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Financial Literacy

Financial Literacy

Retirement

Retirement

“The only thing you should ever re-tire is your car.”

-Irving P. Siminoff

Los Altos, California, 2003

Ever been cold? Like cold because you can’t pay for heat? Now add to that notion the fact that your bones are 82 years old and other than an achy back, you are probably going to live another decade or so. You were once a corporate professional. But something went wrong along the way. It likely wasn’t something wrong with you or your career but rather, with the “system” under which you invested. Simply put, you are ending your life with not enough money on which to die with dignity. So now you have to worry about whether the thermostat should be at 67 or 68 – each degree is about 10 bucks a month.

Now frame all of this so that it’s even worse – it’s not you shivering in that building in the winter; it’s Mom and Dad.

Are you going to let them cross the River Styx, going out that way? The two coins you’d normally give the Boatman would pay for a month of warmth, let alone food, maybe a sweater.

But you have grand plans too – you will have kids of your own, a mortgage, debts, that dream of owning a boat and a divorce that won’t bankrupt you. Will you let those dreams pass by just because your parents were either lousy financial planners, unlucky, unhealthy, or a combo of all three?

Remember this thought when the turkey is carved in your cramped old dining room - amid the tension of blade cutting bone, everyone shouts, “Happy Thanksgiving!”

So let’s be frank, life goes one of three ways. The first way is essentially winning the lottery in life…you become a rap icon/producer/businessman: Lil’RichyRich. You go double platinum with your album “Too Many Gs in Da Bank,” build a record label, and sell Lil’ Rich shirts, underwear, cologne, and over-priced sugar water. Your biggest financial worry is whether to pay with cash or credit for your new diamond teeth. Some dude in a suit takes care of your skrilla and you just drink “special juice” out of your golden goblet on your private island. No financial worries about retirement…for shizzle.

The second route you can take is the opposite. You become a Leecherson. You have a fun job managing the “Bean Me Up” coffee shop. The salary is good for paying expenses while you are young but you don’t save a dime. This may work for you while costs are low and you are physically able to work; however, you are living on the financial edge…any little nudge or tap will knock you over. Unless you bite the bullet and marry that ugly rich person that comes in for coffee every day, things aren’t looking good for retirement. Living off the “kindness” of others (aka being a mooch) may be your retirement plan.

The third route, and the most probable, is the path of the Middlesons. The Middlesons have average jobs, an average house, an average family, and a dog with an average number of flees. They have the opportunity to have a good retirement if they save early enough but they could become the Leechersons if they spend their money instead.

Life According to the Middlesons

Mom and Dad Middleson first laid eyes on each other during a college basketball game. Mom was fully covered in red body paint and Dad was dressed as an overweight Spartan but somehow they still fell in love. After college Dad scored a job as a product salesman for FatandSugarinPackaging Inc and Mom got a job hiring and firing people called human resources. They bought to a house in the suburbs and started popping out the little ones. Already they had two sets of financial shackles tied around their limbs (hint: not the kids…yet). One was their new mortgage and the other was the student loans. Unless Dad Middleson pulls a Houdini and takes a key out of his tighty-whities to unlock the shackles, they won’t be saving for retirement for a while. They plan on saving for retirement later on when their debt is paid off and retirement is so close that they are practicing their shuffle board skills already.

Does this retirement strategy sound good to you?

We bet that the concept of sitting around doing nothing all day – or at least not doing something productive like homework – is one of the furthest things from your mind right now. In this little missive we hope to convince you that it shouldn’t be. And we don’t just mean YOUR retirement.

As with all things Shmoop, let’s start with a little base case story.

You’re in high school, maybe early college years. Odds are roughly 50 50 that your original parents are divorced; and odds are good that one parent has remarried and that new family has kids who weren’t baked in the same condo that you were, nigh 18 years ago. The undertone here is that Mom and Dad likely have numerous mouths to feed and that money is likely less plentiful for you than it is for teens in Abu Dhabi (Arab oil city overflowing with wealth) or the lil’ Lil’ RichyRiches. You’re parents are typical Middlesons.

The typical Middlesons will likely have finances looking like the following:

Assets

House

Two Cars

401(k) from work (stay tuned for the explaination later)

Mutual Funds (A bunch of stock and bonds managed by another dude…more later)

Stocks

Bonds

Low Interest Savings

Cash

A Danish that looks like a religious figure

Liabilities

Mortgage

Student Loans (hopefully not)

Bank Loan for renovation

Car Loan

A Little Credit Card Debt (small but deadly)

Income:

Combined Salary of $95,000 per Year
Combined Savings of $6000 per Year Provided by Work

Some mathy thoughts:

It is highly likely that you will need scholarship money for college, either in the form of grants or loans. Mom and Dad Middleson will pay for a chunk of it; hopefully you have a grandparent or two around (not trying to live on their $282 monthly social security check) to kick in a few bucks as well.
The truth is that getting da green for school can be the hardest for the middle guys…and gals. The kids with a golden fork (or some other utensil) in their mouth can just get rich Mom and Pop to foot the bills. On the other side of the tracks, college entrants from low income families can often get government funding or more grants.

Access to mommy’s platinum credit card or Uncle Sam’s checkbook will come in handy, just check out the numbers. The College Board reports that the average cost of tuition, fees, room, and board at a four-year in-state public college is nearly $20,000 per year. The situation gets worse for students attending private colleges where the average cost of attendance is just over $39,000 per year. The icing on the financial-doom-and-gloom cake is that these numbers are just a starting point. College costs increase, on average, about 8 percent each year, meaning that the price you will pay for your last year in college will probably be significantly higher than the one you paid during your freshman year. Lets whip out the old calculator…four years at in-state public college with tuition rising 8% per year will cost a staggering $90,122! Now to make you cry…four years at a private college with tuition rising at 8% per year will cost…$175,738! That’s a lot of flipping burgers!

The basic idea is that you’re going to be broke for a while. More than broke if you enroll in a private school.

And more to the point, Mom and Dad aren’t going to have much if anything left over in savings after they have paid for your college and the legion of siblings, step-siblings and other non-you people to get schooled and ready for life.

If your parents can muster up 10 big ones and you go to an in-state public school, you will still have about $80,000 in student debt to battle with. Ouch! So unless you get that CEO job straight out of school or build the next facebook (maybe Snoutbook…like facebook but just for Rover and the gang), you are going to be paying that debt down for a while.

Let’s hope that by the time you are 50ish, you have finally finished paying for schools and at that point are at least fully out of debt mode and are putting away extra savings for retirement.

The Upper Scale Middlesons:

Mom: 50, corporate Human Resources lady, $70,000/year, pension worth $5,000/year.

Dad: 50, product manager for FatandSugarinPackaging Inc, $85,000/ year, pension worth $7,000/year.

Together, they make $155,000 – you’d think that’s “wealth” but whoa are you ever wrong (as we will see later)! And together, they are in the top quintile of earners in the U.S. And they are still married. And they haven’t done anything totally stupid financially in their lives like speculate on hot stocks or invest in planets. Instead, they’ve “done everything right” – and are likely still to get totally screwed in our system.

So on their $155,000 a year, they one initial, and massive deduction…taxes. They pay Federal Tax of $35,000 and State Tax of about $10,000. So they have $145,000 - $45,000 = $110,000 to live on. Seem like a lot?

Some annual basics come off the top:

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.
(You drive a car but you bus tables to pay for it, right?)
Clothing: $4,000.
Family trip: $3,000.
Birthday presents: $2,000.
Dinners out every so often: $3,000.
Back yard supplies, maintenance: $2,500.
Home supplies: $2,000.
(Can you really cut costs on toilet paper?)
Home repairs, maintenance: $3,000.
Co-pay healthcare issues: $1,500.
Other stuff that just comes up: $10,000.
Total: $60,000.

So on their $110,000 of after tax income, Mom and Dad have “savings” of $110,000 - $60,000 or $50,000.

Awesome. But what about school costs? They are big. And for “wealthy” Middlesons like this, there aren’t big moneys available in scholarships. If only Mom and Dad were on welfare, living in a tiny shack and unemployed, there would be huge money available for you for college. But there isn’t. And you can’t qualify for the loans you want. So you plus your two siblings will cost Mom and Dad about $10,000 a year each in college expenses if you’re going to relatively inexpensive universities and you don’t run a 40 yard dash in under 4.4 seconds while being able to bench press 300 pounds.

So take off another 30 grand from the $50,000 of savings, Mom and Dad have more like $20,000 of savings, which really isn’t bad.

They each work for 20 more years before they retire, either because they want to or because the company fires them or because 70-something is just “the retirement age” at their companies.

So they have 20 years and 20 big ones to invest every year. What are the options for investing? Can you take risks? What makes the most money? The basic bare-bones investments are stocks and bonds. Stocks are a portion of a business. The business can be mining gold or selling adult diapers…either way, you can be a partial owner. A bond is a portion of a company’s debt or the government’s debt. Adult diaper companies have to pay interest on their debt and, if you own a bond, you get part of the interest they pay. Typically, the stock market (average of all the companies) has made more money for investors over the long run than bonds but (this is a huge sumo sized but) stocks are usually more risky and more crazy. Stocks can sometimes be like a roller coaster ride with the guy behind you puking every turn. They can be crazy.

To get some roller coaster/more money investments and some tea cup ride/less money investments you could invest in an index fund. Index funds group some stocks and some bonds together and create an amusement park compromise. Index funds can be bought for investing just like stocks and bonds. For the riskier investors, some index funds will be mostly stocks and for the safer people, some index funds will be mostly bonds.

If Mom and Dad retire at 70-something and invested in a relatively safe index fund, they could end up with a MILLION DOLLARS. Yep, if you add their pension and their own personal savings (pension is what their companies forcibly put away for them to supplement their personal savings), they could have a million bucks when they retire.

Let’s say their million bucks of total savings is held as $350,000 in pension money, and $650,000 in personal investments. 650 big ones might seem like a lot to save up, but if Mom and Dad Middleson saved $20,000 per year for 20 years they can make it to $650,000. However, this will only happen if their average annual return is a reasonable 4.84%.

What is this annual return we are talking about? Does it have anything to do with those annoying birds coming back every year? Or anything to do with my sister getting back with her ex every year before the holidays? Well the answer is no. Annual return is the amount the investment made during the year. If you invest $100 and a year later you get $105, you made $5 on that investment. In percentage terms, $5 on $100 is 5% so the annual return is 5%. Yes, $5 is equal to a cheeseburger and not anything you will live off of but over time and with a bigger original investment, you will have a nice nest egg (nothing to do with the geese…unless they are golden.)

When investing, there are three ways to increase the height of your mountain of cash monies. The first way is to invest for a longer period of time. Start when you are young and your voice is making squeaky noises. The second way is to increase the amount of dollar bills you invest every year. The last way is to increase your annual return. Making 6% over 5% may seem like the same to you but you are waaaaay off. A single percent difference can mean $100,000s in the long run. Your Middleson parents can drastically change the final treasure chest they have available at retirement by just making a few baby changes. Check out the chart below.

Years of SavingAnnual Amount SavedAnnual ReturnRetirement Amount
20$20,0004.84%$650,246.00
Increase Years21$20,0004.84%$701,717.87
Increase Amount20$22,0004.84%$715,270.57
Increase Return20$20,0005.84%$723,182.24

If they save for an extra 365 days, they can increase their private investment by over $50,000. That additional year of investing $20 grand turned into an extra $50 grand in the end… crazy. Also by cutting costs on toilet paper and eating more Ramen noodles they could save an extra $2,000 per year (to $22,000) and end up over $65,000 richer in the end. However, the biggest difference occurs when the annual return is increased by a percent. By squeezing out an extra percent every year, your parents will have about $73,000 more when they let loose on those rocking chairs. These tiny changes make a huge difference… like paying $0.50 extra at the fast food joint and getting twice as much grease for your belly. It is worth it.

Even that idiot kid down the street knows how increase the number of years of saving (+ years) and how to increase the amount saved annually (+ extra monies), but increasing the annual return (the amount you are making on your dollars per year) is a little trickier. Differences in annual return depend on where you put your money. It is strongly suggested by financial gurus to just buy mint condition Star Wars toys. Hairy alien toys will be worth a lot one day….actually you might want to stick to less geeky ways of investing.

Stocks have a higher return (remember the geese and sister’s ex story) with an average of 10% from 1926-2010. So on 1 mil of stocks, the average return should be $100,000 per year after you sell them. Oops, we forgot that the White House needs new golden garden gnomes so the government will take a chunk of your gain. If you ever sell you’re your stocks for a profit, you have to pay the government 0-35% of the profit. The cut for the government depends on your income and the length of time you held the stock. Let's say the government demands 30% from the Middleson’s profit…that’s $30,000! On top of this some state governments want to kick you while you’re down and take a piece of the loot too. Bonds have a lower return (average of 5.5%) and lower risk but they are also taxable.

Fortunately there are a couple ways to dodge the tax collector…or at least hold him off for a few years. Option one is moving to the middle of a forest in Canada, hiding from the US government, and eating smoked moose meat for the rest of your life. This option is legal and probably not to fun. Option two is better and actually legal. Let’s take a peek at the funds your employer is giving you for retirement (the $350k in the Middleson’s case). Your boss can throw this cash into a super special account called a 401(k) (pronounced fohr oh wuhn kay, not fohr oh wuhnk). This special account lets employers save money for their little pawns (you), without the pawns having to pay tax on that income right away. You dodged the taxman for now but when you take the cash out during retirement to buy a new scooter and case of prune juice, the government will tax you. So, initially you aren’t taxed but once the money is taken out you are taxed. Another big bonus of the 401(k) is that all the profits you make off the investments in the 401(k) also aren’t taxed until you take them out. Overall, the 401(k) helps you defer taxes to a later date but not totally avoid paying them.

Deferring taxes might seem like procrastinating on homework or telling your boyfriend/ girlfriend that you want to break up after avoiding them for three weeks…it is painful but you still have to do it sometime. Well that is kind of right but there is another major benefit holding off the government. When you are in the prime of your career you are making a bunch of cash so the government wants a larger percentage of your income. However, when you are old, wrinkly, and living off your investments, your income is likely to be lower. People with lower incomes pay a smaller percentage of their income to the government. By deferring your taxes, you are steering clear of the high taxes in the peak of your career and then paying lower taxes when you are pruny.

Now what about the other part of the Middleson’s moolah? Can we do any tax procrastination there? Oh yes…it also has a boring name but it could save you a chunk of money. It is a retirement account called an IRA or Individual Retirement Arrangement but should be called a WAAPOT or Wicked-Awesome Account to Put Off Taxes. It works like a 401(k). The investor can avoid paying taxes on some income by putting the income into an IRA. Then, during the old dude phase, the investor can take the money out and pay taxes on it.

There is actually a second type of IRA created by the legendary Speedo Warrior. Billy Roth was a Speedo model for most of his life and became a fashion icon. People called him the Speedo Warrior. He was known to wear a Speedo in his everyday life…I mean, he looked so good so why wouldn’t he? After conquering the world of European swimsuit modeling, he started a new career in advocating for changes in the tax system. After years of discussions and Speedo-clad protests, the government gave in. They created a new type of IRA named after the Speedo Warrior. A Roth IRA allows you to put income into an account after you pay taxes on the income but when you take the investment out, there are no taxes. This IRA might not seem as awesome but you still dodge some taxes. Investment gains in a Roth IRA are never taxed. The tax collector can’t get to you. God bless you, Roth!

Sadly, IRAs and Speedo IRAs have limitations. Before you reach 50 you can only contribute $5000 to both accounts combined and after 50 you can only contribute $6000. Since the Middlesons were investing $20,000 per year, most their investments could be in some sort of IRA (after 50 their combined IRA limit is $12k).

So even though the Middlesons have $1 million and they can defer some of the taxes, there is still a problem. On their current consumption pattern of living on about $60,000 a year, they will likely go bankrupt before they die.

So in a given year they take out $60,000 from their pension – they are plundering the pension moneys first because, well, they sort of have to. Many pensions require you to start taking out the money at age 72. If the Middlesons have dividends coming in from their personal investments and $60,000 from their pension, they will have $70,000 in gross income. They pay $10,000, give or take, in taxes and net $60,000.

So you may fairly ask, “Why all the worry? They are getting $60,000 after taxes each year and they have $60,000 in living expenses.”

One big thing to consider: The $350,000 in pension just shrunk this year to be $290,000. In 6 more years, it will be gone. Money then has to come from the $650,000 pot.

So think forward. In 6 years, the pension will be gone; Mom and Dad will be in their late 70s – still expected to live another 5-10 years, maybe more. Since some of their investments were in stocks that went up more over time, the $650,000 is now $800,000 but they worry about a big stock market correction and realize that they have to take the more conservative approach and buy bonds instead of stocks.

So in a relatively short period of time – maybe a year or two – they sell out of the remaining stocks they have and convert them into bonds. This is great except for one thing – taxes. Their cost basis on these investments started decades ago. Remember they started saving when you were still in school. As they go to sell the $800,000 there will be capital gains taxes on the amounts not in an IRA and after those are paid, that $800,000 shrinks to $700,000, give or take.

(The state they live in has a lot to do with that number – Florida has low or no taxes; California and New York have extremely high taxes… we are trying to take a blend here just for illustration.)

So now they have $700,000 and it’s all in bonds. And because your parents can’t afford a big loss, the bonds have relatively low yield - a decent chunk of them are just in U.S. government backed T-Bills. T-Bills, the favorite investment of Mr. T, are short-term bonds on the government’s debt (so they are very safe…the government can just tax everybody to pay the interest). So their average yield is 2%. That’s $14,000 a year in income. And there are taxes, albeit modest ones at that level of income, but also fees for social security if it even exists by then, health care, other insurance and so on.

So maybe they are able to take home after taxes and fees, $12,000 (and we think we are being generous here). So they effectively have to “destroy” $56,000 of their investments each year, and receive $48,000 after tax, so they can still live off $60,000 a year ($12k interest + $48k after tax investment withdrawal). Can you ask your parents to live with less heat in their home? Less toilet paper? No travel?

So next year, their base is $644,000 – it still generates 2% yield but it’s on a smaller base so the new income is closer to $13,000 instead of $14,000 and things spiral downward from there.

After 11 years, they are completely bust – and now in their mid 80s. Lots of 85 year olds are still sharp as a tack and the bottom line is that people are living longer. Could your parents live to their mid 90s? Sure! In fact, by then, the odds are good.

Check out Google’s cool interactive life expectancy charts here.

So.. what do you do when your Middleson parents are 85 and broke? At this point you are in your 50s, just exiting the “we are totally broke from putting our kids through school” phase of your lives and you are wanting to start saving for your own retirement.

Yet you can’t – much of your excess capital has to go to Mom and Dad to keep them… heated.

And this is a success story. The story we just told you presumes that there aren’t life’s curve balls thrown in that make life very tough financially. Health care costs are the big unknown. This story presumes that Mom and Dad never got cancer, diabetes, or had other special needs that required costs that exceeded whatever health care insurances you were carrying. And we presume that the cost of that insurance was relatively low.

More realistically, the Middlesons will get sick and if they survive their ailments in old age, they will die from the shock of the monster health care costs. While employed most people will get a hunk of their health insurance paid for by the company. However, when you are retired and have a higher risk of visiting the health care hotel, health insurance costs will sky-rocket and your old company probably won’t be helping you out.

The government will give you a hand with the Medicare program, but only if it still exists when you retire. Through Medicare, the government will fork over some health insurance to you but a lot of health care is not covered… so you either need to become super-human or you need your own private insurance too.

So how do you handle things when Mom slips and breaks her hip and the insurance company says that they won’t cover the operation because it isn’t in their policy? Do you tell Mom to just limp around the rest of her life or do you pony for the 5 grand or so to get it fixed? And the 5 grand is an operation at Wal-Mart (i.e. the cheapest you can find, and assumes no complications in the surgery).

And this was a couple who stayed married their whole lives (over half of our country gets divorced), who had no real health problems along the way, both worked full careers and retired millionaires. (It also presumes that there isn’t a lot of equity in their home, by the way, which may be conservative – but they have to live… somewhere other than your basement. So if there isn’t a home, there is meaningful rent costs… You aren’t going to let Mom and dad live in a dump, are you?)

And who is paying for the funerals when Mom and Dad kick the bucket? They certainly aren’t paying for funeral insurance. Funerals can be a lot of dough…that’s why many people are now being cremated instead. Cremations go up in bad economies. Got to save cash somehow!

For some people, like the Lil’ Lil’ RichyRiches, it may seem like they can just spend all their money buying bing and caviar while working because their inheritance will be their retirement fund. Think again! Even if big Papa has $6 million when he passes away, each of his 5 kids won’t be set for life. Papa’s money will have to pay off his debts and pay for the lavish funeral. RichyRich may have designated part of his funds to go to his favorite charity that builds houses for homeless poodles. In the end there is $4 million…but before it gets to the kids the White House needs cash to pay for new golden lawn flamingos to match the new golden garden gnomes. The government will grab about 35% of the $3 million! Plus, they will want 35% of Lil’ RichyRich’s diamond dentures and ruby-clad cane. So the kids will get about $520,000 each! They are even poorer than the Middlesons and they also expect caviar every day. I guess you rapper wannabes should have invested early too!

So what’s the plan, Stan? What’s your retirement going to be like? Lots of golf and fishing and travels to China like you see in the TV commercials? Or whittlin’ skills improved in a trailer park where a toothless man plays the banjo all day?

What’s it gonna be, Skip?

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