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FORGET KANSAS, GET TO KNOW OZ. YOU'RE NOT IN KANSAS ANYMORE
It's one of the greatest moments in one of the greatest movies of all time, The Wizard of Oz. Dorothy Gale, played by Judy Garland, has just been transported along with her little terrier, Toto, from the Kansas farm where she lives with her auntie Em and uncle Henry to a mysterious place called Oz. The flat, monotone Kansas prairie has been replaced by a bizarre landscape bursting with color and lush with exotic flowers and plants.
Bedazzled, Dorothy looks around, trying to gain her bearings in this unfamiliar terrain. And then she utters those famous words to her little dog: "Toto, I have a feeling we're not in Kansas anymore."
When it comes to describing the situation most of us face today when planning for retirement, I can hardly think of a better line: You're not in Kansas anymore. The old, familiar landscape we once took for granted, the cozy, secure world where you could count on the combination of government largesse and an employer-funded pension to provide you with a comfy retirement, has given way to a totally new environment, one as alien to the world we knew before as Oz is to Kansas.
Granted, in this new retirement world we don't have to deal with such nasty creatures as the Wicked Witch of the West or her army of freaky flying monkeys, as Dorothy, the Tin Man, the Scarecrow, and the Cowardly Lion did. But the twenty-first-century retirement-planning landscape is nonetheless teeming with daunting challenges of a different breed. We must learn how to get the most out of financial instruments that retirees a generation ago never had to concern themselves with, an alphanumeric soup of 401(k)s, 403(b)s, 457 plans, IRAs, Keoghs, SEPs, and so on. (IRAs, Keoghs, and SEPs, oh my!) And then there are the myriad rules concerning IRA rollovers, early withdrawal penalties, borrowing regulations, and RMDs (required minimum distributions). On top of all this, we've got to invest our retirement savings and thus learn to navigate the often treacherous waters of the financial markets, where sudden setbacks can sometimes undo years of diligent saving. In short, just as Dorothy had to familiarize herself with the strange ways of Oz in order to find her way back home, so too must we develop retirement-planning strategies that offer the best chance of success given the new realities we face.
In this chapter I'll bring you up to speed on the new retirement landscape, including a number of distinctly positive developments stemming from recent changes in the tax laws that can increase our chances of achieving a comfortable retirement. Only by coming to grips with the various changes that have transformed the world of retirement planning and understanding how those changes affect you can you sensibly plan for your own retirement.
Changes in the Financial Aspects of RetirementSocial Security Ain't What It Used to Be
Traditionally, retirement-planning experts have told us to think of our income sources during retirement as a three-legged stool, the first leg being Social Security, the second company-funded pensions, and the third personal savings. In fact, however, this stool would have been pretty lopsided because for most people the role of that first leg, Social Security, was much, much bigger than the other two.
But today's and future generations of retirees aren't going to get anything remotely approaching the kind of windfall Social Security recipients received in years past. For one thing, there aren't enough workers paying into the system to provide benefits comparable to those past generations received. You don't have to be a financial whiz to figure out that fewer people putting money into the system and more drawing it out spells trouble. And that, according to the Social Security Administration's own projections, is exactly what lies ahead. Given the uncertain outlook for this program, some financial planners suggest that people filling out retirement-planning worksheets put a big fat zero on the line where you enter your expected Social Security benefit. I think that's a little extreme. Even if the Social Security trustees' projections are accurate and the trust fund runs dry in 2042 or so, it's not as if the Social Security system will go bankrupt then, as is often suggested in the press. Payroll and income taxes will continue to flow into the system as before. Those taxes just won't be enough to pay full benefits, but they would be able to pay between 65 and 73 percent of currently scheduled benefits over the subsequent thirty-five years.
It's anyone's guess how this will be resolved. At some point in the future the Social Security system could include some version of individual accounts that would allow us to put a portion of our Social Security taxes into stock and bond mutual fund accounts instead of having the money invested solely in U.S. Treasury bonds, as is now the case. That might help some of us earn a higher rate of return on the money we put into the plan and possibly boost what we collect in benefits down the road. Or Congress might try to shore up the existing system by raising payroll taxes or tinkering in other ways. Or maybe we'll see a combination of both approaches. Whatever is done, however, I would expect that future Social Security benefits will be smaller than they've been in the past. If you are relying primarily on Social Security to carry you through retirement, you are (a) counting on a very short retirement, (b) counting on a very grim retirement, (c) fooling yourself, or (d) all of the above. Suffice it to say that planning to make Social Security the cornerstone of your retirement isn't really planning at all.
Corporate Pension Plans Are Going the Way of the Hula Hoop
Remember hula hoops? They were all the rage back in the early 1950s among hip-swiveling young baby boomers. But within a few years, sales of these plastic novelty items fell from the millions to perhaps a few thousand a year, and today the few remaining hula hoops are little more than nostalgic relics of a more innocent era.
Well, the trajectory has been similar, though not nearly as short-lived, for defined-benefit pensions. These are the types of pensions most of us think of (or used to think of) when we hear the term pension—that is, one in which the company puts money into an investment fund and, regardless of the performance of the investments, promises to pay you a monthly check for life based on how many years you worked at the company and the size of your salary. Often, after putting in twenty-five or more years at a company, retirees could walk away with pension benefits that guaranteed them upward of half of their salary.
As these types of pension plans were nearing their peak in the late twentieth century, the seeds for their demise were being sewn. For one thing, companies began to realize that with this type of pension they could be on the hook for much bigger liabilities than they'd expected. After all, with more and more people living well into their nineties or even hitting the century mark, companies could end up making monthly payments for thirty or forty years, if not longer, to retirees who stubbornly refused to die. Many companies began to decide they were better off shutting down their defined-benefit plans or at least not starting any new ones. As a result, the number of company-funded pensions fell from 114,000 in 1985 to about 31,000 today, a drop of more than 70 percent.
The old pension arrangement where the company funded the plan and you were guaranteed a monthly check for life is rapidly becoming a vestige of a near-obsolete system. If you are lucky enough to work for a company that still provides such a plan, that's great. But that's not the case for most of us, which means that for the majority of Americans that second leg of the retirement stool has gotten a lot shorter.
More than Ever Before, the Onus Is on Us to Save and Invest for Our Own Retirement
With the first two legs of that three-legged retirement stool contributing less to our retirement security than in the past, we now have to rely more than ever before on that third leg: personal savings.
Fortunately, even as traditional defined-benefit pension plans have been disappearing, most of us have had access to a growing array of other types of retirement savings plans. At the top of the list are defined-contribution plans such as 401(k)s, which allow you to contribute a percentage of your salary before taxes into a variety of investments, typically mutual funds. In many cases, employers will match a portion of what you put into the plan. These are called defined-contribution plans because in accordance with federal pension law the plan stipulates, or defines, how much you can contribute to the plan. No guarantees are made about the benefits the plan will pay, however. Which makes these plans the mirror image in a sense of the defined-benefit plans discussed above, where it was the benefit payment that was defined, while the employers' contribution could change depending on the performance of the plan's investment assets.
401(k)s and other types of plans require us to take on a much bigger role than ever before in planning for retirement in two specific and crucial ways.
First, you've got to take the initiative to put your money into these plans. If you contribute only a small percentage of your salary to your 401(k) plan, then you will have only a little bit of money at work for your retirement. If you don't contribute any of your salary, then the plan is absolutely no help to you at all. Even in the cases where the employer is willing to kick in some contributions to the plan, those contributions are matching contributions.
Those who are willing to stash away money in these plans, however, got a big break in a piece of legislation known as the Economic Growth and Tax Relief Reconciliation Act of 2001, or more simply the 2001 tax bill. In addition to phasing in cuts in marginal income tax rates, this bill dramatically increased the amount of pretax dollars we can stash away in virtually the entire panoply of retirement savings plans not only this year but stretching out into the future. Those higher contribution allowances, plus other modifications that make it easier to keep tabs on your retirement savings when you switch jobs, have made everything from 401(k)s and 403(b)s to SEPs, Keoghs, and traditional IRAs even more effective retirement savings tools than they were before.
People who are willing to save and invest for their own retirement also got some help from an even more recent change in the tax laws—namely, the Jobs and Growth Tax Relief Reconciliation Act of 2003. This tax bill provided a number of goodies. For one thing, it accelerated across-the-board income tax cuts that had already been enacted in the 2001 tax bill but were not scheduled to kick in until 2006 or later. Result: As of 2003, the top income tax rate immediately dropped from 38.6 percent to 35 percent. But the bill also lowered the tax rate on capital gains—dropping the maximum from 20 percent to 15 percent for gains realized after May 6, 2003—and lowered the tax on most dividends by making the tax rate on dividends the equivalent of that on capital gains. This created a huge cut for many investors, lowering the maximum rate on most dividends from 38.6 percent to 15 percent in 2003. Of course, many lower-income investors will pay lower rates on capital gains and dividends than the newly reduced maximums I've mentioned here.
I'll be the first to admit that both the 2001 and the 2003 tax bills contain a number of squirrelly provisions that undermine their effectiveness and make planning more difficult. The lower tax rates on capital gains and dividends in the 2003 bill tax cuts, for example, revert back to their earlier higher rates in 2009, while the lower income tax rates initiated by the 2001 bill and accelerated by the 2003 bill revert to their older higher levels after 2010—unless Congress votes to keep the lower rates. But even if the relief is only temporary, lower income tax rates still mean less money going into the government's coffers, which leaves more money available to you for retirement saving. Similarly, the less of your investment gains you have to share with the government, the faster your money can compound and the larger a retirement nest egg you can grow with the same amount of savings. And for those of us who like to believe that reason and sound judgment will ultimately win out (and feel that we need every edge we can get when it comes to retirement planning), there's always the chance that Congress will make these tax cuts permanent.
In light of these changes, you'll want to reevaluate your investing strategy to make sure you're getting the maximum possible benefit of the new rules both in terms of the types of investments you buy and which ones you hold in tax-advantaged versus regular taxable accounts. We'll get into that in the investment discussions in Chapter 6. It's important to keep in mind, however, that no revisions of the tax laws will change this basic fact: The extent to which you can create a sizable nest egg for retirement these days increasingly depends on how much of your salary you are willing to save today.
Second, you've got to assume responsibility for investing whatever you save. In the old company-funded defined-contribution plans, you didn't have to concern yourself with how the money was invested. The company hired one or more professional investment advisers to deal with questions such as how much of the plan's money should be invested in bonds and how much in stocks, as well as what kinds of each.
But in the world of defined-contribution plans and IRAs, you are the investment manager. You've got to decide how much of your money should be in bonds or bond funds, and what kind. You've got to figure out how much to put in stocks or stock funds, and what kind. Which brings us to the final financial change . . .
From the Trade Paperback edition.