Recently, a friend (not a client) asked about getting started with a retirement plan.
The awkward part of the question? Though successful in his small business, he’s late to begin preparing for retirement. Mid-fifties.
The good part of his situation? Lots. He enjoys an impressive income. The business sits well-capitalized. Life’s big expenditures–college for the kids, a house and so on–are already taken care of.
The one problem? That lack of retirement savings.
I didn’t have a good answer when first asked the question. But after thinking about the issues since our conversation, a handful of thoughts come into focus for my friend and anyone else in a similar situation.
Thought #1: Get Handle on Anticipated Social Security Income
The first thing to do? Get a good estimate of the Social Security benefit he and his spouse will probably enjoy.
This bit of advice ranks as important for everybody of course. But it becomes critical for small business owners. Many of these folks have used S corporations to save on payroll taxes… which was good… But that tax saving gambit depresses the Social Security benefit someone receives in retirement.
You can get the exact benefit formula at , but the benefit formula roughly pays you an amount equal to 90 percent of the first $11,000 you average plus 32 percent of next $56,000 you average plus 15% of the next $66,000 you average.
Example: Someone who averages $11,000 a year over their work years receives a benefit equal to roughly 90% of $11,000 or roughly $9,900 annually.
Example: Someone who averages $67,000 a year over their work years receives a benefit equal to roughly 90% of the first $11,000 they earn (roughly $9,900 a year) plus another 32% of the next $56,000 they earn (roughly $17,900). The total benefit for this person equals $27,800.
Example: Someone who averages the $132,900 FICA limit a year over their career receives a benefit equal to 90% of that first $11,000 (or $9,900), 32% of that next $56,000 (or $17,900) and then 15% of that last $66,000 (or another $9,900). The total benefit for this person equals roughly $37,900.
Note: Your spouse typically chooses to either receive his or her own Social Security benefit or 50% of your Social Security benefit.
Thought #2: Size the Needed Retirement Nest Egg
My next thought: My friend needs to quantify the size of the retirement nest egg he and his spouse want.
A reasonable rule of thumb to start? His family needs maybe $20 to $25 dollars of savings for each $1 of retirement income they want their portfolio to generate.
Example: If someone wants (say) $75,000 of retirement income and anticipates $35,000 of Social Security benefits counting both spouses, the family wants to draw about $40,000 from a retirement savings nest egg.
To generate $40,000 of income, a nest egg probably needs to be between $800,000 (that’s 20 times $40,000) and $1,000,000 (that’s 25 times $40,000).
By the way, I’m thinking you use the “25 times” rule for a 30-year retirement and the “20 times” rule for a 20-year retirement.
Thought #3: Guesstimate Small Business Sales Value
Hopefully my friend can sell his business for a much needed chunk of savings.
A small business, by the way, often sells for somewhere between two times and five times earnings. The average, according to the runs about 2.5 times earnings.
Example: If someone’s small business earns $100,000 a year for the owner, the business’s value probably falls between $200,000 and $500,000. And a good off-the-cuff guess says the business’s value probably sits right around $250,000.
Note: The value won’t include cash or accounts receivable or real estate. And the seller will need to pay off any accounts payable or notes payable.
One wrinkle to remember? If a small business sells his or her business for $250,000, he or she will owe income or capital gains taxes on much or all of the proceeds. A 20% tax, for example, might reduce $250,000 of gross proceeds to $200,000 of after-tax proceeds.
Obviously, however, whatever a business owner gets from the sale of the business becomes a big chunk of the retirement nest egg.
Example: If someone needs $800,000 of retirement savings but $200,000 of this comes from the sale of a business, that means he or she also needs another $600,000 of additional savings.
Thought #4: Calculate Required Retirement Plan Contributions
You’ll need to calculate how much you need to save and for how long you need to save.
The table that follows shows the amounts someone accumulates if they save the “50 or older” maximum in an IRA account, a Simple-IRA account or a 401(k) account for a given number of years.
Note: These amounts come from The Finance Buff’s blog post (Check out that blog post for more, easy-to-digest details about pension plan limits.)
The table assumes, by the way, that you make the largest contributions at the end of the year and earn a 5 percent real (adjusted for inflation) return: $7,000 into an IRA, $16,000 in a Simple-IRA or $25,000 into a 401(k). I ignore employer matching contributions in the calculations below to simplify. But these amounts might add another little chunk to the annual contribution.
|
Years of Saving |
IRA |
Simple-IRA |
401(k) |
|
1 |
$7,000.00 |
$16,000.00 |
$25,000.00 |
|
2 |
$14,350.00 |
$32,800.00 |
$51,250.00 |
|
3 |
$22,067.50 |
$50,440.00 |
$78,812.50 |
|
4 |
$30,170.88 |
$68,962.00 |
$107,753.13 |
|
5 |
$38,679.42 |
$88,410.10 |
$138,140.78 |
|
6 |
$47,613.39 |
$108,830.61 |
$170,047.82 |
|
7 |
$56,994.06 |
$130,272.14 |
$203,550.21 |
|
8 |
$66,843.76 |
$152,785.74 |
$238,727.72 |
|
9 |
$77,185.95 |
$176,425.03 |
$275,664.11 |
|
10 |
$88,045.25 |
$201,246.28 |
$314,447.31 |
|
11 |
$99,447.51 |
$227,308.59 |
$355,169.68 |
|
12 |
$111,419.89 |
$254,674.02 |
$397,928.16 |
|
13 |
$123,990.88 |
$283,407.73 |
$442,824.57 |
|
14 |
$137,190.42 |
$313,578.11 |
$489,965.80 |
|
15 |
$151,049.95 |
$345,257.02 |
$539,464.09 |
|
16 |
$165,602.44 |
$378,519.87 |
$591,437.29 |
|
17 |
$180,882.56 |
$413,445.86 |
$646,009.16 |
|
18 |
$196,926.69 |
$450,118.15 |
$703,309.62 |
|
19 |
$213,773.03 |
$488,624.06 |
$763,475.10 |
|
20 |
$231,461.68 |
$529,055.27 |
$826,648.85 |
Just to make sure you understand this table, note that even saving for 20 years in an IRA doesn’t get my friend to $600,000. Rather, the estimated 20 year future value equals $231,461.
To get $600,000 of retirement savings, my friend either needs to use a 401(k) plan and save for roughly 16 years (so until age 70).
Or my friend and his spouse need to both save into a Simple-IRA for roughly 14 years. At 14 years, each might accumulate roughly $313,578. Double that amount and you’re just over $600,000. Again, though, that means working until age 70 or so.
And one final observation connected to the preceding table: My friend and his spouse could both save into a 401(k) (so that’s $25,000 a year each) for roughly 10 years. That allows each spouse’s 401(k) to grow to roughly $314,447. Combined, their 401(k) account balances equal roughly $629,000.
Note: My friend asked me where to save this retirement balances when I shared above comment. My suggestion? A cheap target retirement fund from Vanguard or Fidelity. (More information available from this free download:
Thought #5: Augment Retirement Plan Contributions with Mortgage Paydown
A tangential thought: If someone wants to save more than is possible with a retirement plan, paying down debts helps.
Paying off a 5% mortgage on a house equates to a 5% return.
Thought #6: Work the Numbers to Avoid a Panic Attack
A final thought: When someone puts off saving for retirement until their 50s–as many people do–running the numbers may cause a panic attack.
But rather than panic, what someone needs to do is choose the least bad option of the following three choices:
-
- Work longer so one can make more years of annual contributions and (just as important) support fewer years of retirement.
- Save more (and so spend less during your work years).
- Downsize one’s retirement income requirements (which may mean one should also spend less during the work years).
You get to pick whichever option makes most sense in your situation. But these three comments. First, you ought to look at the option of working longer if that’s available, something I’ve talked about in more detail in
Second, probably you want make sure current spending and retirement spending “balance out,” something I’ve described here:
Finally, and third, you (and me too by the way) need to acknowledge our mortality, something discussed here: .
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