Three-Legged Retirement Stool Part II: Personal Savings

InsuranceNewsNet

In the first installment of my “Three Legged Stool” series, I mentioned that $250,000 seems to be the current inflection point for the definition of “wealthy” in the United States, given recent political rhetoric. In the ongoing debate in this country over how to help shore up our federal, state, and municipal finances in the wake of the financial crisis, those making over $250,000 a year have become the target of discussion where potential tax increases are concerned.

Since that first article was written, more specific plans have been shared with the American people within the 2013 proposed budget that the Obama administration released in early February.

Here are a couple highlights of that proposal related to taxes on the “wealthy”:

Allow the top two marginal income tax rates -- currently 33 percent and 35 percent -- to revert to their pre-2001 levels of 36 percent and 39.6 percent.

Change tax rates on investment income for the wealthy by raising the long-term capital gains -- currently 15 percent -- to 20 percent on those making more than $200,000 ($250,000 if married and filing jointly) and calling for dividends to be taxed as ordinary income for upper-income households.

People living in big cities or on a coast are all too aware of the fact that this kind of income, while healthy, does not necessarily make one “wealthy” because of the high cost-of-living in those areas. Nevertheless, you may recall that in my first installment of this article series I thought it might be instructive to see what kind of challenges a household, at or above $250,000 in annual income, faces in regards to accumulating enough resources to help sustain a comfortable retirement.

To help illustrate the challenges, the first article looked at Social Security in the context of the classic three-legged retirement stool, pointing out its relative shortcomings in preparing the “wealthy” for adequate future retirement income.

Now, in this second installment, I’ll examine the second leg of the stool, Personal Savings, in a similar fashion. This includes Defined Contribution plans like the 401(k) plan and its non-profit cousin, 403(b) plans. And to a lesser extent, individual retirement accounts, annuities and other vehicles designed for personal asset accumulation objectives.

Personal Savings: Defined Contribution Plans

For those earning in excess of $250,000 a year, the defined contribution plan is a good start but not nearly adequate to the task of helping accumulate enough wealth for this cohort’s future income needs. Two numbers bear mentioning when trying to understand the special challenges that the affluent face with regard to defined contribution plans being a major portion of their future retirement income: $17,000, and $5,500.

But first, let’s start with just a bit of history. The 401(k) plan has been in existence for over 30 years, having started in November of 1981. Many employers will now offer it alongside or in place of a traditional defined benefit pension plan. (Those who want more history on these plans can check out this helpful link from the Investment Company Institute, celebrating 25 years of the 401(k) back in 2006. http://www.ici.org/pdf/per12-02.pdf)

Let’s go back to our numbers: $17,000 and $5,500. The maximum contribution amount in 2012 that an employee may defer on a pre-tax basis to a 401(k) plan, regardless of income, is $17,000. The other number, $5,500, is an additional contribution amount that those aged 50 and over are permitted to make on a pre-tax basis, which is commonly known as a “catch-up” contribution.

Let’s put those numbers in context. If you are making, say, $300,000 a year in gross income and are over 50 years old, your total 401(k) pre-tax contribution can’t be any more than $22,500 in 2012. While that is a tidy sum to set aside, in percentage terms it only amounts to 7.5 percent of gross income. Do you reasonably think you can set aside less than 8 percent of your income per year to adequately prepare for retirement?

To that point, American General conducted a simple calculation in 2010 that assumed the person had essentially done “everything right” with maximizing his/her 401(k) opportunity, going back to 1987 when the 402(g) limits (pre-tax deferrals) into 401(k) plans were established. The findings indicated that the total amount that the person would have accumulated in a 401(k) plan over time, despite taking full advantage of the plan limits, was far less than necessary to support the retirement needs of the affluent, at well under a million dollars. In fact, the amount of lifetime income that even one million dollars will buy a 65-year-old couple today is depressingly small relative to those who have lifestyles built on years of six-figure working incomes.

The upshot: we’ve now reviewed the shortcomings of two of the three legs of the retirement stool. On deck for our next installment in this series is defined benefit pension plans. Once we’ve reviewed those plans and their shortcomings, we’ll discuss opportunities for a “fourth” leg of the stool that may make sense in helping address the unique challenges of this affluent group.

Information provided in this article shall not be construed by any person as legal, tax or accounting advice. American General is solely the provider of the insurance product. American General strongly suggests that any life insurance owner, proposed owner, insured or proposed insured retain the services of qualified tax, accounting and legal counsel for advice on such matters. To ensure compliance with requirements imposed by U.S. Treasury Regulations, we inform you that any tax advice contained in this communication was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

John Rafferty is vice president of marketing at American General Life Companies, www.americangeneral.com. American General Life is the marketing name for the insurance companies and affiliates comprising the domestic life operations of American International Group, Inc. American General Life Companies insurers offer a broad spectrum of life insurance, fixed annuities, accident and health products and worksite benefits to serve the financial and estate planning needs of customers throughout the United States.