Investing for retirement Using IRA, Roth and 401(k) Plans
For the past 20 years, most individuals have saved and invested for retirement on their own because company pension plans are largely a thing of the past. Living on Social Security alone during retirement isn’t appealing for most of us, since the maximum benefit is around $40k/year for 2022.1 But how much and where should we invest for retirement? The short answer: Most individuals should be saving and investing about 15% of their income into a retirement savings/investment plan such as an IRA or 401(k) or 403(b), or some combination.2
Companies typically offer some form of retirement savings plan with employee contributions coming directly out of their paychecks. These are many times 401(k) or 403(b) plans but could also be 457 or deferred compensation plans, depending on the employer and type of business. Many but not all companies will match a specific percentage of their employees’ contributions, which if you’re lucky enough to have this option, you should be taking advantage of it because this is “free money”. Investment options for these types of retirement savings plans are generally selected by the employees from a pre-defined list of 15 to 50 mutual fund or similar options. The IRS does set annual contribution limits for the employee portion, which for 2022 is $20.5k for employees under age 50 and $27k for employees aged 50 or older.3
Many but not all companies will match a specific percentage of their employees’ contributions, which if you’re lucky enough to have this option, you should be taking advantage of it because this is “free money”
If you work for a small company, or for yourself as an independent contractor, you may not have a company-sponsored 401(k) or 403(b) or 457 plan available. In this case, you could set up a Simplified Employee Pension, or SEP, plan if you own your own business or work for yourself as a consultant or entrepreneur. Small companies sometimes do offer a SIMPLE plan, which operates much like a 401(k) but has lower annual contribution limits and requires employers to match at a specific safe-harbor level. But if none of those is available, employees can contribute to their own Individual Retirement Account, or IRA, set up directly with a brokerage firm or bank. Annual IRA contribution limits are even lower than the others mentioned, and sometimes higher income individuals may be prohibited from making contributions altogether (e.g., Roth IRA) or may lose the tax deduction (e.g., traditional IRA). Investment options in IRAs are virtually unlimited, with most any stock, bond, ETF, or mutual fund available.
when it comes to saving for retirement, sooner is always better than later
But later, in retirement, all monies distributed from these plans are considered taxable income. The tax benefit comes on the front end when contributions are made. Once a retiree turns 72 years old, Required Minimum Distributions (RMD’s) apply, necessitating withdrawals be taken according to an IRS table.
In contrast, Roth IRAs do not provide a front-end tax benefit, meaning employee contributions to Roth IRAs are not deductible. But unlike traditional IRAs, Roth IRA distributions come out tax-free during retirement if the Roth account has been in place for 5 or more years and the employee is 59 ½ years old or older. Roth IRA tax benefits are accrued on the back end, meaning during retirement when distributions are taken to supplement Social Security income. Today many employer-sponsored retirement plans also allow employee 401(k) contributions to be designated as Roth. This is an excellent way to build up a large retirement account which may be available tax-free in retirement. And because monies inside a Roth account have already been taxed, no RMD’s are generally required.
Which is better – Traditional or Roth? Both, actually! Using either or both retirement savings/investing vehicle is better than not saving/investing at all, and when it comes to saving for retirement, sooner is always better than later, and higher contributions are always better than lower. If I were advising a 25-year-old employee just starting out and making $50k per year, I’d suggest building up the Roth 401(k) and/or Roth IRA as much as possible since a tax deduction now isn’t as critical at this juncture. But if my client was 58 years old and making $650k annually, I’d suggest they use all the tax deductions they can get right now, because they’re in a very high tax bracket already. This means using a traditional 401(k) or IRA for this client would be my suggestion.
1 Social Security website https://faq.ssa.gov/en-US/ 2 What Percentage of your Salary Should go Toward Retirement?, Investopedia, by Tim Parker, March 30, 2022 3 401(k) Contribution Limits Rising Next Year, by Jackie Stewart and Elaine Silvestrini, Kiplinger, September 23, 2022
Scott McClatchey is a wealth advisor and CERTIFIED FINANCIAL PLANNER™ with WWM Financial in Carlsbad, CA, an SEC-registered investment advisor. He can be contacted by phone on 760-692-5190 or by email at firstname.lastname@example.org .
WWM Financial is an SEC Registered Investment Advisor.
The opinions expressed in this program are for general informational purposes only and are not intended to provide specific advice or recommendations for any individual or on any specific security. It is only intended to provide education about the financial industry. To determine which investments may be appropriate for you, consult your financial advisor prior to investing. Any past performance discussed during this program is no guarantee of future results. Any indices referenced for comparison are unmanaged and cannot be invested into directly. As always please remember investing involves risk and possible loss of principal capital; please seek advice from a licensed professional.
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Scott McClatchey is a CERTIFIED FINANCIAL PLANNER™, CFP® with WWM Financial in Carlsbad, California. Scott can be reached at 760-692-5190 or email@example.com.
WWM Financial, an SEC-registered Investment Adviser. Advisory services offered where client advisory agreements are in place and WWM Financial is properly licensed. Past performance may not be indicative of future results. No investor should assume future performance of any specific investment will be profitable. This communication is for informational purposes only and not intended to be investment advice. Please seek professional financial advice before investing.
If I asked you what happened in the summer of 1969, what would you say? For those answering Woodstock, you’re right, the groundbreaking Woodstock Music & Art Fair took place over 3 days in August 1969 on a farm in Bethel, NY. The cultural significance of Woodstock persists, and in some sense, is arguably more relevant today than it has been for decades as US citizens have again taken to the streets in a rising tide of protests not seen since the civil rights era. And as a music lover, it’s hard to ignore the impact musicians such as Jimi Hendrix, Janis Joplin, Jefferson Airplane, CCR, Joe Cocker, Crosby Stills Nash & Young, Arlo Guthrie, Joan Baez, and Richie Havens had on the young baby boomers sliding around in the muddy fields that day who have since come to symbolize that era’s expression of peace and love. Music then, as now, provided a much-needed escape from the turbulence of the Vietnam War and the widespread unrest associated with the civil rights movement.
The Woodstock Music & Art Fair in Bethel, NY, August 1969
But what I had in mind wasn’t Woodstock at all, but rather Neil Armstrong’s walk on the moon which took place a month before Woodstock on July 20, 1969 at 1:17 pm PT. It turns out the “space race” was also a phenomenon largely playing out in the 1960’s, as the Soviet Union (now known as the Russian Federation or just Russia) and the United States battled to become the first to establish a space-based beachhead. Sputnik was the ‘shot heard round the world’ to begin the “race”, and Apollo 11 represented the finish line. By the time Armstrong famously uttered, “That’s one small step for a man, one giant leap for mankind,” the world was transfixed and forever changed. I still remember watching the first images from the moon’s surface, even though I was only a 10-year old boy in small town America at that time.
The Apollo missions leading up to Apollo 11 that July 1969 were anything but preordained, as NASA had never done anything even close to this before. The complexity of Apollo was extraordinary even by today’s standards, but it was almost unimaginable, and unbelievable, by 1960’s era standards. Mainframe computers were just becoming useful, but weren’t yet miniaturized because VLSI didn’t come into being until the 1970’s. Apollo missions were conducted using a guidance computer less powerful than what you carry in your pocket today. In fact, today’s iPhone can process instructions 120 Million times faster than Apollo 11’s guidance computer! Let that sink in for a minute or two.
Neil Armstrong became the first human to walk on the moon in July 1969
How did they do it? Well, through lots and lots of hard work, persistence, dedication, planning, testing, thinking, more planning, more testing, rethinking, rehearsing, and so on. As I learned when I hired into the satellite industry in 1982, double or triple redundancy is a best practice for all spacecraft, and contingency planning is critical to the success of every mission. In short, getting to the moon and back safely wasn’t easy, and Apollo is certainly an example of leadership and teamwork at its very best. Anyone who has watched the movie Apollo 13 understands how difficult, stressful, and complex these missions were. But the leadership exemplified by people like Gene Kranz, who famously replied, “No, this is going to be our finest hour” when asked during the mission if Apollo 13 was going to be NASA’s darkest moment, is but one example of how it all came together, and how the US came to “win” the space race. Incidentally, the movie line also attributed to Kranz “Failure is not an option” was more of the movie’s theme or tagline than an actual quote, according to multiple sources.1
APOLLO 13: AMERICA’S FINEST HOUR virtual event at San Diego Air & Space Museum on 50th anniversary
What does this have to do with me, someone who has been practicing financial planning for over 14 years? In a strange sort of way, growing up watching the Apollo missions on TV and following every nuance prepared me not only for my upcoming career as a satellite systems engineer and business-marketing executive after that, but it also taught me important lessons I still apply today in my financial planning practice. I started as a communications payload systems engineer, responsible for incubating and babysitting the communications payload from early design to eventual test, launch, and on-orbit operations. In big-aerospace, at least in my day, systems engineering was a kind of jack-of-all-trades profession wherein we needed to have the communications and business skills necessary to work with our customers and the program management team, but we also needed to have adequate technical depth to work with designers, thermal and structural engineers, test engineers, safety specialists, quality assurance personnel, and operations specialists. Using a hub & spoke analogy, system engineers were the hub and all the other professions were the spokes. Or you can think of a conductor with the various musicians in his/her symphony orchestra.
HUGHES Satellites circa 1980’s, before the HS 601/702 family of 3-axis satellites were developed
Fast forward to today, and my role is again to be the hub, or “symphony conductor”, of a group of specialists. But today, as a CERTIFIED FINANCIAL PLANNERTM, the specialists I work with (i.e., the spokes) are portfolio managers, bond traders, stock analysts, estate planners, tax CPA’s, retirement plan specialists, college savings plan experts, annuity and insurance agents, Social Security specialists, and mortgage brokers. Because to serve my clients, I need to “conduct” a symphony orchestra consisting of all the financial experts who can, collectively, help me best assist my clients with their financial challenges. One skill I’ve carried over from my aerospace engineering days is problem solving. To survive in systems engineering, it’s necessary to become a good, if not great, problem solver. As a financial planner, those skills come in handy almost every day as I work with different clients having different goals, circumstances, and challenges. There is more of a quantitative or statistical basis to modern-day finance than many realize, and for the average finance major, these are some of their toughest courses and most difficult career challenges. But for someone with a Master’s in Electrical Engineering and experience in aerospace systems engineering, this stuff is relatively easy for me. It’s just simple math.
Another lesson I learned early on in my aerospace career is risk management. Thinking through all the things that could go wrong on a space mission and building in redundancies where necessary, and then doing extensive contingency planning taught me an important life lesson and developed my risk mitigation skills beyond most ordinary finance programs. Today when I design a financial plan for a husband and wife and their 3 children, I apply those lessons to how I create the plan in the first place, but I also apply these concepts in discussions with the family. It’s not enough to run a Monte Carlo simulation once and tell my clients they’re adequately prepared for retirement. I run the software about 25-30 times to create a number of ‘what if’ scenarios so my clients can understand how their retirement would be impacted were inflation to be higher than we expected, or investment returns lower, or Social Security were to be cut by 10% or 25%, of if the husband or wife were to need assisted living or nursing home care later in life. This creates a risk matrix for the clients to use as a decision-making tool going forward.
Apollo 13 astronauts Fred Haise, Jim Lovell, and Jack Swigert return safely to Earth
When we discuss their plan, which is really a baseline plan plus 25-30 sensitivities or scenarios, we talk about margin of safety. Why? Because, like during the Apollo missions of the 1960’s, today’s retirement is fraught with things that can and do go wrong. Being prepared means building in an adequate margin of safety in order to handle all the ways things can unravel as retirement plays out over a 25 to 30 year period. Sometimes this also entails building in redundancies, just like on satellites. But in retirement planning, it’s more about creating multiple income streams — just in case one doesn’t pan out. That’s not to say I insist all my clients save and invest enough money to see 98% to 99% success likelihoods for their retirement plans. (In retirement planning, a successful retirement outcome means the client doesn’t run out of money before running out of time — i.e., passing away.) But I do want my clients to understand the “extra” risk they’re taking if they decide to retire this year versus next year or the year after. In some situations, I need to be the bearer of bad news and tell my clients they’re just not ready for retirement, from a money standpoint, anyway. Having 25-30 sets of statistical outcomes aids in this discussion, however, because the numbers tell the story for me. If someone expects to spend $125k per year in retirement and their planning outcomes predict a 23% to 31% probability of success, for example, they need to either rachet down their retirement income expectations and/or plan to work a little longer before retiring. Simply put, they’re not on track for a successful retirement.
Returning to the Apollo 13 movie, another analogy to financial planning comes from the real heroes of that extraordinary story. Mission Control played a pivotal role in orchestrating a successful conclusion to an unexpected and very dangerous situation. Had the astronauts been on their own, there’s no chance they would have returned home safely. These kind of “black swan” events happen in finance also, and how someone responds in the moment determines what their financial future will be, in a very tangible and unforgiving way. A “black swan” is an unpredictable, very low probability event that isn’t normally planned for or expected to happen, but if it does, it has a very severe impact. Examples are the Japanese bombing of Pearl Harbor in 1941, the terrorist attacks on September 11, 2001, and the coronavirus pandemic we’re currently experiencing. The point being, clients who are working with a professional financial planner who can provide a “Mission Control” function for their finances have a much greater chance of surviving during these financial calamities, and maybe even flourishing. It’s again a kind of hub & spoke architecture, but in this context, the hub – or financial planner – acts as the risk manager and troubleshooter for her clients, just like Mission Control did for Neil Armstrong and Jim Lovell. Functioning without this critical Mission Control element would be suicide in the manned spaceflight context. In personal finance, someone might get away with it for a while during “normal” times, but once an emergency ensues, it’s very difficult for someone untrained in finance, troubleshooting, and risk management to handle a black swan level financial crisis without incurring significant and likely permanent financial damage.
Flight director Gene Kranz and others in NASA’s Mission Control Center during Apollo 13 mission
You might be wondering at this point how a satellite systems engineer became a financial planner with responsibility for his clients’ financial future. That’s an interesting story which played out over many years. For the full version, I’ll offer to tell it over a craft beer sometime, but here’s the Cliffs Notes version. As a boy, I was fascinated with the Apollo missions and idolized Neil Armstrong as my hero. Naturally, I wanted to become an astronaut. But during my college years I realized I was overly susceptible to motion sickness, had horrible eyesight, and really didn’t want to live in Houston, so I decided to do the next best thing to becoming an astronaut. I hired into HUGHES Space & Communications Group in El Segundo, California to build satellites and spacecraft. It was a blast, but the seeds of my future financial career were sown during the 1980’s when I worked at HUGHES S&CG by day and drove to Westwood to study personal financial planning at UCLA in the evenings. The impetus was my onboarding at HUGHES when the HR rep asked how many tax withholdings I wanted to take, and what investment options I wanted to use for my 401k plan. My response at the time was, “401k plan, what’s that?” I signed up for night classes through UCLA Extension and learned about financial planning from seasoned CFP® professionals in the LA area who taught these courses. It’s was enlightening for me. I loved it! And I still do.
In time, I’ve found that helping clients achieve their goals and strive for financial independence is a very rewarding way to earn a living. I bring a lifetime of experiences to the table which collectively enable me to guide my clients while reducing their financial stress and allowing them to live the life they desire. It’s not rocket science, but it’s a worthwhile pursuit and, for me, a heck of a lot of fun!
Helping clients achieve their goals is what financial planning is all about.
Scott McClatchey is a wealth advisor and CERTIFIED FINANCIAL PLANNERTM in Carlsbad, CA with WWM Financial, an SEC-Registered Investment Adviser. He can be contacted by phone on 760-692-5196 or by email at firstname.lastname@example.org .Advisory services offered where client advisory agreements are in place and WWM Financial is properly licensed. Past performance may not be indicative of future results. No investor should assume future performance of any specific investment will be profitable. This communication is for informational purposes only and not intended to be investment advice. Please seek professional financial advice before investing.