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Saving for retirement is a topic that is not talked about enough. It is staggering to see how many people will not have enough money built up to financially survive their entire retirement.
Life expectancy is getting longer, which means people will need to have more money saved up if they want to continue retiring at the normal age of 65. In fact, 1 in 3 women and 1 in 5 men who are 65 years old today will live until they are 90 years old according to the Hamilton Project. This is a long time to fund your retirement with no income – assuming you won’t be able to count on Social Security.
According to a study done by Charles Schwab, Americans believe that they will need $1.7 million on average to retire comfortably. They also note that the majority of people are not investing and saving enough to reach that goal.
Investing for Retirement vs Saving For Retirement
Before we get started, it is important to keep in mind that when we talk about “saving for retirement” throughout this article, we really mean investing for retirement. According to The Logic of Money, if you were to save $500 each month for 30 years in a savings account at 0.5 percent interest, you would have $194,158. Alternatively, it you took that same money and invested it at an extremely conservative 6 percent rate, you would have $502,258.
That is a huge difference when you finally decide to retire. Not to mention, in most cases you will probably get more than a 6 percent return if you invest in quality assets.
4 Steps to Saving for Retirement
When it comes to saving for retirement, the process is actually pretty simple. All you really need to do is figure out your goals, get a plan in place, and then execute that plan.
You want to make sure your nest egg will last for the entirety of your retirement. If you run out of money, your only option may be going back to work. And who actually wants to go back to work in retirement when you could be traveling the world or trying new restaurants or hobbies?
Step 1: Determine How Much Money You Will Need to Retire
There are a few different things you will need to do to determine how much money you will need to retire comfortably. Most experts say that you will need to replace 80 percent of your income in retirement. This figure likely comes from the idea that while you are working, you are saving 20 percent of your income, and in retirement, you will just need the other 80 percent of your income to live on.
After you determine what 80 percent of your income is, you then need to multiply it by 25 or divide it by 4 percent. This is commonly referred to as the Rule of 25 or the 4 Percent Rule. This rule essentially indicates that your retirement will last 25 years, or you will withdraw 4 percent of your retirement savings each year. It is a great way to get a rough estimate of how much money you will need for retirement.
You may also need to factor in things like taxes depending on which retirement account you choose to use, and inflation. If you use a retirement account that taxes withdrawals in retirement, you will need to save more money for retirement because you won’t be entitled to your entire nest egg.
Additionally, inflation plays a major role in what your retirement savings is really worth in the end. For example, have you ever heard your grandparents say something like “I used to be able to go to the convenience store and get a soda and a bag of chips for a quarter.” Well, you sure as heck can’t do that in today’s world and that’s because of inflation. Your dollar today will be able to purchase you much more than your dollar will be able to in 20-30 years.
Here’s a quick example to get you started on the right track:
Income at Retirement: $90,000
Retirement Income = 80 Percent of Income at Retirement = $72,000
Necessary Retirement Savings = Retirement Income / 4 Percent (or multiplied by 25)= $1,800,000
Don’t forget that taxes and inflation may affect this number. You can use this inflation calculator to get an idea of how much money you need to save based on actual historical inflation rates.
2. Choose The Right Retirement Account(s)
When it comes to retirement accounts, there is no shortage. This is why choosing the right account can be an intimidating task. There’s a Traditional 401(k), Roth 401(k), Traditional IRA, Roth IRA, Solo 401(k), 403(b), 457(b), and SIMPLE IRA just to name a few. So how are you supposed to know which one is the right one for you?
Really, it depends on two factors: 1) Are you an employee of a company/the government or are you self-employed and 2) How much money are you planning to contribute?
If you are an employee of a company, your company will likely offer a Traditional 401(k) or a Roth 401(k). If you are a government employee, you will likely have the opportunity to use a 403(b) or a 457(b). These are essentially the equivalent of a Traditional 401(k). If you are self-employed, you will probably use a Solo 401(k) or a SEP IRA.
Regardless of what your employer offers, or if you’re self-employed, you can always start your own Individual Retirement Account if you are already maxing out your contributions in your primary retirement account and want to invest more for your retirement.
The biggest thing to consider when choosing the right account is whether you are taxed on your contributions or on your withdrawals. In a Roth account, you will make your contributions after tax. In other accounts, you will make your contributions before tax and the contributions will offset your tax bill in the current year.
Depending on where you are at in your career, this could have a huge impact. If you are 20-30 years away from retiring, you are probably making less now than you will be withdrawing each year in retirement. Therefore, it makes more sense to pay less in taxes now, than when you withdraw the funds in retirement. So, you should choose a Roth account.
If you are closer to retirement and will be withdrawing less than what you are making now, you will probably choose to defer your taxes until you withdraw the money in retirement. It will save you money in the end. So, you would choose an account that defers your taxes until later.
This has just been a brief overview of some of the retirement accounts. There are certain contribution limits, tax treatments, early withdrawal penalties, etc. with each account so it is important to do your research before choosing which one(s) to use.
3. Start Saving 15 – 20 Percent of Your Pre-Tax Income
This is a general rule of thumb that works best for people early in their career or for people who have been following this rule from the start. If you are in your late 40’s or 50’s and are behind on your retirement savings goal, 15 – 20 percent isn’t going to cut it. You are going to need to be saving 30 or maybe even 40 percent of your income to catch up. This is why starting early is so important.
For instance, let’s imagine you start your career making $60,000 and your salary never increase (I know this isn’t realistic, but it paints a good picture) and you save 20 percent of your income – $12,000 – every year for retirement. Let’s pretend you’re 25 years old and are going to be retiring at age 65 so you have 40 years until retirement. When you retire, you would have a nest egg of just under $3.5 million at an annual interest rate of 8 percent.
Alternatively, let’s imagine you’re 45 years old, are making $100,000 a year and are saving 20 percent of your income at the same 8 percent rate. However, you only have 20 years until retirement, but you currently have $150,000 saved for retirement. When you retire at 65, you will have a nest egg of only $1.7 million. Make sure to take advantage of investing early if you still have the chance to do so.
One last thing: if you can’t afford to save 15 – 20 percent at the start, then save as much as you can without putting yourself in financial danger. However, if your employer offers some kind of matching plan, you should really try to make sure you meet that at a minimum. It is free money towards your retirement.
Most employers will offer a percentage match of your salary. Let’s say a 5 percent employer match and you are making $60,000. If you can contribute just 5 percent – $3,000 – of your salary, your company will match the other 5 percent so you will have a total savings of $6,000. Make sure you take advantage of this if your employer offers it.
4. Aim to Payoff All of Your Debts Before You Retire
The last step is to put a plan in place to pay off all of your debts before you retire. If you go into retirement with a huge amount of debt, whether that be a mortgage, car loans, credit card debt, or even student loans, your retirement savings will quickly deplete.
Your retirement savings isn’t something you should dip into to pay off your debts. If you have loads of debt going into retirement, where you will have no more income, you will struggle to make it last. You won’t be using your savings to live, but instead you will be using it to pay off other people.
You’re goal should be to go into retirement as free as possible. If you can pay off your mortgage, your car loans, student loans, credit card debt, or any other lingering debt, you will have a much smoother, much easier, and much more enjoyable retirement.
Saving for retirement is something that needs to be talked about more. It is concerning how many people will be underfunded in their retirement and are relying on Social Security payments. The problem is, we don’t even know if Social Security will be able to make their payments in 30-40 years because the program is so underfunded as is.
This is why it is more important than ever for everyone to assess their current retirement savings, determine what their goal is, and then put a plan in place to reach those goals. It really doesn’t have to be a complicated task. You just need to run the numbers and then execute the plan.
About the Author
Austin is the founder of The Logic of Money and has a passion for finance and helping others. He studied finance, investments, and banking as well as real estate and urban land economics in college. He hopes that he can share his knowledge and tips with others to help make personal finance less stressful for everyone.