k

A Roth 401k is a retirement plan where you make contributions on an after-tax basis compared to a traditional 401k, where contributions are made on a pre-tax basis. The contribution limit is $19,500 for 2021 or $26,000 if you are age 50 or older. 

The downside of Roth 401(k) contributions is they don't reduce your current taxable income. However, the primary advantage of a Roth 401k is that earnings and employee contributions are tax and penalty-free on withdrawal if the account owner is at least 59½ and has held their Roth 401(k) account for at least five years. The employer match of Roth 401(k) contributions is not treating as a Roth contribution and will be taxed as ordinary income on withdrawal. Withdrawals can also be taken penalty-free if the account owner becomes disabled or by a beneficiary of the Roth 401(k) after the account owner's death.

Change #3: No 401(k)? Utilize an IRA

You can put up to $6,000 a year into an IRA or $7,000 if you are 50 older.³ You’ll want to choose between a traditional IRA or a Roth IRA. The difference will be the tax advantages. A traditional IRA means you’re contributing money tax-deferred to your retirement account. When you withdraw in retirement, you will need to pay taxes on the withdrawals. Because the money is contributed tax-deferred, it lowers your current year’s adjustable gross income.

Alternatively, a Roth IRA means your contributions are made with after-tax dollars. When you make withdrawals in retirement, they will be tax-free (because they were already taxed when deposited into the account).

IRAs offer everyone a simple way to save money. To simplify the process further, consider establishing automatic deductions. Each month, a set amount of money will automatically be deposited into your IRA from your checking or savings account.

Change #4: Do Not Touch Your Retirement Savings

By withdrawing from your retirement savings now, you lose valuable principal and interest that could have been income in retirement. Additionally, you may lose valuable tax benefits and pay a tax penalty for withdrawing early. If you change jobs, make sure that you leave your savings in your current retirement plan. Or you can roll them over to an IRA or your new employer’s retirement plan. I've included 2 PDFs below to help you evaluate the potential taxes and penalties you could be subject to in different situations.

WILL A DISTRIBUTION FROM MY TRADITIONAL IRA BE PENALTY-FREE?

WILL A DISTRIBUTION FROM MY ROTH IRA BE TAX & PENALTY-FREE?

Disadvantages of Withdrawing 401(k) Funds Early.

Withdrawing your 401(k) funds before you're 59½ can practically eliminate the main benefits of a 401(k) plan: tax deductions. This is caused by a number of penalties attached to early withdrawals. As mentioned previously, any withdrawal amount is considered taxable ordinary income, which means you'll be losing a significant amount of your savings simply by the timing of your withdrawal.

In some cases, you may be in a higher tax bracket when you withdraw the money than when you're in retirement, which can significantly increase the amount of taxes you'll have to pay once you do withdraw. Additionally, by taking your money out early, you're preventing it from growing and multiplying, which is one of the main reasons to contribute to a 401(k) plan. While the reward may initially seem worth it, by the time you get to retirement, these funds will most likely be missed. Ultimately, the longer your money sits in a 401(k), the more it will compound.

A $10,000 withdrawal as 30 year old could cost you over $280,000 by the time you retire.

We always work with our clients to establish a solid foundation of personal finance fundamentals. Saving early and often, even a small amount, is crucial to long-term success. When working with clients and taking them through the Dream Financial Planning Process ™, we work to optimize their budget and establish an emergency fund so they can handle unexpected expenses. We never recommend withdrawing money from a 401k unless it's a last resort or to possibly buy a home. 

For example, let's say you're a 30-year-old that is contemplating withdrawing $10,000 from your 401k or IRA (Individual Retirement Account). If you don't qualify for an exemption, that $10,000 is going to be approximately $7,000 after taxes and penalties, depending on your tax rate. 

You plan to retire at 65 years old, so you have a 35-year time horizon. $10,000 invested for 35 years, earning 10% per year, which happens to be the long-term return of the stock market as defined by the S&P 500 index, comes out to approximately $281,000. 

Early Withdrawal Exceptions

While there are exceptions to early withdrawal, it's important to note that your withdrawal will still be counted as taxable ordinary income. However, if you meet one or more of the below exceptions, you will not have a 10 percent penalty to pay in addition to the taxes. As always, make sure to read your own individual plan's requirements, as not every 401(k) plan follows the same rules.

You may be able to withdraw from your 401(k) early with minimal consequences if: 

• You have a disability. 
• You were fired from your job when you were 55 or older.
• You have significant medical expenses.
• You have a qualified domestic relations order.

Change #5: Ask Your Employer About Pension Plans

Does your employer offer a traditional pension plan? Even though many companies no longer offer one, check to make sure. If they do, see if you’re covered. Before you change jobs, find out what will happen to your pension benefit. If your spouse has a pension plan, you may be covered through theirs as well. 

Change #6: Talk to Your Financial Advisor

One of the most impactful things you can do for your future retirement is work with a financial planner who is familiar with your situation. They can provide you with realistic expectations, savings goals, and investment advice based on your tolerance for risk. Be open and honest in your discussions, and express your fears or anxieties regarding your future retirement.

When it comes to your retirement, it’s important that you’re knowledgeable, confident, and diligent in your planning efforts. If you are used to living a particular lifestyle and want to continue doing it once you are no longer working, planning ahead is critical. And if you are unsure where to start, speak with a trusted financial professional to find what works best for you and your unique 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. If you're looking for guidance on Financial Planning, optimizing employee benefits, budgeting, student loans, and managing your 401k or investments, we can help.

Complimentary Consultation

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.

Monthly Newsletter

If you're looking for guidance on your investments, you'll want to read this month's Newsletter. In my April Newsletter, I discuss Gamestop, market speculation, long-term investment returns, and 9 investing mistakes you should avoid.

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