Young and mid-career professionals often wonder about the adequacy of their retirement savings and whether they will achieve their retirement goals. While social security is designed to supplement retirement income, it was never intended to be a comprehensive retirement plan. This is particularly true for higher earners. The more one earns during their career, the less pre-retirement income social security will replace. This reality, coupled with the significant shift from defined benefit pension plans to 401(k)s, underscores the increasing importance of personal savings for retirement. Personal savings provide security, ensuring you have a financial cushion to rely on in your golden years.
You must consider numerous factors when determining how much you should save for retirement. For instance, the decision to retire early means there will be less time for savings to compound and fewer earning years to contribute. Moreover, the type of lifestyle you envision for your retirement will significantly influence how much you need to save.
Do you aspire to maintain your buying power by accounting for inflation? Do you wish to preserve your principal savings for your heirs? Or do you anticipate consuming all your savings during retirement? These lifestyle choices can have a profound impact on your retirement savings. As a general guideline, saving at minimum 10-15% of your income is recommended. In addition, try to prioritize tax-advantaged accounts, leverage any employer match, and commence saving as early as possible to secure a comfortable retirement.
Let’s dive a bit deeper into the details you want to consider:
Accumulation Period & Retirement Age
When it comes to compounding, timing is everything. The earlier you commence saving, the more time your savings have to grow. This implies that initiating your savings journey early and extending your working years can significantly reduce the percentage of your income you need to save while allowing you to maintain a similar lifestyle in retirement. Conversely, if you delay your savings start or plan to retire earlier, you’ll need to save a higher percentage of your income to meet your retirement goals. Therefore, it’s crucial to start saving as early as possible to harness the power of compounding and fortify your retirement future. Though the exact amount of savings you should have is based on many factors, institutions like T. Rowe Price have developed general benchmarks to aim toward.
Consider Your Savings Vehicles
Not all savings vehicles are created equally, and where you put your money can drastically affect the amount you need to save and the impacts on your retirement income. Let’s discuss the pros and cons of some of the different options:
Qualified Employer Plans:
Try to prioritize saving in qualified plans (401(k)s, 403(b)s, etc.), as they have unique creditor benefits. Many of these plans also feature employer contributions or employer matches, which can significantly boost your retirement goals. Funds in pre-tax retirement accounts grow tax-deferred, meaning your investment earnings continue to compound without being reduced by taxation as long as you keep them in the account. If investing in a Roth plan, the funds will grow tax-deferred, and you can pull them out tax-free during retirement, subject to specific rules. Even if you aren’t maxing out your qualified plan contributions, try to get at least the full employer match available, as not doing so is leaving money on the table.
IRAs:
Once you’ve maxed out your qualified plan contributions, consider saving for retirement in an IRA. Most types of IRA don’t have matching employer contributions and may not have as much creditor protection as qualified plans, but they feature similar tax benefits. Keep in mind there are income limits around contributing to Roth IRAs and being able to deduct contributions to Traditional IRAs, so make sure you check with your tax advisor to see what options are available. The backdoor Roth strategy may indirectly allow high-income taxpayers to contribute to a Roth IRA.
Annuities:
Annuities are tax-deferred savings products that can provide income in retirement. They are almost the reverse of life insurance—annuities are designed to mitigate the risk of outliving your savings (superannuation). Funds can be contributed in a lump sum (single-premium) or multiple payments. They can grow based on a guaranteed interest rate (fixed) or the performance of a separate investment account (variable). They may be designed to provide income immediately or after some time (deferred).
Suppose the owner decides to annuitize the contract (turn the income on). In that case, the annuitant loses access to the principal but is guaranteed payments for life based on the account’s value and the annuitant’s life expectancy. There are hundreds of types of annuities, and the complexities of their tax treatment are beyond the scope of this article. Still, they can be a viable retirement vehicle with tax-deferred growth and lifetime income.
Variable Life Insurance:
For very high earners who max out their 401(k) and IRA contributions, there is a lesser-known tax-advantaged savings option called variable universal life insurance, or VUL. A VUL is primarily a life insurance product with a built-in investment account. The Internal Revenue Code (IRC) allows this investment account to grow tax-deferred and be accessed tax-free under certain circumstances. These funds may also be accessible before retirement age. VULs are very complex and require life insurance and investment expertise to administer, so talk to a trusted CFP® professional to see if it is right for you.
Taxable Accounts:
Finally, additional retirement funding can be saved in a taxable brokerage account. While these accounts don’t carry particular tax advantages, they are much more accessible than most retirement plans, as money can be contributed and withdrawn freely. This is the ideal place to build retirement savings once all the tax-advantaged options are maxed out.
Not all retirement savings plans are created equal. Remember: the tax advantages of most retirement plans also come with limitations. With some exceptions, if you contribute to a retirement plan, expect to have the non-taxed money locked in there until 59 ½ to avoid early withdrawal penalties. Non-taxed money refers to pre-tax contributions and the earnings on Roth and nondeductible contributions.
Risk Tolerance
The risk you take in your investments typically affects the overall return you expect over a long period. That means people with a higher risk tolerance may not have to save as much to meet their retirement goals, as they expect to receive greater returns on average. On the other hand, conservative investors may want to consider setting aside more for retirement as they will likely experience a lower overall return on their investments. Many people invest aggressively when younger with a long time horizon. They then invest more conservatively as they approach retirement. This strategy is essentially the concept behind target date retirement funds, which have become quite popular.
Goals and Lifestyle in Retirement
When deciding how much to save for retirement, one should also consider what they want their retirement to look like. A lavish retirement with expensive trips and fine dining will require a lot of funding. Goals to purchase a vacation home or boat in retirement will also add to the needed savings. Will you want to help fund your grandchildren’s educations and give a lot of gifts? These things will all impact the ideal size of your nest egg and, therefore, how much you should be saving.
On the other hand, some people choose to maintain a simpler lifestyle in retirement, staying in the home they’ve paid off and taking similar vacations to what they took while working. Some people even downsize during retirement, trading in their homes for something smaller.
Another thing to consider is buying power protection, especially with an early retirement. Nowadays, people are living 20, 30, or even 40 years in retirement. Even 2% inflation can cut your buying power in half over 40 years. Do you want to ensure your income retains its value throughout your retirement? If so, that will require a higher retirement savings rate.
Legacy Goals
One final consideration when determining how much to save for retirement is your legacy goals. Legacy goals are things you want your wealth to accomplish when you pass away. Do you have dreams of leaving a charitable foundation? Do you want to provide a sizeable inheritance to your heirs? Or do you plan to consume all of your assets in retirement? The answer to these questions can significantly affect the money you need to save.
Some retirees want to live off the earnings on their retirement savings and leave the principal to heirs. The money needed to live without touching the principal is much higher than if you expect to consume all your assets.
Conclusion
The amount of money you should save for retirement lies at the heart of many financial plans. There are several factors to consider when answering this question; no hard-and-fast answer will fit every situation. It is important to talk to a CFP® professional who can review your full financial picture and help build a customized plan to meet your specific goals and circumstances. Schedule a complimentary consultation with me today and start building your DreamVision retirement!
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