Retirement experts and financial planners often tout the 10% rule: to have a good retirement, you must save 10% of your income. The truth is that—unless you plan to go abroad after retiring—you will need a substantial nest egg after 65, and 10% is probably not enough.
While the government assures us that Social Security will be around when it’s time to retire, it’s best not to rely too heavily on others when planning how to live out some of the most vulnerable years of our lives.
Remember that the average retirement benefit for a retired worker in June 2020 was $1,514, according to the Social Security Administration, or roughly $18,168 per year. Even though there are various plans that could ensure the longevity of Social Security, it’s best to be ultraconservative and not rely on it as the main element of your retirement income.
- Saving 10% of your salary per year for retirement doesn’t take into account that younger workers earn less than older ones.
- 401(k) accounts offer considerably higher annual contribution limits than traditional IRAs.
- 401(k) accounts can come with a matching employer contribution, which is in effect free money.
There are two broad rules some experts use to calculate how much you’ll need to save—and how much you can afford to spend—to sustain yourself in retirement.
If you have a 401(k) match program at work, you should take advantage of it, otherwise, you are losing out on “free” retirement funds.
This rule requires that for every dollar in income needed in retirement, a retiree should save $20. Let’s say you earn about $48,000 in a year. You would need $960,000 by the time you stop working to maintain the same income level afterward. If you had somehow managed to save 10% of that salary or $4,800 per year ($400 per month) for 40 years at 6.5% interest, that would get you to slightly more than $913,425, which is close.
However, young people generally earn less than older ones. And how many people save $4,800 a year for 40 years? Realistically, most people need to save well over 10% of their income to come close to what they need.
This rule refers to how much you should withdraw once you get to retirement. To sustain savings over the long term, it recommends that retirees withdraw 4% of their money from their retirement account in the first year of retirement, then that they use that as a baseline to withdraw an inflation-adjusted amount in each subsequent year.
“I think 3% as a withdrawal rate is a more conservative and realistic rule for withdrawals—only to be used as a rough guideline,” says Elyse D. Foster, CFP®, founder of Harbor Financial Group, in Boulder, Colo. “It does not substitute for a more accurate planning projection.”
SEP Account: Jessica Perez
Basic high school math tells us that saving only 10% of your income isn’t enough to retire. Let’s take a salary of around $48,000 and the rule of 20 retirement savings amount of roughly $960,000 and look at it in a different way. By saving 10%, your money would need to grow at a rate of 6.7% a year for you to retire 40 years from when you start. In order to retire early, after 30 years of contributing, you would need an unrealistically high rate of return of 10.3%.
The same problem applies to people in their 30s or older who don’t have 40 years left before retirement. In these situations not only do you need to contribute more than 10%, but you also need to double it (and then some) to have a $960,000 nest egg in 30 years.
“For 30-year-olds, moving from a 5% savings rate to a 10% savings rate adds nine additional years of retirement income,” says Craig L. Israelsen, Ph.D., designer of the 7Twelve Portfolio in Springville, Utah.
Israelsen adds:
Moving from 10% to 15% adds nine more years. Moving from 15% to 20% adds eight more years. In general, adding an additional 5% to your savings rate lengthens your retirement portfolio’s longevity by nearly a decade. For 40-year-olds, add another 5% savings chunk and you get about six more years of retirement income. For 50-year-olds, add another 5% savings chunk and you get about three more years of retirement income.
The easiest way to save more retirement money is to find some for free. The most obvious way to accomplish this is by getting a job with a 401(k) match. In this situation, your company will automatically deduct a portion of your paycheck to contribute to the plan, then throw in some of its own money at no additional cost.
“Let’s say you contribute 3% of your income and your company matches 3% with 3% of its own. This equals 6% of your income,” says Kirk Chisholm, wealth manager and principal at Innovative Advisory Group in Lexington, Mass. “Immediately, you are receiving a 100% return on your contribution. Where else can you expect to get 100% return on your money with almost no risk?”
The beauty of a 401(k) match contribution is that it doesn’t count against your maximum annual contributions—that is, up until a combined contribution of $57,000 in 2020 and 2021 (the rest would have to come from your employer) per year. While a regular employee can contribute $19,500 in 2020 and 2021, a person whose employer contributes $5,000 will get to put away $24,500 in 2020 and 2021 instead.
Larger 401(k) contributions have a double benefit. A $5,000 increase in contributions every year for 40 years, compounded at 6%, boosts retirement savings by almost $800,000. Add in the 2020 and 2021 annual contribution of $19,500 and the tax savings from contributing to a retirement account, and soon retirement savings are over $4 million.
This is where individual retirement accounts (IRAs) come in. They don’t allow you to save as much—the maximum for 2020 and 2021 is $6,000 until you’re 50, then $7,000—but they’re one vehicle that can get you started. Depending on your income and some other rules, you can choose between a Roth IRA (you deposit after-tax money and get more benefits at retirement) or a traditional IRA (you get the tax deduction now). You can have both an IRA and a 401(k), with deductions dependent on various Internal Revenue Service rules.
If you are an entrepreneur or have a side business, you can save some of that money in a variety of retirement vehicles available to the self-employed. And there are other ways to invest money that can help with retirement, such as real estate. Discuss this with a financial advisor if possible.
It’s important (and cheering) to remember that with every 401(k)-contributed dollar (and traditional IRA dollar), the government gives you a slight break on your taxes by lowering your taxable income for that year. The tax deferral is an incentive to save as much money as you can for retirement.
The easiest way to duck the pain of saving a huge chunk of money each pay period is to automate your savings. By having your…