The Hidden Danger of an Underfunded Retirement

The Problem: Few Americans have enough saved for retirement

The Federal Reserve's 2022 report on Economic Well-being in U.S. Households shows that 25% of Americans have no retirement savings. Forty percent feel they are not on track for retirement. These are staggering numbers.

Many people with some savings and employer-sponsored plans are certainly in better shape than the previously-mentioned 25%. Still, even they may be short-changing themselves (pun intended) with one or more of these issues:

• Limited Investment Options: Employer-sponsored plans often have a limited selection of investment options, which may limit your ability to tailor your portfolio to your financial goals.
• Potential Fees: Some employer-sponsored plans may have higher administrative fees and investment expenses, reducing the overall return on your investments.
• Limited Eligibility: Some retirement plans, such as 403(b)(7) plans, are available primarily to employees of educational institutions and certain non-profit organizations, which limits access for individuals in other fields. These types of plans may also have more investment restrictions than other retirement offers.
• Tax Implications: Earnings in taxable investment accounts are subject to capital gains taxes, which reduces the overall growth of your savings.

So how can people with little or no retirement savings, and those with only one of the options above, get on track for a fully-funded life of leisure in their golden years? This Life Hack is a perfect start for most people.

The Hack: Open a Roth IRA

One powerful tool that can help you achieve your long-term financial goals is a Roth IRA (Individual Retirement Account). The Roth is a retirement account that allows your investments to grow tax-free. 

There are several types of IRAs, so you might be asking yourself, "Why is the IRA or 401K I already have not enough?" Here's why:

1. Tax Treatment of Contributions and Withdrawals:
   • Traditional IRA: Contributions to a traditional IRA are made with pre-tax dollars, meaning you get a tax deduction in the year you make the contribution. However, when you withdraw funds during retirement, those withdrawals are subject to ordinary income tax, including both contributions and investment earnings. Even though your income is lower, you may wind up paying more taxes once you begin withdrawing from a traditional IRA.
   • Roth IRA: Roth IRA contributions are made with after-tax dollars, so there is no upfront tax deduction. However, the major advantage of a Roth IRA is that qualified withdrawals during retirement are tax-free, including both contributions and investment earnings.
2. Required Minimum Distributions:
   • Traditional IRA: Once you reach the age of 72 you are required to start taking annual minimum distributions from your traditional IRA. These distributions are subject to income tax and can impact your financial planning in retirement.
   • Roth IRA: Roth IRAs do not have required minimum distributions during the account owner's lifetime. This allows for greater flexibility in managing your retirement income and leaves the option to let the money continue growing tax-free if you don't need/want to withdraw it.
3. Impact on Social Security Benefits
   • Traditional IRA: Distributions from traditional IRAs are considered taxable income, which may increase your overall income and, in turn, affect the taxation of your Social Security benefits.
   • Roth IRA: Since Roth IRA withdrawals are tax-free, they do not count as taxable income and do not impact the taxation of Social Security benefits.
4. SEP IRAs and SIMPLE IRAs
   • Employer Contributions: While SEP IRAs and SIMPLE IRAs allow for higher employer contributions, the responsibility to fund these contributions falls on the employer. In some cases, employers may not match contributions at all or contribute lower amounts, impacting overall retirement savings.
   • Employer Participation: These plans may require employer participation, limiting their availability to self-employed individuals or small businesses with eligible employees.

Creating a Roth IRA is a powerful financial Life Hack that can set you on the path to financial independence and a secure retirement.

What You Can Do Tomorrow

Setting up a Roth IRA is just the beginning of your journey towards financial security. Take the following steps to maximize your Roth IRA's potential:

• Start Contributing Early: The earlier you start contributing, the more time your investments have to grow and compound. Even small, consistent contributions can make a significant difference over time.

• Automate Your Contributions: Make it a habit to contribute to your Roth IRA regularly. Set up automatic contributions from your paycheck or bank account to ensure you never miss a deposit.

• Reevaluate and Adjust: Periodically review your Roth IRA's performance and rebalance your investment portfolio if needed. Life circumstances, risk tolerance, and financial goals may change over time, so it's essential to adapt your strategy accordingly.

As with everything that involves banking, there is a unique process to go through to get started. We provide some steps here, based on our own expereince and research. Still, we encourage you seek help from a professional financial advisor.

Step 1: Determine Eligibility: Before you start, ensure you meet the eligibility criteria for opening a Roth IRA. To contribute to a Roth IRA, you must have earned income and your modified adjusted gross income (MAGI) must be within the IRS limits. You can easily find these limits online or with a financial advisor.

Step 2: Choose a Financial Institution: Decide where you want to open your Roth IRA. Many banks, credit unions, brokerage firms, and online investment platforms offer Roth IRAs. Look for a reputable institution with low fees, a variety of investment options, and a user-friendly interface for online transactions.

Step 3: Complete the Application: Visit the website of the financial institution you select, or contact them directly to request an application to open a Roth IRA. Many institutions offer online applications that you can fill out electronically. Alternatively, you may receive a paper application that you can complete and return via mail or in-person.

Step 4: Choose Your Investments: Once your Roth IRA is open, you'll need to decide how to invest your contributions. Most places offer a range of investment options, such as mutual funds, exchange-traded funds (ETFs), bonds, and individual stocks. Talk to your bank and a financial advisor to learn the best strategy for your investments.

Step 5: Fund Your Roth IRA: You can contribute to your Roth IRA from your bank account via electronic transfer or by mailing a check to your bank. Make sure to specify that the contribution is for the current tax year (if applicable).

Step 6: Review and Monitor Your Investments: Regularly review your Roth IRA investments and rebalance your portfolio if needed. Life circumstances, risk tolerance, and financial goals may change over time, so it's essential to adjust your investment strategy accordingly. Keep in frequent contact with your bank and financial advisor to manage your portfolio effectively.

Final Word

Opening a Roth IRA is a powerful financial Life Hack that can set you on the path to financial independence and a secure retirement, especially if you start young.

For example, a 20-year-old invests $6,500 in a Roth annually (the max contribution in 2024). Assume a rate of return of 6%, well below the average of the S&P 500. In 30 years, her Roth wil be worth $551,000. 

At age 50, as of 2024, she can increase her annual contribution to $7,500. At age 65, assuming that same 6% return rate, she'll have just shy of $1.5 million. And remember, that's tax-free money!