A successful retirement plan is like the moon — always present and requiring lots of thought to reach. Unfortunately, many Americans today appear woefully unprepared to save enough money to enjoy any sort of retirement worthy of the name, with a recent Fed report finding 25% of non-retirees lack any sort of savings at all.
We can’t promise to lay out a detailed blueprint for how to reach your retirement (or the moon), but we can tell you how to get past the toughest part — knowing how to get started.
Let’s address these points one by one so you have a good idea of where to start your retirement journey.
Figure out how much you need to save
How much will you spend every year in retirement?
Unless you’re writing an episode of “Lost,” you need to start at the beginning, and in the case of saving for retirement, that means knowing how much you need to save. This number will serve as the finish line for your race to retirement, but keep in mind that it will be a rough estimate.
In the simplest terms, you’re trying to figure out how much money you need to live a comfortable lifestyle — which is up to you to define — until you die. Your first step should be to estimate how much income you’ll need for every year in retirement. There’s plenty of online worksheets and calculators that prompt you with questions to start thinking about your future expenses. Some basics include:
- Health care costs, including medication and insurance
- Food and entertainment
This may sound overwhelming, but one shortcut you can take is to calculate all of your annual expenses now and make an educated guess on how those numbers will change when you reach 65 years old. Keep in mind, you may spend less on certain things, like transportation and entertainment, but more on others, like health care.
Calculating your ultimate nest egg goal
Now that you have a decent estimate of how much income you’ll need each year to sustain your laid-back retirement lifestyle, you can use that number to calculate your final savings goal. There are several theories on how to think about this, but one of the most popular is:
The 25x rule: The idea here is that you need to have 25 times your annual retirement expenses saved away in investments accounts before you can tell your boss what you really think of him. Each year, you withdraw roughly 4% from your savings — accounting for inflation from that first year you withdraw. According to a study by a team of professors from Trinity University, a nest egg built on this basis should last you at least 30 years.
As an example, assume you calculate your yearly expenses in retirement at $70,000. That means you’ll need to have saved $1.75 million in your accounts before you can make that first 4% withdrawal. Even a more modest income of $50,000 —which is close to the average expenditures of households headed by those 65 years or older, according to the latest data from the U.S. Bureau Statistics — requires amassing $1.25 million.
How much should you save every year?
Given the considerable size of the nest egg you’ll have to build up, the importance of sticking to a savings plan cannot be overstated. Again, the key here is not to feel overwhelmed and surrender to paralysis.
“Set your goal and write it down,” said Leon C. LaBrecque, CFP based in Michigan. LaBrecque recommends it’s a specific and achievable goal, such as 18% of your year’s gross income, and advises that you shouldn’t worry if you need to build up to that goal over time.
Putting away 18% of your gross annual income may sound like an unbearable and unsustainable sacrifice, especially if you have student loan debts, a mortgage and other pressing expenses. The beauty of calculating how much money you need to save overall is that you can pace the rate of your savings — within reason. Unless you expect a seven-figure windfall on your 60th birthday, you don’t want to put off aggressively saving for too long.
Fortunately, you have plenty of tools available to help you reach your savings goals, which we’ll look at below.
Max-out your retirement accounts
A recent Stanford study found approximately half of all workers in the United States qualify for some sort of employer-sponsored retirement savings account. The most well-known and prevalent of these plans is the 401(k), which allows employees to put a portion of their paycheck in a tax-deferred account. That means the money in your 401(k) is placed there before taxes and remains safe from the IRS until you start withdrawing funds from the account in retirement.
Many employers pledge to match whatever contribution you make to your 401(k) as part of their benefits package. The exact method and amount depends on the individual employer. You want to take advantage of the employer match and push it to the policy’s limits, otherwise you’re just leaving money on the table. “At least maximize the match, but more is always better,” said Kenneth B. Waltzer a CFP based in Los Angeles.
Waltzer also suggested younger savers look into choosing a Roth 401(k) if the employer provides that option. The main difference between a traditional 401(k) and a Roth 401(k) is that with the Roth option, the money you contribute is taxed before it goes into the account, instead of when you take your withdrawals.
What’s the difference for younger savers? Chances are your income places you in a lower tax bracket as a 20 year old than when you’re 50, reducing your total tax payments.
Open up your own IRA
Regardless of whether your job offers you a 401(k) account or not, you should also set up your own tax-advantaged retirement account. Individual Retirement Accounts (IRAs) come in all different shapes and sizes, meaning no matter what your employment or economic situation, you’ll likely find one to suit your needs. The two most common IRAs are:
- Traditional IRA: The vanilla ice cream of retirement accounts, this IRA works a lot like a traditional 401(k). The money you place in a Traditional IRA remains sheltered from taxes until you begin withdrawing your money. You can begin withdrawals without paying a penalty at age 59 ½ . There’s an annual cap to how much you can contribute to any IRA, with Traditional IRAs maxing out at $6,000 (or $7,000 if you are 50 or older).
- Roth IRA: As you may have guessed from reading about 401(k)s, money placed into a Roth IRA is taxed at your current income bracket. However, when you make your withdrawals, the money is tax-free. Younger people who believe they’ll pay more taxes in the future should choose this type of IRA over the traditional version. The contribution limit is $6,000 a year ($7,000 if you’re 50 or older).
Contribution rules unique to Roth IRAs
Unlike a Traditional IRA that allows you to contribute up to the limit without any restrictions, Roth IRA contributions are governed by your modified adjusted gross income (MAGI). The more you earn, the less the government allows you to contribute to your Roth IRA, eventually barring you from contributing anything. This begins to kick in when your MAGI is around $122,000 (if you file as single) or $193,000 (if you file as married jointly).
Prioritize the right investments for your age
Your 401(k) and IRA accounts don’t just magically grow your money for you. They serve as a tax-advantaged shelter for the earnings from your investments, and what you choose to invest in can make or break your retirement savings plan.
“In the beginning, what you save means the most, so focus on saving as much as you can and don’t worry about markets or research,” said LaBrecque. “As you approach retirement, preservation [of your savings] become critical.”
In other words, allocate your investment portfolio so it’s heavily weighted toward high-earning but more risky stocks when you are younger and can make up the financial hits you may take from the market.
“If you are age 30, you should have a good portion invested in equities, not all in bonds or cash,” said Joyce Streithorst, a CFP based in New York.
When you start injuring yourself in your sleep, that’s when you need to think about shifting your money into lower risk products since you don’t have an additional 40 years to save. Examples of these include:
Stick with the plan
This final piece of advice comes with a caveat, which is you need to remain flexible while still working toward your retirement goal. Events will crop up in your life that both help and hinder your plan, and you can’t let yourself either grow discouraged or overconfident. The most important action you can take is to keep plugging away at your savings, even if things look grim.
“Forget market timing. Forget hot stock tips,” said LaBrecque. “The key is to stay in the market. Missing the best 10 days in the S&P 500 over the last 20 years [would] cut your return in half. I’ve been doing this for 40 years and have always had some assets in the markets.”
You’ll also have to balance saving money for retirement with living your life. While some adherents of the FIRE movement may disagree, making yourself miserable for the sake of your retirement savings just makes you a slave to the future.
You are the most important part of the plan
The most crucial part of your retirement savings plan will be, well, you. Determining how much income you’ll need every year, how you can cut back on today’s expenses in order to save enough, how to invest and more depend on your lifestyle and current means. However, the above steps should provide you with a guide to getting started and bring you that much closer to reaching your work-free nirvana.