Farm Horizons, Feb. 2016
Are you financially ready for retirement?
By Myron Oftedahl
It is now after Jan. 1, you are sitting with your tax-preparer doing your farm tax return, and you learn that you will have a much larger tax bill than you were anticipating.
Now what do you do?
Fortunately, you still have a couple of options to manage that tax liability.
But, first, let me say that it is OK to pay some taxes. That means that you had a profitable year.
Secondly, at least part of that tax liability is for self-employment taxes or Social Security.
So, if you want to have a decent amount due to you from Social Security when you retire or are old enough to start drawing Social Security, you need to pay in.
I also recommend that you pay in at least one quarter every year, so that you maintain your disability coverage should you need it.
Now, what can you do about the income tax liability since it is past Jan. 1 and you can’t do any more prepayments?
You still have a couple of options, and both involve putting money into a retirement account. You may put up to $5,500 into an IRA if you are under 50 years of age, and up to $6,500 if over 50 years of age. You may also put money into an SEP account, which often has a higher limit because it is a percentage based on income.
Why should you put money into a retirement account?
First, will Social Security income be enough for you to retire on?
Secondly, the practice of selling the farm and buying a house in town doesn’t work well if you consider the capital gains taxes involved and the effect of inflation.
Thirdly, we are living longer. When Social Security was started, the average life span was 65 years old and the average payments from Social Security was three months. Now, our life expectancy is approaching 90 years old. So, if you retired at 65, you would receive 300 payments by the time you turn 90.
I sat down with Russ Runck with Ameriprise Financial and asked him what it would look like if we compared three people beginning an IRA at different ages.
Using one of Ameriprise’s spreadsheet tools, we compared a 25-year-old, a 40-year-old and a 50-year-old. Each of them put $5,500 into the IRA each year. We did not increase the amount at 50 years of age. We assumed that each would retire at 67, with an annual inflation rate of 3 percent, and a return on the investment of 7 percent prior to retirement, and 5 percent after retirement.
The chart below clearly shows the differences in growth of the investment, and how long the money will last in retirement. We did not include any Social Security income, rental income, etc. We strictly used the IRA for retirement income.
In Scenario 1, your retirement savings and expected contributions will not provide all of your retirement income needs. Your savings will be exhausted by age 82.
In Scenario 2, your retirement savings and expected contributions will not provide all of your retirement income needs. Your savings will be exhausted by age 73.
In Scenario 3, your retirement savings and expected contributions will not provide all of your retirement income needs. Your savings will be exhausted by age 70.
I was amazed at the effect that inflation has on the amount of money that it took to cover living expenses in retirement.
We assumed that each person was earning $40,000 on their tax return, but the 50-year-old needed $66,114 at retirement to equal the $40,000 income at 50.
The 40-year-old earning $40,000 would need $88,852 per year at retirement.
The 25-year-old earning $40,000 would need $138,428 per year to be equivalent.
Now, do you need any more encouragement to begin a retirement account?
You can reduce the amount of taxable income, you don’t need to fund the IRA or SEP account until you file your tax return, and you build yourself a very nice retirement account.
It is also a good way to spread the risk for your retirement, as now you aren’t relying solely on the farm or Social Security for retirement income.
Another advantage is that most IRAs or SEP accounts will allow you to withdraw money for your children’s education, so you don’t need a separate college fund.
Let’s review quickly; it is OK to pay some taxes, pay at least one quarter of self-employment tax in order to maintain your disability coverage, use an IRA or SEP account to reduce your taxable income, and build a retirement account so that you can comfortably retire.
I would like to acknowledge Russ and Ameriprise for his help in my research for this article. Feel free to ask either of us for more information, or contact your financial advisor.