Now or later - What type of plan do you need?

Here is a primer on the ways you can save for retirement. Each has it advantages and disadvantages. 

• Pay taxes now - These are traditional savings accounts and stock and bond investments. A bank pays me interest each year and I pay taxes on it immediately. If the stock pays a dividend, I am taxed. And when I sell the stock or bond I have to pay taxes on what I earned. I have prepared taxes for folks for several years, and these always cause the most disappointment. They come in with a big smile on their face with their statements from their investment firm, to show me how much they made on the stock market this year. I then have to tell then that they now I taxes as regular income at their normal withholding rate. What this means is that they not only have to pay taxes on the earnings, the income could push them into a higher tax bracket causing them to pay even more tax. The advantage is that the cash is easily available which is where I would want to keep my emergency fund.  
The trouble with this method is that when I pay taxes as I go along, I never get ahead. For instance, consider starting with one dollar and double it every year for 20 years without paying taxes. How much would you have? The answer is over one million dollars! But take that same dollar and double it each year and pay taxes as you earn it. What would I have then? About $27,000 assuming a 30% income tax rate. Enter the pretax savings plans.

• Pay taxes later with tax free growth - 401k, 403b and IRA all let me deduct money from my paycheck before taxes are deducted. The money is placed into a fund managed by someone like Vanguard or Fidelity, who offer a number of mutual funds for growth. Also, when, or if, the money grows, the income isn't taxed until I take it out. Money taken from my pay is usually based on a percentage of my total pay. Also a few of my employers gave me a match up to a certain limit. For instance, if I were to save 5% of my paycheck, the employer will give me another 2 to 5%. It all depends on the employer and how generous they want to be. I like free money.  This method is better because I can take advantage of growth without paying taxes, as I mentioned earlier. There are no free lunches, though, because I will have to pay taxes on the money as I withdraw it. And no matter how you may feel about taxes, one thing is certain. Taxes will increase. Our national debt has to be paid and we have to pay it someday.

For example, if I need to have $50,000 cash to live on each year, and my only source of income is from my pre-tax account, I will have to withdraw at least $70,000 to cover both what you need and what Uncle Sam wants.

• Never pay taxes with after tax money and tax free growth - The Roth IRA lets me take money from my payroll after I have paid taxes on it and invest it. The growth is tax-free while it grows, and, if I keep it the required number of years, I can take out the earnings tax-free as well. Unfortunately, for most of us, we can only put $5,000 per year or $6,000, if I am over 50. Not quite enough money for a big nest egg, but a good start.

What I want, though, is something I can invest it, not pay taxes as it grows, not pay taxes when I spend it and have something left to take care of my family when I die. And maybe, if I am a good planner, I could even use it for part of my retirement money.

Other than the pay now tax now savings accounts, all the other methods are for a long term plan. I should not put my money in with the expectation of taking it out until retirement.

After all, what I want, when I retire, is the ability to continue getting a paycheck. I don't want some huge windfall of cash because I would still need to put it somewhere safe so I can take it out as I need it. Given that, there are two ways I can invest my money into something that will protect my money from the falls in the market, give a death benefit to my wife, grow, and give me a tax advantage with the growth. For me, at my age, I would invest in annuities. For someone younger, say in their 20's, they would want to give serious consideration to a permanent life insurance policy.

Coulda, Shoulda, Woulda

$108,000 from $100k in ten years.  I could have done better keeping it in a savings account.  That would have been a poor choice, as well, though.  What would have happened if I had met my friend ten years earlier?  Would I have more in savings and how much would that be?  Leaving my money in my IRA let me ride the market with all its ups and downs.  The annuity had protection from the market that I couldn't get in my IRA.  First, here is how my money grew in ten years without protection.

Between 2000 and 2003, I lost almost $40,000.  Then the market recovered with that big bubble everyone talked about, but didn't do much to change.  Besides, who knew about credit default swaps and such?  I certainly didn't.  By 2007 I recovered my $40,000 and added another $13,000.  Wow!  Now I am back on track.  Well, almost.  In 2008, I dropped back to $71,000, again losing $40,000.  Finally, after all that pain and excitement, by the end of 2010, I recovered back to $103,000.  In ten years, my money had grown by $3,000. 

What if I had met my friend earlier, perhaps in 2000, before the first drop?  If I had met him, believed him and taken a chance with my money, I would have been ok.  Would I have actually done that?  It is difficult to say.  As a reminder, the annuity I have is called a variable annuity.  It lets me put my money in various types of mutual fund type accounts, including something that would have followed the S&P 500.  These are index funds.  The beauty of the annuity, though, is that when the market falls, the company continues to pay me 6% interest on my balance.  How different would my outcome have been?  Look at the chart below.

If I had put my money into this annuity in 2000, my money would have grown from $100,000 to $340,000!  My money would have more than tripled.  Leaving my money in my IRA I gained $8,000.  Putting it into an annuity would have given me $240,000.  How much would you have been willing to spend to get that return?

A Real World Example

I like to see how the market is doing each week, so I check out a few numbers, one being the Dow Jones Industrial and the other is the S&P 500.  Both are a selection of the largest stocks in the market and the numbers represent how the stocks have grown or shrunk in value.  Each morning when I turn on the news, since I live on the west coast, I get to see the opening of the stock market at 6:30.  After that, I get to see the Dow Jones and S&P numbers as they rise and fall.  The market is up today because of .....  The market is down because....  I am never really sure what to believe other than the numbers. 

For instance, sometimes the market increases because some big companies have laid off workers, with the assumption that less money given to payroll will add to the value of the company.  The next day the market drops because of rising unemployment.  That never makes sense to me, but that is the world in which I live.  As an investor, the best I can do is read, watch the market and pray.  Or I can do what a lot of other people do which is to put my 401k money into some funds that HR suggested, and then ignore them from then on.  Frankly, that is what I did for a long time and now I see the error of my ways. 

When I started this blog, I mentioned that I had spoken to a friend who showed me how I could be safer putting my money in an annuity rather than leaving it in my IRA.  I had complained that my money had not grown at all in the ten years that I had held on to it.  How could I possibly expect to live off money that wasn't even growing? 

What I got was a program that let's me still invest in the market and I can take advantage of the growth.  When the market goes down, the annuity pays me 6% until the market recovers.  The program isn't free, so I decided to do a bit of math to see if I was getting a good deal.

If you go to a web site called http://www.moneychimp.com/ and go find the Advanced CAGR or Compound Annual Growth Rate of the stock market.  There I found the percent change in the S&P 500 over the last 10 years.  Between 2000 and 2010, the S&P 500 rose, on average a little over 2%.  Really?  Here are the numbers.

S&P Annual Percent Change   

2010        14.32 

2009        27.11

2008       -37.22    

2007          5.46

2006        15.74     

2005          4.79

2004        10.82     

2003        28.72     

2002       -22.27    

2001       -11.98    

2000         -9.11     

Avg Return         2.40 

Here is how this looks graphically.

Another way to look at this is to add some money to it and see where it goes.  Let's take me, for example.  Over the years, I had managed to accumulate $100,000 in my 401k that I had rolled over to an IRA.  A popular way to invest was, and is, to put it into an index fund.  For instance, if I put my money into a fund that matched the S&P 500, my money would keep up with the market.  In 2000, that sounded like a pretty good idea since I could never keep up with all the changes.  So, let's see what happened to my money when I put it into the S&P 500 Index Fund and let it ride.

Keeping my money in that fund let it grow from $100,000 to $108,000.  Is that magic, or what?  Where did my money go?



Ten percent solution

What does it mean to have protection from market changes?  Let me give you an example.  First, I will take an investment that pays me 10% the first year, loses 10% the next year, pays another 10% the next year and so on.  If you were to take five years at plus 10% and five years at minus 10%, the average return should be zero.  That is, you should have as much money at the end as you started with ten years ago.  That would be nice, but it is a little like hoping your one A in Art is going to compensate for your two C's in Math and Science. 

Start with $100.  The first year you make $10, and let's assume you don't have to pay taxes on the growth.  That leaves you with $110.  The next year you lose 10% or $11.  Now you are down to $99.  In my graph below, I carried that logic out for 14 years. 

My $100 shrank to $85 losing $15 from my beginning balance.  I don't like that result. 

What if I were able to get something that always let me have the positive 10% growth when it happened, and then didn't pay anything when the return was negative.  How would that look?  In my first year I earn $10 and the next year I earn nothing, but I keep my $10.  The next year I earn $11 bringing my balance up to $121.  I like that much better.  Let's see how that looks over 14 years again.

In just 14 years, with protection, my account grew to $177.  How does that look in comparison to my other result?  I think it looks a whole lot better.  But 10% each year isn't really possible, is it?  In my next article I will give a real world example.