The Basic Structure of Retirement Funding

While we work, we pay Social Security taxes (part of FICA) into a Social Security "account" and we save for retirement in a 401(k) or other type of retirement account. There is no actual Social Security "account" with our name on it, but there is a record of our earnings and of the FICA taxes we pay that will determine the amount of our Social Security benefits one day. Our employers withhold about 7.5% of our paycheck for FICA. About 6% is withheld for Social Security taxes and another nearly 1.5% is withheld for Medicare.

Our 401(k)s and IRAs are real accounts with real funds in them that we can withdraw at anytime. However, withdrawals made before age 62 are subject to taxes and penalties except under special circumstances. Our retirement savings accounts grow through more savings contributions from our paychecks and by investing our savings in assets we hope will grow in value, like stocks and bonds.

After we retire, our job income stops but the bills continue. We receive Social Security retirement benefits based on how much we paid in Social Security taxes. If we are able to accumulate retirement savings, we can spend about 4% to 4.5% of our savings total on the day we retire every year. This amount, added to Social Security benefits, will provide nearly all retirement income for most households.

For example, if we will receive $14,000 a year in Social Security benefits and have $100,000 in savings on the day we retire, we can spend $14,000 plus 4% of $100,000, for a total of $18,000 per year.