Sources of retirement income

Funding your retirement

What sources of income do you expect to have when you retire? If you have been participating in Social Security by having money withheld from your paycheck or you are married to someone who participates, the benefits to which you’re entitled will likely cover some of your costs.

Overview

There is a benefits calculator on the Social Security website that lets you estimate what you can expect to receive. However, the results tend to be more accurate the closer you are to retirement, when there are fewer unknowns about your lifetime earnings and any potential changes to the Social Security program itself that might affect you. In addition, keep in mind that Social Security will provide only a portion of your total income in retirement and should not be thought of as the sole source of income.

A defined benefit pension from your employer may be another source of income. Such a plan promises to pay you an income in retirement based on a formula included in the plan. Although plans vary, in most cases the amount is determined by the number of years you worked for the employer and your final average salary.

These benefits alone will probably not provide enough income to let you live the way you’d like to in retirement. The rest will have to come from savings and investments you make while you’re working and perhaps from continued employment after you leave your primary job. You can take advantage of the benefits of tax-deferred and tax-free Roth investment accounts, which the federal government has established to encourage you to save for retirement.

With a tax-deferred account, you postpone income taxes on any investment earnings and sometimes on your contributions until you begin to withdraw from the account, usually after you retire. Then the withdrawals are taxed at the same rate as your ordinary income. With tax-free accounts, earnings can be withdrawn tax free if you’re at least 59 ½ and your account has been open at least five years. You can also save and invest in regular taxable accounts.


The power of compound interest

Time is a critical element when it comes to building a retirement account—and the more time you have, the better your chances of meeting your goal. That’s because of compounding, or the way earnings accumulate and increase your principal when you reinvest them. The added advantage of tax deferral means your account has the potential to compound faster, since you don’t have to take out any of your earnings to pay annual income or capital gains taxes.

For example, if you have a one-year 5% return on an investment of $10,000 in a tax-deferred account, your account value at the end of the year is $10,500. If you have another 5% return the following year, the new base amount of $10,500 earns $525, and your balance grows to $11,025. Because a larger balance has the potential to generate more earnings, the longer the process continues, the bigger impact each additional dollar has. In fact, after 30 years of returns averaging 5% annually, your $10,000 could be worth $43,219 before taxes.