Saving for retirement is vital and most Americans are a far cry from where they need to be. You’ve heard all the scary statistics, like 70% of the country can’t afford a $1,000 emergency, or the median 60-year-old has less than 150,000 saved for retirement.
It’s obvious most people need help. In this article, we’ll go through the normal advice you hear, a few different methods for calculating what you need, what you need to consider, and much more.
What’s the standard advice?
- 10% of your paycheck - This use to be the standard recommendation about how much you should save from your paycheck. Unfortunately for some people, 10% doesn’t cut it anymore. The millennial generation (Gen Y) is earning less than previous generations (indexed for inflation) and starting their retirement savings journey later because of things like student loans.
- Four percent rule - This is still a pretty good rule of thumb for spending in retirement. Here’s how it works. You have your retirement savings (for simplicity sake, it’s $1,000,000). During your first year of retirement, you withdraw 4% from your retirement account. In this example, it would be $40,000. Every year after, the percentage you withdraw goes up a little to account for inflation.
What should you save?
- Annual spending x 30 years = how much you need. For example, if your annual spending is at $50,000. You would need to save $1.5 million for retirement. Be advised, your spending in retirement will change, and inflation will make things more expensive, so you would need much more than that.
- As much as you can - If money is tight, you might not be able to save much. The best thing you could do is save as much as you realistically can. If that’s 1% per pay period, great! If that’s $5 per month, that’s great too! As long as it’s something.
- Do you get a company match? If the answer is yes, you should do everything you can to at least contribute up to what they match. How much they match will depend on the type of retirement plan as well as the employer. If it’s a Simple IRA, the employer is required to match up to 3% if you contribute. They also have the option to contribute a flat 2%, regardless if you contribute or not. With a 401(k), it varies by plan. The most common I’ve seen is a dollar for dollar match up to 3%, and then a 50% match from 3 to 6 percent. For example, if you are paid $1,000 per paycheck and you contribute 6%. That’s $60. Your employer would match you dollar for dollar up to $30, and then reduce that match to $15 for the next $30.
- Increase savings slowly - Regardless of how much you are saving, it’s important that you make small increases over time. If you’re currently contributing 1%, in a few months, up to that percentage to 2% and see how it feels. After a month or two, you’ll get used to that extra percent not being there, at which point, you can increase it one more percent.
What really, really matters?
- Lifestyle in retirement - What are you going to do? How are you going to spend your time? If you plan on traveling all over the world during your first few years of retirement, you better believe you will need to save more. What you do during retirement has a big impact on how much you’ll need to save.
- Where you live - Different cities and countries across the world have different costs. Retiring in a suburb in the Midwest will cost significantly less than retiring in a big city. Additionally, there are many countries around the world that are much less expensive than the U.S. Here are two articles I wrote about retiring out of state and retiring abroad.
- When you retire - This may be the most important factor when planning for retirement. The reason this it's so important is it affects how long you need your retirement savings to last for. It also determines when you stop saving and start spending. The longer you work, the more you can earn and the more you can save. Not to mention, by working longer and delaying Social Security, you increase your monthly Social Security Income (SSI) benefit. This isn’t possible for everyone, however, so determine what is best for you.
How should you invest?
Investing, in general, is challenging. Not only do you have to worry about selecting the right investment, but you also have to make sure you are keeping your emotions in check. Your behavior and your psychology, in my opinion, have the largest effect on your investing success.
When you enter into retirement, your primary goal with your investments is capital preservation. You need to protect what you’ve earned and saved up to this point. Your secondary goal is to make some money with those investments.
Your investment strategy should be tailored to your personal risk tolerance and time horizon. If too much risk makes you uncomfortable, then scale back the amount of stock you own and stick with bonds and cash. You’ll earn less of a return, but it’ll keep you at ease.
If I were now entering retirement and had to pick an investment allocation, I’d choose the following: 50% bonds, 40% stocks, and 10% cash.
The bond portion of the portfolio will react less to ups and downs in the market, the stock portion will, hopefully, earn you some returns over the long-term, and the cash portion will give you something to fall back on in case of emergencies.
The cash is also available to put to work if the stock market declines and you want to get in on the ground floor.
Should I pay off debt first?
Heck yes, you should pay down debt first. To make your retirement savings last as long as you can, you need to limit your expenses. Getting rid of debt is a very easy way to do that. This includes credit cards, student loans, and yes, your mortgage.
If we are talking about paying off debt prior to saving for retirement, that’s a longer answer. Debt is mostly bad, we know that, but some debt is actually necessary. Most real estate (77% to be exact) is purchased using some sort of debt.
So no, you shouldn’t pay off your mortgage before you start saving for retirement unless you actually have the means to do so, and even that isn’t a definitive yes. With regard to your other debt (i.e. student loans, credit card debt, etc.) it’s important to “get a handle” on the high-interest debt first
Here’s the best way I can explain it:
Say you have $10,000 in credit card debt, spread among three cards. Card 1 has a balance of $6,000 and a 19% interest rate. Card 2 has $3,000 and a 23% interest rate. Card 3 has $1,000 and a 29% interest rate. Paying off card 3 effectively earn you a 29% annual return because you no longer owe interest on that card. Same logic goes for the other two cards. No investment will earn you that kind of return on a consistent basis.
Besides getting rid of your high-interest debt, the question of whether you should pay off debt before you start saving or pay off debt while you save, is a personal one. Are you comfortable with doing both at the same time? Would you rather have that debt gone so you have fewer liabilities?
The one thing you should consider is the effect of compounding on your retirement savings. The sooner you begin saving for retirement and investing, the more time you allow compounding to work it's magic.
What vehicles are available?
Plans available to individuals and businesses differ. If you’re an individual, you have the Traditional IRA, the Roth IRA, and any retirement plan you available through your employer.
If you’re a business, you have more options. You have the 401(k) and variations of it, the Simple IRA, and the SEP IRA. If you’re a non-profit or a government entity, you have 457 and/or the 403(b). Both of which are strikingly similar to the 401(k).
For an in-depth look at all of these plans, go here.
Saving for retirement is difficult and most people need help. It pays to know what your options are and how you should invest your retirement savings, as well as how to calculate what you need and what really matters when doing that calculation.
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