At a glance, planning for retirement can seem overwhelming and even insurmountable. The retirement landscape has definitely changed since your parents or grandparents retired. I didn’t deal with the retirement issues they did, so I can’t say that they were harder or easier, but it’s definitely a whole new set of issues these days. You likely won’t ever get a pension. Your investments, and retirement accounts, are largely up to you to manage (for better or for worse).
Does that mean you can’t have the retirement you’ve been envisioning? No! You can still make it, you just need to be proactive and get ahead of the game. The earlier you start, the easier this will be. So, if you’re young, go ahead and start so you don’t have to worry as much later. If you’re older and stressed about retiring, it’s time to kick this into high gear.
How Much Do I Need To Save?
I discussed the details of this in my article on early retirement. How much you need to save really depends on how much you plan to spend during your retirement. But, as a general rule of thumb I’ll say the following:
- A common standard (based on a variety of factors) is to save 25-33 times your annual expenses. So, if your expected annual expenses in retirement are $50,000 – that means you’ll need to save at LEAST $1.25 million!
- Withdraw around 4% each year from your retirement accounts. This makes it easier for you to maintain your lifestyle, without running out of money. Using our previous example, 4% of $1.25 million is $50,000 – what a surprise! Of course, the less you withdraw each year, the longer you can stretch your retirement funds. If you withdraw a smaller portion each year, that also means you’ll have to save more money (and be closer to 33 times your annual expenses, rather than 25).
What Expenses Should I Factor In?
Let’s keep this simple:
- Inflation (usually 2-5% annually)
- Housing, including utilities and any additional warranties or insurance you pay for
- Groceries
- Transportation
- Entertainment and travel
- Increased health care costs and optional life insurance
How Do I Start Investing?
I have a complete guide that explains how you can start investing in index funds and ETFs. You need to keep it simple and consistent, and as with everything in personal finance – start now. I understand that investing is on the back burner when you’re first starting out, but may sure you take it seriously and make an effort to contribute to a retirement account consistently. To make it easier on yourself, try automating deposits on a monthly or weekly basis.
If you haven’t started at all, open an account with M1 Finance or Vanguard. As you start, simply focus on index funds and ETFs with a good track record and low fees (aka expense ratios). Remember, diversity is ideal!
Account Options
So, we know that investing is important, we know we need to stay consistent, we know to invest in low-fee index funds and ETFs, but we don’t necessarily know which retirement accounts we should use! Now, the most important part is clearly investing, but investing in the right account can save you a huge amount in taxes. Also, if you want to retire early, you may need to consider investing in an account with no tax benefits, so you can begin withdrawing from it much earlier (with no penalties).
401(k)
A 401(k) is a type of tax-advantaged investment account. There is a cap on how much you can contribute annually, but usually your focus is simply on reaching the amount your employer will match.
In a traditional 401(k), your contributions are deducted from your taxable income. This means that your contributions are made tax-free, but you will have to pay tax on them when you withdraw them in retirement. This can be a good thing since a lot of people will be in a lower bracket when they retire. However, it is always unknown how policies and taxes will change in the future, so you can never be completely sure which will end up being the better option in the long run.
In a Roth 401(k), you make contributions that have already been taxed. That means you won’t have to pay taxes on them later, when you withdraw.
Often, you may only have a traditional 401(k) available to you. However, if you have the ability to do both, you could always split your contributions between them to hedge your bets to a certain extent.
IRA
An IRA is another type of tax-advantaged investment account. There is a cap on how much you can contribute annually to a Roth IRA, which you’ll ideally reach.
In a traditional IRA, your contributions are deducted from your taxable income. Like the traditional 401(k), this means your contributions are made essentially tax-free, however you will have to pay tax when you withdraw them during retirement.
Roth IRAs use contributions that have already been taxed. While that seems unfortunate now, it does mean you won’t have to pay taxes on them later on, which could turn out in your favor (but it could also work against you too). The main issue for Roth IRAs is that they have an income cap, so once you make over a certain amount you can’t contribute to it anymore.
Some people like to do a combination of Roth and traditional IRAs, but it is more common to just focus on maxing out a Roth IRA. While IRAs, like 401(k)s, have a minimum age of 59.5 years old before you can withdrawal with no penalties, there are a few exceptions if you need them – but it’s best to avoid early withdrawals altogether.
High-Yield Savings Account
A high-yield savings account is useful because it is safe. It won’t make you the most money in the long-term (probably not in the short-term either), but it lets you earn SOME interest on money while keeping it ready to withdraw to use towards your expenses. How much you keep in a high-yield savings account during retirement is up to you, but it’s wise to keep at least several months of expenses in it. During retirement I’d recommend erring more on the side of caution with this and saving 12-18 months worth of expenses in one, even if you don’t foresee major issues (it’s better to be safe than sorry after all).
Asset classes
Bonds
Bonds offer a safer investments investment than stocks, but at a much lower return. They can be used to help stabilize your portfolio, but due to their performance people are increasingly using a mix of larger emergency funds and index funds to mitigate the need for bonds.
Index Funds & ETFs
If you don’t know what an index fund is, check out this article. All you really need to understand is that investing in an index fund is like investing in a huge group of stocks. Basically, it’s a wider net. Over time, they perform very well – even putting a lot of active traders to shame.
Target Date Funds
Think of this as something like an index fund, but instead of it just being a mix of stocks, it is a mix of different asset classes that get reallocated based on your retirement timeline. It may sound good in theory, but they usually have extraordinarily high fees. If you choose to use one, proceed with caution and double-check the expense ratio.
How Should I Structure My Portfolio?
Well, that’s a loaded question. It depends on too many factors for me to give you a fair answer. Even if I knew your age and how long you plan on being retired, it still wouldn’t be enough. If you need help building your specific portfolio, talk to a financial advisor or specialist. I will add, even though I haven’t discussed it, using real estate (because of its great cash flow) to retire is another option that you can explore too.
Eliminating Debt Helps
Obviously, eliminating all of your major debt (particularly any high-interest debt) before retirement will help you out. I’d definitely recommend knocking out debt related to credit cards, cars, or student loans – if you still have them. You don’t have to completely pay off your mortgage, but a lot of people like doing it.
When you do the math, it generally turns out that investing money instead of paying off a mortgage is better. However, psychology – specifically, your mindset – is one of the most important parts of personal finance. A lot of people feel much more secure if they have their mortgage paid off, so it’s a must for them. At the end of the day, that’s up to you and what you think you can handle.
Conclusion
I hope that helped clear up a lot of confusion! Just remember, if you start now and stay consistent you’ll see some great growth – don’t get discouraged. If you have any other useful information, be sure to share it in the comments! For more content like this, and a free budgeting template and financial goals worksheet, be sure to sign up for the Bitter to Richer newsletter.
