Most people plan to leave the workforce at some point in their life. While some have a desire to maintain a sense of purpose by working well into their seventies, we more often find ourselves helping people plan for an earlier departure. Achieving financial freedom, or the ability to work because one wants to and not because one needs to, takes time and thoughtful retirement planning.
How much savings an individual requires to retire is based on a person’s unique needs and will depend on several variables. If you want to know how much money you will need to retire, ask yourself these questions:
- What is the annual cost to maintain my lifestyle?
- Am I planning to have new expenses for activities such as travel?
- Do I wish to gift assets to my children or charitable interests?
- What are my other goals?
- What assets and liabilities do I have?
- Will I receive a pension or other on-going income stream in retirement?
When building financial plans, we spend time learning about the household’s situation, future income streams and the types of assets owned. We pay special attention to investment accounts and whether the account is pre-tax, tax-free or taxable.
Usually a household’s largest financial assets are retirement accounts. Employees can accumulate significant amounts of wealth in employer-provided retirement plans. These retirement plans fall into one of two categories; qualified or non-qualified. So what’s the difference between a qualified and non-qualified retirement plan? The major difference is the employer’s ability to deduct contributions into the plan; however, both plans allow the employee to defer income into retirement.
Let’s take a closer look…
What is a qualified retirement plan?
Qualified retirement plans are most common and include 401(k)s, 403(b)s, Simple Employee Pensions (SEP), Savings Incentive Match Plans for Employees (SIMPLE), as well as a few others. Since qualified plans meet the requirements of Internal Revenue Code Section 401(a), contributions by an employer or employee are eligible for tax benefits. For employees, contributions reduce current taxable income when designated as pre-tax. Some plans allow Roth contributions, which are made with after-tax dollars. Whether pre-tax or after-tax contributions are made, annual contribution limits are imposed.
There are restrictions on the ability to access the funds because they are designed to accumulate wealth for the purpose of retirement. Qualified plans specify when distributions can be made. Typically the employee needs to reach a defined retirement age, unless the plan is terminated or the employee becomes disabled or dies.
What is a non-qualified retirement plan?
Employers who want to offer retirement benefits in addition to qualified plans might add non-qualified plans. As mentioned above, employers receive no tax benefit for contributions into non-qualified plans making it less attractive for the employer to contribute. Non-qualified plans benefit employees in high income tax brackets who reach the qualified plan contribution limit and want to defer more income. The most common type of non-qualified plan is a 457 Deferred Compensation Plan which allows eligible employees to defer salary and the associated income tax. This allows the funds to grow tax-deferred until withdrawn from the plan years later.
When we start peeling back the layers of someone’s financial situation, we find many variables affecting how much is needed to retire. The types of assets owned and their tax character is just as important as the value of assets because of the tax cost to withdraw funds. Imagine seeing that liability on your balance sheet – all of the sudden a $500,000 tax-deferred account doesn’t seem so large. Only when the entire picture is in view can we begin to answer the question, “How much do I need to retire?”
If you want to know how much you need to retire, contact your advisor to begin your plan.
Distributions from employer sponsored retirement plans are taxed as ordinary income and, if taken prior to reaching age 59 ½, may be subject to an additional 10% IRS tax penalty.
