But before I get into the ins and outs of various retirement accounts, let's take a look at Social Security, the one retirement plan that almost everyone qualifies for.
First, remember that there are many aspects to the Social Security program.
In my tape on introductory personal finance, I discuss the disability and life insurance Social Security provides to workers, so in this tape I'll focus on the retirement aspects of Social Security.
To qualify for Social Security retirement benefits you need to have 40 so-called credits. At one time a credit represented a quarter of a year's worth of work, but now a credit is based on your annual income. You now can get up to four credits by earning as little as $2,600 in a year.
So if you work even part-time each year for as little as ten years, you qualify for Social Security retirement benefits. But if you don't qualify for benefits on the basis of your work history, you might be able to qualify for Supplemental Security Income if your income and net assets are very low.
In 1984 Social Security coverage was expanded to include people who worked for the federal government and people working for nonprofit organizations. Now, with a few exceptions, nearly everyone is covered by Social Security, and over 90 percent of America's seniors get Social Security benefits.
So if you qualify for Social Security, how do you calculate your retirement benefits?
The Social Security Administration uses a complex formula to determine your benefit. It looks at the total number of years you've worked, and your salary during those years, making adjustments for inflation in your salary over the years.
The exact computations are complex, but if you worked more and paid more in Social Security taxes, you'd receive a higher benefit. However, the difference in benefits for low-income and high-income workers is actually small.
You can get an estimate of your Social Security benefits by requesting your "Personal Earnings and Benefit Estimate Statement". You should request this statement from the Social Security Administration every two or three years to ensure that the Administration has credited your account with all of your earnings.
Let's take a look at the retirement benefits for a single person. If you have a non-working spouse, multiply the these benefits by 50 percent to estimate your benefit. If you and your spouse both worked full-time, you could double the numbers to estimate your benefit.
The following numbers also assume you retire at age 65 with full benefits. You can begin getting 80 percent of full benefits at age 62. Retiring early may be an option, but unless you've got a good pension or significant savings, I doubt if you'll be able to retire at age 62.
Let's say you retire with full benefits at age 65 and your average annual salary in today's dollars was only $10,000. Despite this low salary you can expect to get about $6,000 annually in Social Security benefits, or about 60 percent of your old salary.
If your salary was $20,000, you'd get a higher benefit of about $9,000 per year in retirement or about 45 percent of your old salary.
If you made $30,000 a year during your working years, you'd receive about 40 percent of your pre-retirement salary or $12,000 annually. Finally, if your average salary was $40,000 you'd receive about $13,000 or 32 percent of your old salary each year from Social Security.
So under Social Security you get higher benefits if you had a higher salary, and thus paid more in taxes, but the system is skewed in favor of lower-income workers. Take the last example I mentioned. If your average salary went from $30,000 to $40,000, you'd only get a slight increase in benefits for all the extra Social Security taxes you paid.
Most Americans wouldn't find fault with a system that favors the less fortunate, but if you're a middle-class worker, notice that Social Security will replace only about 40 percent of your pre-retirement income.
Since most people need to replace about 75 percent of their income in retirement, it's clear you'll need something in addition to Social Security.
So as you can see, Social Security is almost like a welfare program where benefits are determined by political considerations rather than a conventional savings program where benefits are determined by actual savings and the return on those savings.
You should also realize that there is no such thing as the "Social Security Trust Fund", despite what the politicians tell you. As the current joke goes, the Social Security Trust Fund has no trust and no funds.
This joke is a little harsh, however, because Social Security currently is running a surplus. Thanks to large numbers of working baby boomers, the government collects more in Social Security taxes than it currently pays out in benefits.
These surplus funds, however, aren't stuck in a "trust fund". When politicians use phrases like this, people assume that their money is sitting in a vault somewhere, in their name, waiting for them when they retire.
In fact the surplus is used to fund the government's current deficit. By law all surplus Social Security funds must be "invested" in non-negotiable US Treasury bonds.
These bonds are simply IOUs made out to tomorrow's retirees. The only way to pay off the obligations represented by these bonds is to tax tomorrow's workers. So when you hear the words "Social Security Trust Fund" think "higher taxes on tomorrow's workers".
This is like having a $100 IOU from a deadbeat. You can list the loan as a $100 asset on your balance sheet, but in reality it's worth less than $100 because of the deadbeat's inability to pay.
Social Security has helped many people, but it soon will be subjected to a squeeze. You're making a big mistake if you plan on relying totally on Social Security for your retirement.
And we've already begun to see the squeeze that the long-living baby boomers will place on Social Security. Social Security taxes already have increased, and benefits already have been cut.
Social Security taxes, known as payroll or FICA taxes, increased from less than 6 percent in 1976 to 7.65 percent in 1990. This rate is levied on both employees and employers so the total FICA tax is now over 15 percent of your salary.
Also, the taxable wage base grew dramatically over this time. In 1976 you paid FICA taxes on only the first $17,000 in wages. Now you pay taxes on your first $62,000 in wages.
By the way FICA stands for Federal Insurance Contributions Act. But make no mistake. These are taxes, not contributions.
If you decide not to contribute this year, you'll be getting a telephone call. The IRS almost ruthlessly pursues those who don't pay their payroll taxes.
FICA taxes are also hard to avoid. There are no exemption levels as there are with income taxes. You pay FICA taxes on your first dollar of wages. Although you can defer income taxes via retirement accounts, you can't avoid paying FICA taxes, so FICA taxes hit low-income people especially hard.
Just as FICA taxes have gone up, Social Security retirement benefits have gone down. Whereas today's seniors can retire with full benefits at age 65, people born after 1960 will have to wait until age 67 before they can collect full benefits.
Retirees also probably will see a reduction in benefits as the cost-of-living adjustment is scaled back.
Finally, even the benefits you receive probably will be taxed increasingly.
In 1938 the IRS ruled that Social Security benefits were non-taxable because the original contributions were made with after-tax dollars.
But the rules changed in 1983 when Congress said that many retirees must include up to 50 percent of their Social Security benefits in their taxable income.
In 1993 the Clinton administration increased this amount to 85 percent, and the tax affects those retirees with incomes of as little as $25,000.
Although Social Security probably will remain as a source of retirement income for lower income people, middle-income people probably will see their expected benefits reduced over the next twenty years through tax increases, increasing retirement ages, and possible means testing for Social Security.
What this means is that if you're a middle-income baby boomer, you can't count on Social Security to help you maintain your current standard of living. Your best bet for a good retirement is to take advantage of the magic of compounding and retirement accounts.