Why Having More Cash Doesn't Mean a Better Retirement

Maybe you think that having more money will allow you to retire comfortably so you can afford rockclimbing in your 80s, like that cute pink-cheeked grandmother that you saw on Buzzfeed.

You'd be wrong.

Even if you earn an upper middle class income, it's depressingly easy to whittle away the money and leave yourself without much to retire on. Worse, even when you try to do the right thing the system can mess up your plans.

Meet the Richardsons

Mom Richardson has a good PR job earning $70,000/year with a $5,000/year pension. Dad Richardson is a business guy pulling in $85,000/ year, with a pension worth $7,000/year. They're upper middle class with a salary of $155,000 and can afford good dinners out—not to mention the nice clothes they need for their jobs.

They're married, they don't have alimony payments to ex-husbands or ex-wives, and they haven't done anything ridiculous with their money like investing in Space Monkeys or trying to claim that inheritance overseas that some nice man in an email told them about.

That doesn't mean they have it made.

Since the Richardsons earn more, they get taxed more than their neighbors with smaller incomes. On a salary of $155,000, they might pay state taxes of $10,000 and federal taxes of $35,000, leaving them with $110,000 to live on.

But then there are expenses. Their annual costs for stuff adds up:

Mortgage: $10,000.
Groceries: $8,000.
Heat for the house: $3,000.
Electrical and Water bills: $3,000.
Two cars, gas, insurance, maintenance: $5,000.
Clothing: $4,000.
Family trip: $3,000.
Birthday presents: $2,000.
Dinners out every so often: $3,000.
Backyard supplies, maintenance: $2,500.
Home supplies: $2,000.
Home repairs, maintenance: $3,000.
Co-pay healthcare issues: $1,500.
Other stuff that just comes up: $10,000.

Grand Total: $60,000.

So assuming that there's no disaster, they might save $50,000 a year ($110,000-$60,000). But if Mom and Dad Richardson have had three children (including you) and you're all headed to college, that's going to cut into their savings.

If you go to a modest state school and earn part of your way or get some scholarships or student loans, maybe they only need to contribute $10,000 per year for each of you. That's still $30,000 for three kids. And that's assuming that you and your siblings aren't gunning for the Ivy Leagues, where costs are much higher.

Even if they pay $30,000 a year for college costs and other costs, that still leaves them with $20,000 in savings and investment money each year.

Seems like a decent amount.

The Reality of Retirement

Let's say the Richardsons work for 20 more years, socking away their $20,000 each year faithfully. Over 20 years, that's $400,000 in savings.

What can they do with that? Well, they can invest in stocks, which are tiny parts of a company. They can buy stocks in Apple, IBM, or any company that is traded publicly on the stock market. If the company does well, they can earn dividends or profits on their stock, or they can sell the stock for profit if the company's stock goes up in value. If the company goes out of business or drops in value, though, they could end up losing money.

They can also invest in bonds, a portion of a government's or company's debt. They get part of the interest that the government or company pays on their debt. Bonds are less risky than stocks, but can also earn less money.

Another option is to invest in index funds. Index funds group together stocks and bonds together in one investment, so that the stocks make the fund make more money while the bonds make the whole thing more stable. If they wanted to be careful with their cash, the Richardsons could invest in an Index fund with more bonds or if they wanted a shot at more money from their investment, they could choose one with more stocks.

Let's say the Richardsons went with an index fund that had plenty of bonds. After twenty years, they're 70 years old and have a million dollars for their retirement, including $650,000 in personal investment and $350,000 in pensions.

They can get $650,000 from their index fund if their average annual return is 4.84%. (The annual return is the amount of money an investment makes during a year. So if you invest $1,000 and then have $1,050 after a year, you have made $50 or 5% of your investment, and your annual return is 5%.)

Making the Most of Retirement Investments

The Richardsons (and you) want to make the most money from investments, and there are three ways to do that:

(1) Start young. If the Richardsons had started investing from the time they set up their first lemonade stand at the heady age of five, they'd have a lot more than a million dollars now.

(2) Increase the amount of money you're investing.

(3) Increase the amount of your annul return. If the Richardsons had invested the same amount of money at the same time but got an annual return of only one tiny percent difference, they'd have a huge difference when it came time to spend their money:

Even tiny changes—like saving for an extra year or saving an extra $2,000 per year by downgrading their toilet paper—could mean tens of thousands of dollars by the time they retire.

There's just one tiny problem: it's hard to tell whether a stock will go up in price or whether an Index fund will perform as well as it's supposed to. So how can you tell whether you're making smart investment choices? The local science fiction convention may swear by Star Wars collector's items and your bank may suggest the new fund they've created.

Ultimately, though, you get to choose—and we hope you don't pick a lemon.

Whose Money is it, Anyway?

It may seem that the Richardsons are doing well with $650,000 in private investments. But what happens when they try to get at some of the money?

Good old Uncle Sam shows up at their door.

If you sell your stocks for profit, you may have to pay taxes on that profit: anywhere from 0%–35%. If the government demands 30% from the Richardsons, they're seeing $30,000 taken away from them. The state government may want to get in on the party and take its portion of the tax, too. And bonds? They're also taxable.

So how can you keep other people's grubby mitts off of your money? Well, you could move into the wilds of Canada and live off moose meat to escape the IRS.

401k

A better option—one that includes showers and dental floss—is to stay put and put money into a 401(k). This is a type of retirement account that your boss can set up for you. Your money goes directly into the account, and the IRS can't touch it until you take that money out.

Once you're retired and get a craving for prune juice or decide to add rims to your wheelchair, you'll start to take money out of your 401(k); that's when you're going to get taxed. The good news is that while the money was hanging out in the account, there was no tax, which allowed the money to grow faster.

It can seem like you're just procrastinating on the inevitable, but there's a money advantage to paying the tax later. When you're (relatively) young and hard at work, you're probably making more money and the government is taxing you more. By the time you're old and wrinkled, you're likely earning less in pensions and the government is taxing you less and going after those who are still in the workforce. So by waiting to get taxed on your retirement until you're older, you're being taxed a smaller amount.

IRA

If you don't like the numbers 401(k) or your boss doesn't offer the accounts or there's some other hold-up, you can check behind Door #2, where there's the IRA. The IRA, or the Individual Retirement Arrangement as it's called by those in the know, lets you sock money away for your retirement. Unlike your sock drawer, an IRA lets your money grow and also allows you to avoid paying taxes on the profits and the amounts you put in. You won't need to worry about taxes until you're older and want to get at the moolah.

Roth IRA

If you're really picky and that still doesn't float your boat, there's another option behind Door #3: the Roth IRA. If you don't like the idea of procrastinating too much (you always get your homework done on time, don't you?), this retirement account lets you put money in after you've paid your taxes on the money. Investment gains in this account are never taxed, which means you won't be taxed when you take the money out.

Sounds pretty good. The Richardsons can put their cash into IRAs and 401(k)'s and ride off into the sunset…right?

Not exactly.

There are limits on what you can put into IRAs and retirement accounts. Before age 50, you can only put a total of $5,500 into all your IRAs. Before age 50, that meant that the Richardsons could only put $11,000 into their IRAs each year. The rest would have to go into some other sort of investment, where it could be vulnerable to taxes.

The Real Risk of Retirement

Even though the Richardsons have to worry about taxes, it can still seem like a million bucks is a lot of money. The problem? It's not.

The Richardsons spend $60,000 on living expenses. If they keep spending like that, they'll almost certainly run out of cash before the die. (Unless the majority of that $60K is spent on cheeseburgers.)

And it's not because they're big spenders. The Richardsons get $70,000 in income before taxes from personal investments and dividends on their investments. After taxes, they may make $60,000. That's barely enough as it is. But then there's the problem that their pension will shrink in size each time they withdraw from it and could be gone in just six years.

No problem, you say; they still have that $650,000 in investments.

Not so fast.

Now that the pension is gone, Mom and Dad Richardson worry that any drop in the stock market will wipe out the money they have left on retirement. They decide to switch to bonds, which are safer. But once they sell their stocks, they will have to pay capital gains taxes. Even if they sell when their stocks peak at $800,000, after taxes, they may only get about $700,000 (the exact amount will depend on the taxes in their state).

They need to keep that $700,000 safe, so they invest in T-Bills, short-term bonds on the government's debt. They are very stable, but because there is almost no risk, they only make about 2% on your investment per year. So the Richardsons are only making $14,000 yearly on these investments. And they still need to pay taxes, insurance, and everything else.

They can chip away at the $700,000 to make up the difference (they can't really go from living on $60,000 a year to living on $14,000). The problem? Once they start withdrawing money, they have less money being made on their investment, and they have to pay taxes on what they take out. Each year, they're taking out more money and have less coming in from investments. At that rate, they could be completely broke by the time they hit 86—even if they have lots of living left to do.

And it goes downhill from there. It's great news that people are living longer (want to do something creepy? Test your own life expectancy with this online calculator), but living longer also means you need more cash to keep going after you stop working.

The bills don't stop just because your paycheck does.

If you retire at 70 and live to 90, you're going to need 20 years of income to get by. And keep in mind that with inflation, the value of your money will drop. When you first retire, you may be able to buy the premium brand of novelty yard for $60, but twenty years later, you might only be able to get half as much of the cheapie brand for that price.

And this all assumes that the Richardsons never get more than the sniffles. If they get heart disease or any illness, they're in for a huge shock when they get their medical bills (which is bad for their blood pressure). In their old age, a lot isn't covered when they go to the hospital, even with Medicare. That means they either have to never be sick or be ready to spend a lot of cash on their medical bills.

And when Mom and Dad Richardson are gone, they might not have left much to their kids—except the funeral costs.

Being Rich Must be the Answer, Right?

The Richardsons may look to the Poshes down the street and assume that the guys in the McMansion have it better.

Not necessarily.

Even if Daddy Posh was worth $6 million, when he's gone, some of that money may go towards debts, charities, and a big funeral. The kids may get $4 million—and that's before the IRS swoops in. The IRS isn't showing up with condolence cards; they'll likely take about 35% of the $4 million that's left. Divided by a few kids, each kid will get less than the Richardsons are left with.

Let's hope they didn't develop expensive tastes.

So what's the plan? Whether you're texting on a diamond-encrusted phone right now or slinging lattes to make ends meet, there's no guarantee that you'll end up enjoying a retirement filled with cruises and fishing. You could just as easily end up broke and listening to the radio to while away the time.

Whether you've got a little or a lot, you need to start socking some of it away now (hopefully where it won't be taxed). Those cool walkers and canes won't pay for themselves, you know.