A fear for most individuals is the inability to maintain the standard of living they grew accustomed to before retirement. This fear could be challenging for many to overcome, especially, believe it or not, for the affluent.
Why? A general misconception is that highly compensated individuals are more able to save and invest for retirement, even on a tax-favored basis. Because they earn more money, one assumes they can more easily accumulate enough to maintain their standard of living throughout their retirement years.
But with contribution limits on 401(k) plans, IRAs and other conventional retirement savings vehicles, highly compensated individuals will find it difficult to accumulate enough wealth to replace their current income, even if they contribute the maximum amount allowable to qualified retirement plans.
To illustrate a highly compensated individual’s tax-favored investing limitations, consider this example comparing three individuals who are all age 50 and work at the same company. Edward earns $275,000; George earns $100,000; and Bill earns $50,000 per year.
What Your Peers Are Reading
George and Bill each contribute 6% of their salary to the company 401(k) plan and receive an additional 3% match from their employer. Edward is only able to contribute 4.7% of his salary because the 2004 maximum individual contribution is $13,000.
Edward, the highest earner, can contribute an additional $3,000 due to catch-up provisions, bringing his total contributions to $16,000 and 5.8% of his salary. He wants to contribute to a Roth IRA but does not qualify because his income exceeds $160,000, which is the 2004 maximum income amount.
George, the middle earner, contributes $3,000 each year to his Roth IRA. Bill, the lowest earner, would like to contribute more to his 401(k) and establish a Roth IRA, but he cannot afford to do so.
For illustration purposes, we will assume the employer provides a 50% match on employee contributions into the 401(k). Edward’s employer 401(k) match is based upon his $13,000 contribution limit and does not apply to his $3,000 catch-up contribution. (See Chart 1.)
Among the three retirement savings accounts, Edward earns the most but contributes the smallest percentage of his income. In the next example, you’ll see how Edward’s present contribution limits during his income accumulation phase will negatively impact his income distribution phase during retirement.
Let’s assume that each employee continued the same savings pattern until age 65 and earned an average 8% rate of return on his qualified retirement account. If Edward, George and Bill retire at the same time, Chart 2 shows the following:
o How much they can save;
o Estimated annual retirement plan distributions;
o Estimated Social Security benefits each year;
o Total income each year during retirement; and
o Annual income during retirement as a percentage of income prior to retirement.
Edward’s standard of living will be substantially lower during his retirement because he’ll only receive 30% of his pre-retirement income each year–much lower than George’s 55% and Bill’s 60%.
Before we start feeling sorry for Edward, he might consider boosting his retirement income using non-traditional alternatives. The question is this: Does Edward’s financial advisor know which solution can produce the highest after-tax supplemental retirement income?”
Consider these retirement investing alternatives: