Managing your income is always important, but it becomes even more critical during retirement, when your income comes from your savings rather than from wages and earnings. Because your source of income – which you saved so carefully during your working years – is limited during retirement, you need to ensure that it lasts through your retirement years. This means determining your income needs in the years leading up to your retirement and, once you retire, efficiently managing your retirement assets. In this article, we look at some issues you need to consider when doing these things.
Planning in Pre-Retirement Years
As the time for your retirement nears, there is always a chance that the amount you thought would be sufficient to finance your retirement years isn’t. Reasons may include cost-of-living increases and lower-than-projected returns on investments. To help increase your chances of having a financially secure retirement, you should make frequent reassessments of your retirement income needs and sources during the 10 years before your projected retirement date.
The performance of the stock market in the 10 years between 1999 and 2009 is a good illustration of how potential retirees had to re-plan their retirement. For many, the market boon of the early 90s gave hope of a financially secure retirement. However, the subsequent market downturn resulted in a significant reduction of retirement assets, which forced many individuals near retirement to postpone their originally anticipated retirement date.
What to Do If You Don’t Have Enough
If your reassessment of your retirement portfolio and current expenses reveals a shortfall in your savings, you may need to continue working beyond your anticipated retirement date. (For more on how to assess how much you will need for retirement and how much you have, see Fundamentals Of A Successful Savings Program.) However, should you decide to work, be cognizant of how your income could affect the amount you receive from social security if you are under the full retirement age determined by the social security agency.
Also, if you find you cannot retire as early as you planned and must keep working, you can try to decrease your extended pre-retirement period by re-strategizing. Basically, you need to increase the amount you save so that you shorten the time until you reach your goal. Here are some ways to increase your savings:
Consider debt consolidation or refinancing to reduce monthly payments for credit cards and other loans, including your mortgage. You can redirect the reduction in interest payments to your retirement nest egg.
Make changes that reduce or eliminate spending on luxury items or other things you don’t need. It may be easier than you think! Consider using a less expensive car, buying better priced items and even moving into a smaller or less expensive house or apartment.While it may be challenging to make these changes, you can take comfort in the fact that they will help increase your standard of living during retirement, when you may not be able to work or get high-paying jobs.
Controlling Your Assets During Your Retirement
Assessing Your Asset Allocation
Making your money work for you is a recommendation often made by savvy financial planners. This recommendation also applies to your retirement years. Making your money work for you means investing your assets to produce a return on investments.
That said, it’s important to keep your assets safe during your retirement years. So you may need to shift from low-risk investments to those that produce a guaranteed rate of return. However, your reallocation depends on the number of years you plan to stay in retirement. A longer life expectancy may require more aggressive investing even during your retirement years.
When reallocating your investments, consider also the resulting level of liquidity and how it will affect your ability to make withdrawals when you need them. For instance, nonpublicly-traded or closely held securities can take from a few weeks to over a year to be liquidated. Reallocating your assets without attention to liquidity may leave you without cash, which becomes a problem especially when you need to withdraw your required minimum distribution (RMD) amounts by the applicable deadline. There have been numerous cases of individuals not meeting their RMD deadlines because assets could not be liquidated in time.
Managing Your Income Stream
Your income stream during your retirement years usually depends on your annual expenses, the amount you have saved and the amount of years you project you will stay in retirement. To balance your income with your expenses, consider doing the following:
Make a list of your monthly expenses, such as utilities – including electricity, telephone, gas and water – groceries, rent or property taxes and transportation. Also consider medical and leisure expenses. These amounts may change each year because of cost-of-living increases, which means that you must do an assessment at the beginning of each year. In general, inflation increases about 3% per year, but could be higher for certain expenses such as medical and health.
Take stock of the amount you have saved for retirement. This includes your regular savings and your retirement account balance.
Consider the amount of years you plan to stay in retirement.
Of course, the last two factors together determine how much monthly income you can have while making your savings last. Look at how much you have saved versus the number of years you plan to stay in retirement. Assume you plan to stay in retirement for 20 years and you have $500,000 saved. Your monthly allocation would be approximately $2,100. Add this amount to the amount you will receive from social security, and this is what you have as income to cover your monthly expenses. (To estimate your income from social security, use the benefit calculators at the social security agency’s website.) Taking a look at your expenses every year will help you determine if you need to make adjustments to your spending, ensuring you don’t compromise your income in future years.
Your Income from Your Retirement-Savings Vehicles
The amount of income you will need from your retirement-savings vehicles generally depends on the amount you have available or will receive from other sources, such as your regular savings and social security. When possible, consider withdrawing no more from your retirement account than you are required to each year by IRS regulations. This will allow the remaining amount to continue growing tax-deferred, or tax-free in the case of Roth IRAs. This will also help to reduce the amount you must include in your income, thereby reducing the amount of taxes you will owe for the year.
Once you have determined how much you should/will need to distribute from your retirement account for the year, contact your retirement plan administrator or financial services provider to establish scheduled distributions from your retirement account. To do this, you request that distributions are paid to you on a future date and continue at a particular frequency, such as monthly, quarterly or annually.
When establishing scheduled distributions, ensure that the amount you request is enough to satisfy any RMD. If the amount you withdraw from your retirement account for the year is less than your RMD amount, you will owe the IRS a penalty of 50% of the shortfall, referred to as an excess-accumulation penalty (see Avoiding RMD Pitfalls). Establishing scheduled distributions helps ensure not only that your RMD is distributed on a timely basis, but also that you receive your payments without having to contact your financial institution each month.
Income from Retirement Vehicles May Affect Income Taxes
When determining your annual expenses and income streams, bear in mind that you may need to pay income taxes on amounts you withdraw from tax-deferred retirement accounts. These amounts will be treated as ordinary income for tax purposes.
If Withdrawals Occur Before Age 59.5
If you withdraw assets from your retirement account before you reach age 59.5, the amounts will be subject to a 10% excise tax, unless you meet one of the exceptions as set out by IRS regulation (see Taking Penalty-Free Withdrawals From Your IRA). This excise tax is charged in addition to any income taxes you owe on the amount. If you must distribute amounts from your retirement account before age 59.5, talk to your financial planner about strategies to avoid or minimize the excise tax.
Are you worried about how a recession might affect you? You can put your fears to rest because there are many everyday habits the average person can implement to ease the sting of a recession, or even make it so its effects aren’t felt at all. In this article, we’ll discuss seven ways to do just that.
1: Have an Emergency Fund
If you have plenty of cash lying around in a high-interest, Federal Deposit Insurance Corporation (FDIC)-insured account, not only will your money retain its full value in times of market turmoil, it will also be extremely liquid, giving you easy access to funds if you lose your job or are forced to take a pay cut. Also, if you have your own cash, it won’t be an issue if other sources of backup funds dry up, such as a home equity line of credit.
2: Always Live Within Your Means
If you make it a habit to live within your means each and every day, you are less likely to go into consumer debt when gas or food prices go up and more likely to adjust your spending in other areas to compensate. Debt begets more debt when you can’t pay it off right away – if you think gas prices are high, wait until you’re paying 29.99% annual percentage rate (APR) on them.
To take this principle to the next level, if you have a spouse and are a two-income family, see how close you can get to living off of only one spouse’s income. In good times, this tactic will allow you to save incredible amounts of money – how quickly could you pay off your mortgage or how much earlier could you retire if you had an extra $40,000 a year to save? In bad times, if one spouse gets laid off, you’ll be OK because you’ll already be used to living on one income. Your savings habits will stop temporarily, but your day-to-day spending can continue as normal.
3: Have More Than One Source of Income
Even if you have a great full-time job, it’s not a bad idea to have a source of extra income on the side, whether it’s some consulting work or selling collectibles on eBay. With job security so nonexistent these days, more jobs mean more job security. If you lose one, at least you still have the other one. You may not be making as much money as you were before, but every little bit helps.
4: Have a Long-Term Mindset With Investments
So what if a drop in the market brings your investments down 15%? If you don’t sell, you won’t lose anything. The market is cyclical, and in the long run, you’ll have plenty of opportunities to sell high. In fact, if you buy when the market’s down, you might thank yourself later.
That being said, as you near retirement age, you should make sure you have enough money in liquid, low-risk investments to retire on time and give the stock portion of your portfolio time to recover. Remember, you don’t need all of your retirement money at 65 – just a portion of it. The market might be tanking when you’re 65, but it might be headed to Pamplona by the time you’re 70.
5: Be Honest About Your Risk Tolerance
Yes, investing gurus say that people in certain age brackets should have their portfolios allocated a certain way, but if you can’t sleep at night when your investments are down 15% for the year and the year isn’t even over, you may need to change your asset allocation. Investments are supposed to provide you with a sense of financial security, not a sense of panic.
But wait – don’t sell anything while the market is down, or you’ll set those paper losses in stone. When market conditions improve is the time to trade in some of your stocks for bonds, or trade in some of your risky small-cap stocks for less volatile blue-chip stocks. If you have extra cash available and want to adjust your asset allocation while the market is down, however, you may be able to profit from infusing money into temporarily low-priced stocks with long-term value.
The biggest risk is that overestimating your risk tolerance will cause you to make poor investment decisions. Even if you’re at an age where you’re “supposed to” have 80% in stocks and 20% in bonds, you’ll never see the returns that investment advisors intend if you sell when the market is down. These asset allocation suggestions are meant for people who can hang on for the ride.
6: Diversify Your Investments
If you don’t have all of your money in one place, your paper losses should be mitigated, making it less difficult emotionally to ride out the dips in the market. If you own a home and have a savings account, you’ve already got a start: you have some money in real estate and some money in cash. In particular, try to build a portfolio of investment pairs that aren’t strongly correlated, meaning that when one is up, the other is down, and vice versa (like stocks and bonds).
7: Keep Your Credit Score High
When credit markets tighten, if anyone is going to get approved for a mortgage, credit card or other type of loan, it will be those with excellent credit. Things like paying your bills on time, keeping your oldest credit cards open, and keeping your ratio of debt to available credit low will help keep your credit score high.
Unfortunately, personal finance has not yet become a required subject in high school or college, so you might be fairly clueless about how to manage your money when you’re out in the real world for the first time.
To help you get started, we’ll take a look at eight of the most important things to understand about money if you want to live a comfortable and prosperous life.
Learn Self Control
If you’re lucky, your parents taught you this skill when you were a kid. If not, keep in mind that the sooner you learn the fine art of delaying gratification, the sooner you’ll find it easy to keep your finances in order. Although you can effortlessly purchase an item on credit the minute you want it, it’s better to wait until you’ve actually saved up the money. Do you really want to pay interest on a pair of jeans or a box of cereal?
If you make a habit of putting all your purchases on credit cards, regardless of whether you can pay your bill in full at the end of the month, you might still be paying for those items in 10 years. If you want to keep your credit cards for the convenience factor or the rewards they offer, make sure to always pay your balance in full when the bill arrives, and don’t carry more cards than you can keep track of.
Take Control of Your Own Financial Future
If you don’t learn to manage your own money, other people will find ways to (mis)manage it for you. Some of these people may be ill-intentioned, like unscrupulous commission-based financial planners. Others may be well-meaning, but may not know what they’re doing, like Grandma Betty who really wants you to buy a house even though you can only afford a treacherous adjustable-rate mortgage.
Instead of relying on others for advice, take charge and read a few basic books on personal finance. Once you’re armed with personal finance knowledge, don’t let anyone catch you off guard – whether it’s a significant other that slowly siphons your bank account or friends who want you to go out and blow tons of money with them every weekend. Understanding how money works is the first step toward making your money work for you.
Know Where Your Money Goes
Once you’ve gone through a few personal finance books, you’ll realize how important it is to make sure your expenses aren’t exceeding your income. The best way to do this is by budgeting. Once you see how your morning java adds up over the course of a month, you’ll realize that making small, manageable changes in your everyday expenses can have just as big of an impact on your financial situation as getting a raise.
In addition, keeping your recurring monthly expenses as low as possible will also save you big bucks over time. If you don’t waste your money on a posh apartment now, you might be able to afford a nice condo or a house before you know it. (Read more on budgeting in our Budgeting special feature.)
Start an Emergency Fund
One of personal finance’s oft-repeated mantras is “pay yourself first”. No matter how much you owe in student loans or credit card debt, and no matter how low your salary may seem, it’s wise to find some amount – any amount – of money in your budget to save in an emergency fund every month.
Having money in savings to use for emergencies can really keep you out of trouble financially and help you sleep better at night. Also, if you get into the habit of saving money and treating it as a non-negotiable monthly “expense”, pretty soon you’ll have more than just emergency money saved up: you’ll have retirement money, vacation money and even money for a home down payment.
Don’t just sock away this money under your mattress; put it in a high-interest online savings account, a certificate of deposit or a money market account. Otherwise, inflation will erode the value of your savings.
Start Saving for Retirement Now
Just as you headed off to kindergarten with your parents’ hope to prepare you for success in a world that seemed eons away, you need to prepare for your retirement well in advance. Because of the way compound interest works, the sooner you start saving, the less principal you’ll have to invest to end up with the amount you need to retire and the sooner you’ll be able to call working an “option” rather than a “necessity.”
Company-sponsored retirement plans are a particularly great choice because you get to put in pretax dollars and the contribution limits tend to be high (much more than you can contribute to an individual retirement plan). Also, companies will often match part of your contribution, which is like getting free money.
Get a Grip on Taxes
It’s important to understand how income taxes work even before you get your first paycheck. When a company offers you a starting salary, you need to know how to calculate whether that salary will give you enough money after taxes to meet your financial goals and obligations. Fortunately, there are plenty of online calculators that have taken the dirty work out of determining your own payroll taxes, such as Paycheck City. These calculators will show you your gross pay, how much goes to taxes and how much you’ll be left with, which is also known as net, or take-home pay.
For example, $35,000 a year in New York will leave you with around $26,430 after taxes without exemptions in 2015, or about $2,032 a month. By the same token, if you’re considering leaving one job for another in search of a salary increase, you’ll need to understand how your marginal tax rate will affect your raise and that a salary increase from $35,000 a year to $41,000 a year won’t give you an extra $6,000, or $500 per month – it will only give you an extra $4,129, or $344 per month (again, the amount will vary depending on your state of residence). Also, you’ll be better off in the long run if you learn to prepare your annual tax return yourself, as there is plenty of bad tax advice and misinformation floating around out there. (To learn all about your taxes, visit our Income Tax Guide.)
Guard Your Health
If meeting monthly health insurance premiums seems impossible, what will you do if you have to go to the emergency room, where a single visit for a minor injury like a broken bone can cost thousands of dollars? If you’re uninsured, don’t wait another day to apply for health insurance; it’s easier than you think to wind up in a car accident or trip down the stairs.
You can save money by getting quotes from different insurance providers to find the lowest rates. Also, by taking daily steps now to keep yourself healthy, like eating fruits and vegetables, maintaining a healthy weight, exercising, not smoking, not consuming alcohol in excess, and even driving defensively, you’ll thank yourself down the road when you aren’t paying exorbitant medical bills.
Guard Your Wealth
If you want to make sure that all of your hard-earned money doesn’t vanish, you’ll need to take steps to protect it. If you rent, get renter’s insurance to protect the contents of your place from events like burglary or fire. Disability insurance protects your greatest asset – the ability to earn an income – by providing you with a steady income if you ever become unable to work for an extended period of time due to illness or injury.
Homebuyers usually have to purchase homeowners’ insurance if they plan on taking out a mortgage on their property. However, standard homeowners’ insurance doesn’t cover flooding, so homeowners at risk must purchase flood insurance coverage. Buyers should do their homework on flood insurance, since there are several myths and misconceptions about this product.
Consumers Must Purchase Private Flood Insurance
One common misconception about flood insurance is that consumers must purchase the insurance from a private insurance carrier. In fact, a federally regulated program, called the National Flood Insurance Program (NFIP), offers the most common flood insurance policies. A prospective policyholder can purchase two types of coverage — one that insures the value of a home up to $250,000 and another type that covers personal property up to $100,000. Buyers who require more than $250,000 of coverage on their homes must purchase excess flood insurance through a private carrier. Some private insurance carriers offer a purely private policy, but these policies cost more than NFIP policies and often only insure properties worth more than $1 million. Furthermore, many mortgage companies won’t accept private flood insurance, since it carries greater risks than the federal program.
Consumers Pay One Flat Rate
Another myth about flood insurance cost is that all buyers pay the same flat rate. Although the average one-year premium for flood insurance is $600, buyers should consult an insurance agent for an actual quote. Factors such as the amount of coverage, the deductible, the flood risk of the area and the condition and age of the building, impact the cost of coverage.
Flood Insurance Covers All Damages
What does flood insurance cover? One myth about flood insurance is that a flood policy covers all types of damage. Buyers of flood insurance should understand what exactly flood insurance covers in the event of an incident. A property policy from the NFIP covers the foundation of the home, electrical and plumbing, air conditioners, water heaters, furnaces, kitchen appliances, permanent carpeting, permanent wallboard and paneling, permanent cabinets and bookcases, window blinds, detached garages (limited to 10% of the home policy) and debris removal. An NFIP personal property policy covers clothing, furniture, electronic equipment, curtains, window air conditioning units, portable microwaves and dishwashers, carpets not covered by the property policy, washers, dryers, freezers, frozen food and up to $2,500 in valuables, such as furs or jewelry.
NFIP policies do not cover precious metals, stock certificates, bearer bonds and cash. They also do not cover trees, plants, wells, septic systems, walkways, decks, patios, fences, hot tubs, swimming pools, boathouses, retaining walls, storm shelters, temporary housing, loss of income, cars or mold damage.
Only Flood-Zone Residents Need Coverage
Another misconception about flood insurance is that only people in high-risk flood areas need coverage. In fact, residents outside of high-flood areas receive one-third of disaster relief for flooding and over 20% of flood insurance claims. Flooding is the most common type of natural disaster in the country, and all 50 states face risks. Buyers in high-risk zones, known as special hazard flood areas, must purchase flood insurance in order to qualify for a mortgage. However, buyers outside of those areas may also wish to purchase a policy. Homebuyers should consult the Federal Emergency Management Agency (FEMA) website to find out if their property is in an area that participates in the NFIP program. Since flooding impacts every state, almost all areas are eligible for coverage. Buyers outside of special hazard flood areas must assess their ability to withstand the financial loss from flooding. One resource that they can consult is the FloodSmart website. Homeowners can enter their address and receive estimates of their risk and their premiums, and a list of agents who serve their area.
All Excess Water Constitutes Flooding
Many people mistakenly believe that all excess water on a property constitutes a flood. In fact, water must either cover at least two acres of normally dry land or damage at least two or more properties in order to constitute a flood. In addition, the water must come from overflowing inland or tidal waters, rapid accumulation or runoff of surface waters, mudflows or shore front land collapses. Flood insurance does not cover water and seepage from sewer or drain backups.
Regret is not a fun feeling to experience. We’ve all been there, and focusing on what you could have done differently in the past will only rob you of your present time and happiness. Having positive financial aspirations will help provide you with joy as you move through life.
Here are five financial decisions you can focus your time on that you’ll surely never regret.
Pay Off Your Debt
In the society we live in it’s easy to forget about delayed gratification. Pretty much everything you’d ever want and need can be financed. Unfortunately, with debt and loans comes an interest rate that dwindles our net worth and saving accounts. Keeping your debt manageable or focusing on eliminating it all together will provide you with a healthier financial picture.
Focus on the Long Term
Financially speaking, focusing on the long term is something that will never disappoint you. The sooner we start planning for our children, life milestones and retirement, the easier those phases of life are. There are many options for saving and preparing long-term such as a 529 college savings plan, a 401(k), an IRA, or Roth IRA. Your retirement plan could depend on your employer and the benefits. The choice between a 401(k) or IRA will depend on your own personal needs and how much you wish to contribute to those accounts.
Save First, Then Buy
This concept is the opposite of how many consumers function financially. The logic we see typically is buy now, pay later. This is why we are a country that’s severely in debt. Not only is saving first and then buying beneficial to our financial health, but it’s also rewarding. When we save and work hard for something, we are likely to appreciate it more. We’re also more aware of the value of money. When we use lines of credit to purchase materialistic items that decrease in value as soon as it’s purchased, we’re less likely to value the dollar, resulting in too much borrowing, spending, and living outside of our means.
Grow Your Savings
Growing your savings is a suggestion you may have heard a million times, but it’s still so important. A good rule of thumb is to save first, then spend. One way to do this is by establishing a monthly budget. If you can set a realistic budget and live within your resources, you can put the extra money you’ve earned into your savings immediately when you’re paid. You’ll be so relieved to have a substantial savings built up when those unexpected life happenings present themselves such as the loss of a job, a big medical expense, or a large home repair.
Hire a Fee-Only Financial Advisor
Now we may be slightly biased on this last tip, but having an expert involved in your financial planning will help you maintain a healthier financial picture. You may find that choosing between a 401(k) or an IRA, planning your taxes, and maintaining little-to-manageable debt is easier with a financial advisor. It’s important to hire a fee-only financial advisor because they have a fiduciary obligation to act in your best interest.
These tips require patience and it could take you several months to implement each one; however, you’ll enjoy living a healthy financial life by accomplishing each step.
Many investors wonder whether or not investing in stocks is worth all the hassle. At the same time, however, it’s important to keep a realistic view of the stock market. Regardless of the real problems, common myths about the stock market often arise. Here are five of those myths.
1. Investing in Stocks Is Just Like Gambling.
This reasoning causes many people to shy away from the stock market. To understand why investing in stocks is inherently different from gambling, we need to review what it means to buy stocks. A share of common stock is ownership in a company. It entitles the holder to a claim on assets as well as a fraction of the profits that the company generates. Too often, investors think of shares as simply a trading vehicle and they forget that stock represents the ownership of a company.
In the stock market, investors are constantly trying to assess the profit that will be left over for shareholders. This is why stock prices fluctuate. The outlook for business conditions is always changing, and so are the future earnings of a company.
Assessing the value of a company isn’t an easy practice. There are so many variables involved that the short-term price movements appear to be random (academics call this the Random Walk Theory); however, over the long term, a company is supposed to be worth the present value of the profits it will make. In the short term, a company can survive without profits because of the expectations of future earnings, but no company can fool investors forever – eventually a company’s stock price can be expected to show the true value of the firm.
Gambling, on the contrary, is a zero-sum game. It merely takes money from a loser and gives it to a winner. No value is ever created. By investing, we increase the overall wealth of an economy. As companies compete, they increase productivity and develop products that can make our lives better. Don’t confuse investing and creating wealth with gambling’s zero-sum game.
2. The Stock Market Is an Exclusive Club For Brokers and Rich People.
Many market advisors claim to be able to call the markets’ every turn. The fact is that almost every study done on this topic has proven that these claims are false. Most market prognosticators are notoriously inaccurate; furthermore, the advent of the internet has made the market much more open to the public than ever before. All the data and research tools previously available only to brokerages are now there for individuals to use.
3. Fallen Angels Will Go Back up, Eventually.
Whatever the reason for this myth’s appeal, nothing is more destructive to amateur investors than thinking that a stock trading near a 52-week low is a good buy. Think of this in terms of the old Wall Street adage, “Those who try to catch a falling knife only get hurt.”
Suppose you are looking at two stocks:
1. X made an all-time high last year around $50 but has since fallen to $10 per share.
2. Y is a smaller company but has recently gone from $5 to $10 per share.
Which stock would you buy? Believe it or not, all things being equal, a majority of investors choose the stock that has fallen from $50 because they believe that it will eventually make it back up to those levels again. Thinking this way is a cardinal sin in investing!
Price is only one part of the investing equation (which is different from trading, which uses technical analysis). The goal is to buy good companies at a reasonable price. Buying companies solely because their market price has fallen will get you nowhere. Make sure you don’t confuse this practice with value investing, which is buying high-quality companies that are undervalued by the market.
4. Stocks That Go up Must Come Down.
The laws of physics do not apply in the stock market. There’s no gravitational force to pull stocks back to even. Over 20 years ago, Berkshire Hathaway’s stock price went from $7,455 to $17,250 per share in a little more than five years. Had you thought that this stock was going to return to its lower initial position, you would have missed out on the subsequent rise to $170,000 per share over the years.
We’re not trying to tell you that stocks never undergo a correction. The point is that the stock price is a reflection of the company. If you find a great firm run by excellent managers, there is no reason the stock won’t keep on going up.
5. A Little Knowledge Is Better Than None
Knowing something is generally better than nothing, but it is crucial in the stock market that individual investors have a clear understanding of what they are doing with their money. Investors who really do their homework are the ones that succeed.
If you don’t have the time to fully understand what to do with your money, then having an advisor is not a bad thing. The cost of investing in something that you do not fully understand far outweighs the cost of using an investment advisor.
You may be wondering at what age you should start saving for retirement. That’s a simple answer – as soon as possible. The moment you start earning money you should think about saving for retirement. The earlier you start, the less money you’ll need to contribute, thanks to power of compounding. Compounding allows you to earn more money on the money you invest as long as you reinvest your earnings on that money.
So how do you get started? The first habit you need to incorporate in your weekly budget is to pay yourself first. Then be sure you take advantage of the free money from your employer if your company offers a qualified retirement plan. If you’re self-employed, you have different options to make saving for retirement easier. If you’re employed with no employee retirement savings options, then you can use a traditional IRA, but may want to consider a Roth. If you change jobs, be sure to take control of your savings by rolling them into an IRA. Finally, start developing a vision of where you want to go and how you want to live in the future.
Let’s take a closer look at these possible steps:
1. Pay Yourself First
Many people think of retirement savings as the money they put away if there is any cash left at the end of the month. Generally when you try to save that way, you tend to put away very little or nothing each month.
“Paying yourself first means saving before you do anything else,” says David Blaylock, CFP, senior financial planner at LearnVest Planning Services. “Try and set aside a certain portion of your income the day you get paid before you spend any discretionary money. Most people wait and only save what’s left over—that’s paying yourself last.”
Try putting aside just $10 a week (maybe bring two lunches rather than eat out twice a week or skip a few trips to your favorite coffee place). That may not sound like much but, thanks to monthly compounding, it could grow surprisingly large.
Let’s say you save $40 per month and invest that money at 4.65%, which is what the Vanguard Total Bond Market Index Fund earned over 10 years. Using an online savings calculator, an initial amount of $40, plus $40 per month for 30 years adds up to $31,550. Jack up the interest rate to 8.79%, the average yield of the Vanguard Total Stock Market Index Fund over 10 years, and the number rises to more than $70,000.
These sorts of funds aren’t open to very small investors, however. If you’re starting with just $40 a month, you won’t be able to purchase these higher earning investments right away. You will need to start with an IRA at your local bank. Most banks allow you to start an IRA using a money market fund for as little as $100. You will need to build that fund to savings level of $1,000 in order to buy into an IRA at most mutual fund companies. At $40 per month or $480 per year, it would take about 2 ½ years to save $1,000. Interest paid on that savings would likely be at only about 1%, so your initial funding will come mostly from savings. One good fund that allows a $1,000 minimum is the Vanguard Star Fund with an average return of 7.6% over ten years. Once you have at least $3,000 in your IRA you can purchase the Vanguard index funds mentioned above.
You can increase your savings as your income increases and your nest egg can be a lot larger. Determine the investment mix that’s best for you and use a savings calculator to see how fast your money can grow based on the amount you can pay yourself first.
2. Get Your Free Money From Your Employer
If you who work for an employer that offers a retirement savings option, be certain you take full advantage of any employer match for that plan.
“If you are a typical salaried or hourly full-time employee in the United States, you’ve probably heard about your 401(k) plan. Fifty-two million Americans use them. Such plans held $3.5 trillion in retirement assets at the end of 2012. Folks who work in educational institutions have access to similar programs, known as 403(b) plans. State employees use 457 plans. They all do the same thing: Give you free money,” writes Mitch Tuchman.
The first part of the free money is that your contributions are made with pre-tax dollars and lower your taxable income. Even better, many employers offer to match your contributions to the retirement savings plan. For example, an employer may contribute up to 6%, but that contribution is based on you making the same contribution out of your paycheck. You don’t want to leave that money on the table, so be sure to find out the details of your company’s retirement savings plan and try to put in enough money to match that employer guarantee.
If you can’t afford to contribute enough for the full employer match, add to your percentage contribution each time you get a raise. For example, if you were to get a 4% raise, increase your retirement savings contribution by 1%. That way you still enjoy some increase in your pay, but pay yourself first as well. Since contributions to these retirement saving plans are tax-deferred, the actual amount of cash that will be taken out of your raise will be less than 1% depending on your tax bracket.
For more information, read 401(k) Plans: Roth Or Regular? and Smart Ways To Manage Your 401(k).
3. Self-Employed Retirement Saving Options
If you’re self employed, you have many different types of retirement savings options. These include a Solo 401(k), SEP IRA and Simple IRA.
The Solo 401(k), also known as an Independent 401(k) is similar to the types of 401(k)s offered by employers. You can contribute money both as the employee and employer. That allows you to save as much as $17,500 if you are under 50 or $23,000 if you are 50 or older as the employee plus up to $52,000 as the employer ($57,500 if you are 50 or older). You can only use this plan if you are a sole proprietor. The only other employee you can have is your spouse.
The SEP IRA another option with similar contribution allowances, but it is simpler to set up. This type of IRA can be used by small businesses with employees, but the disadvantage can be that if you do decide to contribute, you must contribute for all employees who are part of the plan.
The Simple IRA is this third option for small business people or people who are self-employed. This, too, is easy to set up and operate but has lower contribution thresholds.
For more details on these retirement savings options read Retirement Planning for the Self Employed.
4. Traditional or Roth IRA
If none of the above options are available to you, start your own IRA. There are two types – a traditional IRA, which lets you save tax-deferred, and a Roth IRA, which you open with post-tax money. When you use a traditional IRA, you can deduct the amount you contribute each year from your income, but you will have to pay taxes on the money as you take it out. You pay taxes on both your contributions and any gains earned while the money is invested.
Although the money you put into a Roth IRA is after-tax cash, it means that when you take the money out at retirement, you don’t have to pay any taxes – either on the money you originally contributed to the Roth IRA or on the gains your money earned.
To figure out which IRA is best for you, read Roth Versus Traditional IRA: Which is Right for You?
5. Keep Control of Your Retirement Funds
When you change jobs, you’ll need to decide what to do with your employee retirement saving accounts. You’ll have the choice to cash them out, leave them with the employer (if the employer allows this) or roll them over into an IRA or, perhaps, into the 401(k) at your new job.
Rolling your employee retirement savings into an IRA is your best option: “Rolling money into an IRA opens the toolbox, so to speak, for the investor to invest in individual stocks, bonds – the whole range of investments is now available,” says Daniel Galli, a Norwell, Mass., certified financial planner. With an IRA, you can choose how to invest the money, rather than being limited by the choices in an employee plan.
As your savings build, you may want to get the help of a financial advisor to determine the best way to apportion your funds. Some companies even offer free or low-cost retirement planning advice as part of their 401(k) programs.
6. Think About Life in Retirement
As you begin to establish financial goals for your future, start imagining how you might want to live. Do you want to travel the world? Is there a business you want to start or a second career you’ve dreamed of exploring? Do you just want time to enjoy where you’re living and get better at golf – or help your kids. Saving for retirement before anything else will give you the best chance of ending up with a nest egg that will enable you to support your family and your life. Your goals will change, but they probably won’t be free.
Retirement planning is the process of identifying your long-term income, determining your intended lifestyle and defining how to reach those goals. When planning for retirement, you’ll need to consider a variety of factors, such as when you’ll retire, where you’ll live and what you’ll do. Keep in mind with each additional year you hope to retire early, your investment needs greatly increase. Also consider the difference in cost of living among cities, or even among neighboring ZIP codes. Add on daily expenses, medical expenses, vacations and emergencies, and you begin to see how the costs of retirement add up.
Your retirement goals will depend largely on the income you can expect during your retirement and will likely evolve as your plans, risk tolerance and investment horizon change. While specific investing “rule of thumb” guidelines (like “You need 20 times your gross annual income to retire” or “Save and invest 10% of your pre-tax income) are helpful, it’s important to step back and look at the big picture. Consider these six essential rules for truly smart retirement investing.
1. Understand Your Retirement Investment Options
You can save for retirement in a variety of tax-deferred vehicles, some offered by your employer and others available via a brokerage firm or bank. It’s important to take advantage of all your options, including investigating what kind of retirement benefits your employer may offer; some employers still offer defined benefit pensions, which is a big bonus during a time of volatility in the stock market.
When building your portfolio in a retirement account, it’s important to understand the risk/reward relationship when choosing your investments. Younger investors may focus on higher risk/higher reward investments, such as stocks, because they have decades left to recover from losses. People nearing retirement, however, are less able to recover and therefore tend to shift their portfolios toward a higher proportion of lower risk/lower reward investments, such as bonds. Retirement vehicles and common portfolio investments include:
401(k)s and Company Plans – Employer-sponsored plans, including 401(k)s, that provide employees with automatic savings, tax incentives and (in some cases) matching contributions.
Defined Benefit Plans – An employer-sponsored retirement plan in which employee benefits paid during retirement are based on a formula using factors such as salary history and duration of employment.
Individual Retirement Accounts (IRAs) – Individual savings accounts that allow individuals to direct pretax income, up to annual limits, toward investments that can grow tax-deferred.
Roth IRA – An individual retirement plan that bears many similarities to the traditional IRA, but contributions are not tax deductible and qualified distributions are tax free.
SEP – A retirement plan that an employer or self-employed individual can establish. Contributions to SEP IRAs are immediately 100% vested, and the IRA owner directs the investments.
SIMPLE IRAs – A retirement plan that can be used by most small businesses with 100 or fewer employees.
Annuities – Insurance products that provide a source of monthly, quarterly, annual or lump-sum income during retirement.
Mutual Funds – Professionally managed pools of stocks, bonds and/or other instruments that are divided into shares and sold to investors.
Stocks – Securities that represent ownership in the corporation that issued the stock.
Bonds – Debt securities in which you lend money to an issuer (such as a government or corporation) in exchange for interest payments and the future repayment of the bond’s face value.
Exchange Traded Funds (ETFs) – Uniquely structured investment funds that trade like stocks on regulated exchanges that track broad-based or sector indexes, commodities and baskets of assets.
Cash Investments – Low-risk, short-term obligations that provide returns in the form of interest payments (for example, CDs and money market deposit accounts).
Direct Reinvestment Plans (DRIPs) – Plans offered by corporations that allow you to reinvest cash dividends by purchasing additional shares or fractional shares on the dividend payment date.
2. Start Early
No matter what you read about retirement investing, one piece of advice stays the same: Start early. Why?
Barring a major loss, more years saving means more money by the time you retire.
You gain more experience and develop expertise in a wider variety of investment options.
You have more time to survive losses, which increases your ability to recover from major hits and gives you more freedom to try higher risk/higher reward investments.
You make saving and investing a habit.
You can take advantage of the power of compounding – reinvesting your earnings to create a snowball effect with your gains.
Remember that compounding is most successful over longer periods of time. Here’s an example to illustrate: Assume you make a single $10,000 investment when you are 20 years old and it grows at 5% each year until you retire at age 65. If you reinvest your gains (this is the compounding), your investment would be worth $89,850.08.
Now imagine you didn’t invest the $10,000 until you were 40. With only 25 years to compound, your investment would be worth only $33,863.55. Wait until you’re 50 and your investment would be valued at just $20,789.28. This is, of course, an overly simplified example that assumes a constant 5% rate without taking taxes or inflation into consideration. It’s easy to see, however, that the longer you can put your money to work, the better. Starting early is one of the easiest ways to ensure a comfortable retirement.
3. Do the Math
You make money, you spend money. For many, this is about as deep as their understanding of cash flow gets. Instead of making guesses about where your money goes, you can calculate your net worth. Your net worth is the difference between what you own (your assets) and what you owe (your liabilities). Assets typically include cash and cash equivalents (for example, savings accounts, Treasury bills, certificates of deposit), investments, real property (your home and any rental properties or a second home), and personal property (such as boats, collectibles, jewelry, vehicles and household furnishings). Liabilities include debts such as mortgages, automobile loans, credit card debt, medical bills and student loans. Adding up all of your assets and subtracting the sum of your liabilities leaves you with the total amount of money you truly possess (your net worth), and a clear view of how much money you’ll need to earn to reach your goals.
As soon as you have assets and liabilities, it’s a good time to start calculating your net worth on a regular basis (yearly works well for most people). Since your net worth represents where you are now, it’s beneficial to compare these figures over time. Doing so can help you recognize your financial strengths and weaknesses, allowing you to make better financial decisions in the future.
It’s often said that you can’t reach a goal you never set, and this holds true for retirement planning. If you fail to establish specific goals, it’s difficult to find the incentive to save, invest and put in the time and effort to ensure you are making the best decisions. Specific and written goals can provide the motivation you need. Examples of written retirement goals:
I want to retire when I’m 65.
I want move to a small house near the kids.
I want to travel internationally 12 weeks each year.
I’ll need $48,000 each year to do these things.
To retire at 65 and spend $48,000 for the following 20 years, I’ll need a minimum net worth of $960,000 (a simplified figure that does not take into consideration taxes, inflation, changes to Social Security benefits, changes to investment earning rates, etc.).
4. Keep Your Emotions in Check
Investments can be influenced by your emotions far more easily than you might realize. Here’s the typical pattern of emotional investment behavior:
When investments perform well
Overconfidence takes over.
You underestimate risk.
You make bad decisions and lose money.
When investments perform badly
Fear takes over.
You put all your money into low-risk cash and bonds.
You don’t make any money.
Emotional reactions can make it difficult to build wealth over time, as potential gains are sabotaged by overconfidence and fear makes you sell (or not buy) investments that could grow. As such, it is important to:
Be realistic – Not every investment will be a winner, and not every stock will grow as your grandparents’ blue-chip stocks did.
Keep your emotions in check – Be mindful of your wins and losses – both realized and unrealized. Rather than reacting, take the time to evaluate your choices and learn from your mistakes and successes. You’ll make better decisions in the future.
Maintain a balanced portfolio – Create a blend of stocks, bonds and other investment instruments that make sense for your age, risk tolerance and goals. Re-balance your portfolio periodically as your risk tolerance and goals change. Why Investors Need to Rebalance Their Portfolios will give you the details.
5. Pay Attention to Fees
While you are likely focus on returns and taxes, your gains can be drastically eroded by fees. Investment fees cause you to incur direct costs – the fees that are often taken directly out of your account – and indirect costs – the money you paid in fees that can no longer be used to generate returns.
Common fees include:
Depending on the types of accounts you have and the investments you select, these fees can really add up. The first step is to figure out what you’re spending on fees. Your brokerage statement will indicate how much you’re paying to execute a stock trade, for example, and your fund’s prospectus (or financial news websites) will show expense ratio information. Armed with this knowledge, you can shop for alternative investments (such as a comparable lower-fee mutual fund) or switch to a broker that offers reduced transaction costs (many brokers, for example, offer commission-free ETF trading on select groups of funds).
As the table shows, if you invest in a fund with a 2.5% expense ratio, your investment would be worth $46,022 after 20 years, assuming a 10% annualized return. At the other end of the spectrum, your investment would be worth $61,159 if the fund had a lower, 0.5% expense ratio – an increase of more than $15,000 over the 2.5% fund’s return.
6. Get Help When You Need It
“I don’t know what to do” is a common excuse for postponing retirement planning. Like ignorantia juris non excusat (loosely translated as ignorance is no excuse), lack of knowledge about investing is not a convincing excuse for failing to plan and invest for retirement.
There are plenty of ways to receive a basic, intermediate or even advanced “education” in retirement planning to fit every budget, and even a little time spent goes a long way, whether through your own research, or with the help of a qualified investment adviser, financial planner, Certified Public Accountant (CPA) or other professional. You’re planning for your future well-being, and “I didn’t know what to do” won’t pay the bills when you’re 65. Your Retirement-Planning Team will give you some ideas of where to turn.
It’s a long held belief that market timing and investing are mutually exclusive, but the two strategies work well together in producing solid returns over a number of years. The effort requires a step back from the buy-and-hold mindset that characterizes modern investing and adding technical principles that assist entry timing, position management, and if needed, early profit taking.
Start with this set of technical tips that can guide your investments through a gauntlet of modern market dangers.
Become a Student of Long-term Cycles
Look back and you’ll notice that bull markets ended in the sixth year of the Reagan administration and the eighth years of both the Clinton and Bush administrations. These historic analogs and cycles can mean the difference between superior returns and lost opportunities. Similar long-term market forces include interest rate fluctuations, the nominal economic cycle, and currency trends.
Watch the Calendar
Financial markets also grind through annual cycles that favor different strategies at certain times of year. (See Incorporating Seasonality Into The Trading Day). For example, small caps show relative strength in the first quarter that tends to evaporate into the 4th quarter, when speculation on the new year reawakens interest. Meanwhile, tech stocks tend to perform well from January into early summer and then languish until November or December. Both cycles roughly follow the market adage to “sell in May and go away”.
Buy in Ranges that are Setting Up New Trends
Markets tend to trend higher or lower about 25% of the time in all holding periods, and get stuck in sideways trading ranges the other 75%. A quick review of the monthly price pattern will determine how the prospective investment is lining up along this trend-range axis. These price dynamics follow the old market wisdom that “the bigger the move, the broader the base”.
Buy Near Support, Not Near Resistance
The worst thing an investor can do is to get emotional after an earnings report, using it as a catalyst to initiate a position without first looking at current price in relation to monthly support and resistance levels. The most advantageous entries come when buying an equity that’s broken out to an all-time high or coming off a deep base on high volume.
iShares Russell 2000 ETF (IWM) broke out of a 2-year trading range in 2012 and gained 45 points in 16 months before easing into a new range that also lasted 16 months before yielding a fresh uptrend. Investors felt bullish in the upper half and bearish in the lower half of the 2014 range, although buying into the most negative sentiment at the bottom of the range offered the most profitable entry.
Build Bottom Fishing Skills
Traders are taught not to average down or catch falling knives, but investors benefit when building positions that have fallen hard and fast, but show characteristics of bottoming out. (See 3 Ways To Tell If Your Stock Has Bottomed). It’s a logical strategy that establishes preferred average entry and capitulation prices, buying tranches around the magic number while the instrument works through a basing pattern. If the floor breaks, execute an exit plan that disposes of the entire position at or above the capitulation price.
Apple (AAPL) topped out at 100 after a powerful rally and enters a steep correction. Prospective investors can pull up a Fibonacci grid stretched across the 4-year trend and identify harmonic levels that could attract strong buying interest. (For more, read Placing Fibonacci Grids Is Key To Your Trading Strategy). The clearly marked retracements support buying the first tranche of a new position when the decline reaches the 38.6% retracement at 66.
The descent continued to the 50% harmonic level at 56, while monthly Stochastics crossed the oversold level for the first time since 2009 and price settled on the 50-month EMA, a classic long term support level. Investors have another four months to build positions within the evolving base, ahead of an uptrend that reaches an all-time high in 2014.
Identify Correlated Markets
Algorithmic cross-control between equities, bonds and currencies define the modern market environment, with massive rotational strategies in and out of correlated sectors on a daily, weekly and monthly basis. This exposes the portfolio to elevated risk because seemingly unrelated positions may be sitting in the same macro basket, getting bought and sold together. This high correlation can destroy annual returns when a “black swan” event comes along. (See: Black Swan Events And Investment).
Mitigate this risk by coupling each position with a related index or ETF, performing two studies at least once a month or quarter. First, compare relative performance between the position and correlated market, looking for strength that identifies a sound investment. Second, compare correlated markets to each other, looking for relative strength in the groups you’ve chosen to own. You’re firing on all cylinders when both studies point to market leadership.
Buy-and-Hold Until There’s No Reason to Hold
In a passive approach, investors sit on their hands regardless of economic, political and environmental conditions, trusting statistics that favor long-term profitability. What the numbers don’t tell you is they’re computed with indices that may have no correlation to your exposure. Just ask shareholders who bought into the coal industry in the last 10 years. As a result, it makes sense for investors to identify a capitalization price for each position.
Your profitable investments may also require an exit strategy, although you initially planned to hold them for life. Consider a multiyear position that finally reaches an historic high going back between 5 and 20 years. These lofty price levels mark strong resistance that can turn a market and send it lower for years, so it makes sense to take the profit and apply the cash to a more potent long-term opportunity.
Although many Americans worry about retirement and are doing everything they can to save for it, they commonly look at their retirement plan balances as means of measuring their progress. But the ultimate end of retirement savings is to generate income, so projecting your future cash flow can provide a more realistic indicator of financial preparedness. The key is to remember that there is a statistically a real chance that you could live well into your nineties.
Analyzing Desired Cash Flow
The first step to projecting your cash flow during retirement is to look at your current budget. If you are able to save at least 10% of your income now, then your retirement income will probably only need to be 90% of your current income level at most, with adjustments for inflation. But the amount of income that you will need after you stop working is not likely to be substantially less than what you need now. If you make $75,000 now and plan to retire in 10 years when you are 70 years old, then you will probably need to receive at least $65,000 a year after you retire unless your expenses are going to be a lot lower than they are now. If you plan on staying in your current residence and will have it paid off by retirement, then you can obviously reduce your monthly expenditures by the amount of principal and interest (but not insurance and taxes) that you are currently paying each month.
Translating your nest egg into monthly income requires the quantification of several variables and the ability to perform some time-value of money (TVM) calculations. There are several TVM calculators available online at websites such as Bankrate.com, and these tools can help you to see how long you can realistically make your money last with a given set of assumptions. If you have $250,000 saved up and need to make your money last for 30 years, then you will need to allocate a significant percentage of your portfolio to equities. However, you may want to take a more conservative overall position in your portfolio during the first few years of retirement, because your draw down risk (the chance that you will significantly decrease the earning power of your portfolio from initial market losses) is the greatest during your early retirement years.
For example, if you have $500,000 in your 401(k) plan and your plan balance drops by $150,000 the year after you retire because of a market correction, then you have lost $150,000 of principal that you could have used to generate investment income for the rest of your life. Therefore, a more stable allocation at the beginning can help you to avoid large initial losses that can permanently cripple your portfolio. But if the numbers that you run show that you’re not going to have remotely the amount of income that you want to have when you retire, then you will need to start considering some major changes such as delaying your retirement or downscaling your future lifestyle.
Delaying your Social Security benefits can also increase your income in your later years if you are able to afford this option, but you may be better off taking it earlier and then socking that money away in a Roth IRA or other retirement vehicle while you continue to work. There is no one right answer to solving the retirement income equation, but some options are almost always going to be better than others. You may want to take a look at a longevity insurance policy that will provide a substantial guaranteed monthly payout after age 85 if you think that there is a good chance that you will make it into your nineties. This type of policy can allow you to map out the rest of your retirement plan with more precision, as you will usually only have to make the rest of your savings last until this payout kicks in.
Get Professional Help
Cash flow analysis is where a financial planner can really be of service. A comprehensive financial plan can show how long your money will last at a given rate of dispersion in your tax bracket. It can also incorporate other variables such as market performance and your estimated Social Security benefits. Perhaps most importantly, it can also show you what will happen with your finances if you live to be 95. About one in five Americans will. And a financial planner who also manages assets can help you to determine the correct mix of assets during each stage of your retirement so that you can get the most from your money over time.
You’ve finally received a hard-earned raise. Unfortunately, that raise has bumped you into the next tax bracket. Does that mean you should tell your employer you don’t want the raise after all? If all of your income is going to be taxed at a higher rate, with your new raise, you’re actually going to take home a smaller paycheck. Right?
Fortunately, this statement isn’t true, but it’s a common misconception about how our progressive federal income tax system works. While people are taxed at higher rates when they earn higher levels of employment income, only a portion of their income, not all of their income, is taxed at the higher rate. Let’s take a look at how the system works.
How to Calculate How Much Tax You Owe
As you’ve already noticed, the more money you earn, the more tax you pay. Not only that, but as you earn more money, you pay a progressively higher tax rate. The two tax tables below show the tax rates the IRS requires you to pay on your 2011 income if you’re single or married filing jointly.
Your marginal tax rate is the rate of tax that applies to each additional dollar of income that a taxpayer earns. If you are single and you earned $34,500 a year before your raise, you were in the 15% marginal tax bracket. Your tax liability was $850 plus 15% of the amount over $8,500. The amount you earned over $8,500 was $26,000, so you owe $3,900 in tax on $26,000 and $850 in tax on $8,500 for a total of $4,750 in tax. While your marginal tax rate was 15%, your effective tax rate, or the average rate of tax you paid on your total income, was lower. To get your effective tax rate, divide your total tax by your total income. In this case, $4,750/$34,500 gives you an effective tax rate of 13.8%. (For more, check out How Your Tax Rate Is Determined.)
Now, let’s look at what happens to your tax rate and the total tax you owe after your raise. Let’s say you received a whopping $10,000 raise and your annual income is now $44,500. How much tax will you owe?
You already know that you owe $4,750 on the first $34,500 you earned. But now that your total income is between $34,500 and $83,600, you must pay a higher rate of tax. Your $10,000 raise bumps you into the 25% tax bracket. However, you will not pay 25% on all $44,500 of your income, just like you didn’t pay 15% on all $34,500 of your income before you got a raise. The 25% rate only applies to your $10,000 raise. You’ll owe an additional $2,500 a year in tax, for a total of $7,250 ($4,750 + $2,500).
What overall rate of tax are you paying on your $44,500 salary? Divide your salary, $44,500, by your total tax, $7,250, and you’ll see that your effective tax rate is 16.3%, not 25%. With your raise, you’re taking home an extra $7,500 a year. You may not be happy about the high percentage of your raise the government has claimed, but you are going to take home significantly more pay than you did before your raise.
Deductions and Credits
The above example is simplified; it doesn’t account for the deductions and credits that reduce your taxable income. Every taxpayer can choose whether to take a standard deduction or to itemize deductions. If you’re single and don’t own a home, you probably don’t have many deductions to itemize, so you’ll take the standard deduction. The standard deduction reduces the amount of your taxable income. Instead of paying tax on all $44,500 that you earn, you’ll pay tax on that amount minus the standard deduction. In 2011, the standard deduction for single filers is $5,800, reducing your taxable income to $38,700.
Whether you itemize or take the standard deduction, you’re also entitled to a personal exemption, which reduces your taxable income even further. For your 2011 return, the standard exemption is $3,700. Now your taxable income is $35,000. Your marginal tax rate is still 25%, but only $500 of your income will be taxed at 25%.