In today’s financial world, there are many different philosophies and strategies when it comes to retirement planning. It’s easy to get confused with all of the types of retirement accounts and options you may have as you plan for your future. To understand how retirement works, it’s important to know how it came to be and how the idea of retiring has radically changed over the years.
One key thing to remember is that the concept of ‘retirement’ is actually a relatively new idea, whose development can only be traced back to the late 1800’s. Back then, people didn’t retire in the sense we mean it today. Typically when someone became disabled or grew too old to follow their profession, they moved in with their children or other relatives and relied on them to take care of their basic needs. It was very common to see households that included three or four generations under one roof.
An early predecessor to today’s retirement systems was introduced at the behest of Otto von Bismarck, the chancellor to Prussia’s emperor William the First in 1881. During this introduction, William wrote “… those who are disabled from work by age and invalidity have a well-grounded claim to care from the state,” and set the age at which people could begin qualifying in his program at 70 years of age. To put this into perspective, the average life expectancy for a man was 35.6 years and for a woman 38.4 years.
Granted, Prussia was engaged in many costly wars during this period of history; nonetheless it was uncommon for anyone to reach the age of 70 — and if they did they were clearly not in physical shape to engage in the common forms of labor. This early form of a pension plan wasn’t intended provide for ‘retirement’ as we think of it today, but rather to ensure that the few people who did reach that age had their basic needs taken care of for the last few years of their lives.
In 1935, as part of the effort to provide relief to people affected during the early days of the Great Depression, President Franklin D. Roosevelt signed into law the Social Security Act. This law expanded upon the ideas of Otto von Bismarck by lowering the benefit age to 65 and expanding beneficiaries to include the unemployed and disabled regardless of age. At the time, the average person would still not live long enough to benefit from the program – men had a life expectancy of 59.9 years and women at 63.9 years.
As the decades rolled on and people developed better medical technology, we started living longer and healthier lives. Today, the average man can expect to live to age 76.2 and the average woman to age 81.1. The laws governing Social Security were never changed to adequately adjust for these facts so as people began living significantly longer, society started viewing Social Security differently: as an income stream that could assist a person to enjoy a decade or three pursuing other ambitions and hobbies. This new concept of spending one’s Golden Years free from the demands of employment is a very attractive dream that many people have worked very hard for decades in anticipation of that dream’s fulfillment.
Unfortunately, the math doesn’t add up. Social Security, by itself, cannot and was never designed to provide the type of income stream that will allow a person to ‘retire’ in the sense of living a comparable standard of living that they enjoyed while employed. The government has tinkered with limiting benefits, raising the retirement age, and raising income tax to support the program in an effort to keep it solvent, but it’s clear that it will never be what many people hoped, expected, and frankly planned their retirement strategy around.
Types of Retirement Accounts
As part of an effort to help average people build a retirement, in 1974 the government passed Employee Retirement Income Security Act and created certain types of accounts to assist people in accumulating enough wealth to actually retire on. These accounts would be funded by the individual and/or the employer and would carry some unique tax benefits. The theory was that by giving tax breaks to these types of ‘qualified’ funds, the average person would be incentivized to plan for retirement and have an easier time building assets.
Then, when a person was ready to retire, he or she could begin drawing from Social Security as well as start spending the money that he or she had been saving all these years. This would enable someone in theory to spend their Golden Years in comfort and leave a legacy to his or her posterity or to charitable causes.
Today there are many different types of retirement accounts available, though all of them follow a similar function – to act as a storage shed for different investment options. Just like a shed in your backyard, retirement accounts can have all sorts of things inside them: stocks, bonds, mutual funds, precious metals, raw land, real estate, promissory notes, etc. There are a wide variety of assets that the IRS permits retirement accounts to buy, hold, and sell.
Whenever working with retirement funds, it is essential that you are assisted and advised by appropriately trained and licensed professionals like me, a Licensed Financial Strategists before making any final decisions or implementing any actions because of the potentially large tax or penalty consequences.
The three most common types are: the 401k ( aka TSP for fed Gov’t employees), the IRA, and the ROTH IRA. These retirement accounts all follow slightly different rules:
A 401k/TSP is a retirement plan traditionally owned by the employer for the benefits their employees. This is a very important distinction that sets it apart from most other retirement accounts. Because the employer owns the plan, the employer has control over the available investing options, though they may allow the employee to choose which pre-selected option(s) that he or she would like their portion invested in. This can severely limit the investing and risk management options of the employee – the individual who will be depending on these funds to supply a retirement.
The employer also determines under what conditions the employee can access the funds for personal use. Some 401k custodians will permit taking a loan against the existing value of the account, using the funds towards the down payment on a primary residence, or allowing the funds to be rolled over into an IRA. By law, the custodian must allow a rollover or in-service distribution when the employee reaches 59 ½ or when the employee leaves the company.
Both the IRA and the ROTH IRA are very similar tools. These are Individual Retirement Accounts (hence IRA) that are actually owned by the individual who will benefit from them. These accounts must be managed by a licensed custodian, but the owner of the account has the ability to choose the custodian, roll it into an account with a new custodian, and liquidate or take in-service distributions at any time (though there may be tax and penalty consequences).
This freedom to select the custodian gives the account owner a lot more control over what assets the funds are invested in, as well as the risks the account may be exposed to. Generally speaking, it’s usually advantageous to roll a 401k into an IRA when the option comes available because the account owner has a lot more control and investing options.
The difference between a traditional IRA and a ROTH IRA has to do with how the tax advantage applies to the account. In a traditional IRA, the owner of the account can deposit funds into the IRA using pre-tax dollars. In other words, the amount deposited comes out before calculating the amount owed to the government for income tax. Instead of taxing you as the money enters the account, in a traditional IRA your money is taxed coming out. This allows your portfolio to grow faster in the early stages because there is more money available to invest.
The ROTH IRA is the reverse. You pay income tax first, and when you withdraw money from the account it comes out without additional income taxes levied at that time. In effect, the money within this type of account grows tax free. Because of this pre-taxed model, the account holder ends up paying taxes on a much smaller balance, and the tax liability is a known factor whereas the tax rates decades in the future are impossible to predict.
The flaw of most retirement strategies is that you spend decades building a nest egg, and then begin depleting it when you shift into retirement. The theory is that you can sell the stocks and bonds within your retirement account and then take that money to live off during retirement.
The problem comes when your money expires before you do. Even if you follow the advice of most retirement planners and only withdraw 3-5% of your nest egg each year, the fluctuations in the stock and bond markets virtually guarantee that over a typical retirement span of 20 years you’ll run out of money much sooner than forecasted.
What’s the solution?
Simple: Invest in things that do not need to be sold in order to create stable monthly income.
Unlike stocks and bonds, investment real estate can produce stable and significant monthly income that does not require (and indeed discourages) the sale of assets to fuel a retirement lifestyle. If your real estate can cut you a check worth roughly 10% of the value of your nest egg each year (and that’s what our clients are achieving in our cash flow markets today), you can safely shift that rental income into your family budget without ever running the risk that your money will run out because your asset is not depleting.
Learn more about Safe Money Investors Alliance partnered with Strongbrook REIC to see how you can build a retirement portfolio using “Facilitated” Real Estate investing that you don’t have to worry about going away or running out before you do!
Visit www.investorfull.retirewithrealestate.net or call (301) 577-6340 to schedule a consultation with Dr. Jovan Walker today!