Recently, InvestorPlace Editor Jeff Reeves discussed the plight of older Americans regarding their retirement savings — or lack thereof. He cites an Aon Hewitt report showing that the average 60-year-old has $114,500 in his or her 401k, which provides approximately $4,600 per year over a 25-year period.
Almost no one in America can live on that, so those close to retirement are ratcheting up the risk in search of greater returns and a bigger retirement fund. Unfortunately, we know how this scenario all too often turns out — badly.
Therefore, I’d like to look at some ways individuals, with the assistance of the federal government, can improve their retirement picture before it’s too late.
Let’s start with the 401k itself. The IRS formally introduced the rules governing this retirement program in November 1981, and they’ve been in existence for more than 30 years. Many of the earliest participants have likely retired by now. The Investment Company Institute calls the 401k “… a powerful savings tool that can provide significant income in retirement.”
However, Aon Hewitt’s figures seem to dispute that. Furthermore, by allowing participants to be able to borrow from their plans, the situation has only compounded itself. Today, there are $37 billion in annual defaults on 401k loans. In Canada, you can borrow against your RRSP (the equivalent of a 401k) only if you’re a first-time home buyer or going to school. Any other use requires that you withdraw the funds and pay income tax on those funds.
It’s a powerful disincentive to get off the tax-deferral train. Nonetheless, people do it all the time.
That’s why so many financial professionals argue that your home is your best investment because the mortgage becomes a method of forced savings that the 401k can’t match. Current rules allow for couples filing jointly to deduct all of the interest on a mortgage used to buy or build a home up to $1 million in mortgage debt and on $100,000 in equity debt. In addition, if you live in and own a home for two out of five years prior to the sale, you can deduct up to $500,000 of the gain upon a sale. For many homeowners, especially after the housing crisis, they’ll never need more than the current limits in place.
In Canada, you can’t deduct any mortgage interest, although all of the capital gains from the sale of your principal residence are tax-free. In order to deduct mortgage interest, Canadians end up paying down their mortgages and then setting up a home equity line of credit (HELOC) and using it investment purposes (non-RRSP, TFSA accounts) to buy stocks, mutual funds and other investment vehicles with the interest being deductible. It’s a cumbersome way of achieving what already exists in the U.S.
The only change I’d suggest regarding homes is that the U.S. adopt a principal-residence rule similar to Canada’s. People living in places like New York and San Francisco would benefit greatly from this rule. You shouldn’t be punished for living in an expensive city.
For most people, their biggest asset is their home, and I doubt that will ever change. So, why place such an emphasis on tax-deductible savings? I realize that the 401k and IRA were created to help employees cope with the move to a self-funded retirement from a pension-funded one.
However, it clearly hasn’t worked. The average balance of all 50 million 401k plans in America is something like $60,000, despite the fact you can contribute up to $17,000 annually. As Karen Friedman of the Pension Rights Center in Washington, D.C., puts it: “401k’s have failed millions of Americans.”
The Canadian experience isn’t much different. In 2012, an individual can contribute up to CAD$22,970, or 18% of earned income, whichever is less. In 2010, despite the maximum contribution being $22,000, the median contribution was $2,790, or slightly more than 10% of the max. Canadians are never going to change how much they contribute to RRSPs despite the best efforts of the financial planning industry. They just don’t have the money. And the same scenario plays out in the U.S.
There has to be a better way. Here are four possibilities: