Why save for retirement?One reason is because people are living
longer, and a longer retirement means a more expensive retirement. There is no guarantee that working with a financial professional will improve investment results. | | Retirement Planning — The Basics
You may have a very idealistic vision of retirement — doing
all of the things that you never seem to have time to do now. But how do you
pursue that vision? Social Security may be around when you retire, but the
benefit that you get from Uncle Sam may not provide enough income for your
retirement years. To make matters worse, few employers today offer a
traditional company pension plan that guarantees you a specific income at
retirement. On top of that, people are living longer and must find ways to fund
those additional years of retirement. Such eye-opening facts mean that sound retirement planning is critical.
But there's good news: Retirement planning is easier than
it used to be, thanks to the many tools and resources available. Here are some
basic steps to help get you started.
Determine your retirement income needs
It's common to discuss desired annual retirement income as
a percentage of your current income. Depending on whom you're talking to, that
percentage could be anywhere from 60% to 90%, or even more. The appeal of this
approach lies in its simplicity. The problem, however, is that it doesn't
account for your specific situation. To determine your specific needs, you may
want to estimate your annual retirement expenses.
Use your current expenses as a starting point, but note
that your expenses may change by the time you retire. If you're
nearing retirement, the gap between your current expenses and your retirement
expenses may be small. If retirement is many years away, the gap may be
significant, and projecting your future expenses may be more difficult.
Remember to take inflation into account. Although the average annual
rate of inflation over the past 20 years has been 2.6%, that average hides years of unusual spikes, including 2021 (7%) and 2022 (6.5%).1 Also keep in mind that your annual expenses may fluctuate
throughout retirement. For instance, if you own a home and are paying a
mortgage, your expenses may drop if the mortgage is paid off by the time you
retire. Other expenses, such as health-related costs, may increase in your
later retirement years. A realistic estimate of your expenses could help tell you
about how much yearly income you may need to live comfortably.
Calculate the gap
Once you have estimated your retirement income needs, take
stock of your estimated future assets and income. These may come from Social
Security, a retirement plan at work, a part-time job, and other sources. If
estimates show that your future assets and income could fall short of what you
need, the rest would have to come from additional personal retirement savings.
Figure out how much you'll need to save
By the time you retire, you'll need a nest egg that could
provide you with enough income to fill the gap left by your other income
sources. But exactly how much is enough? The following questions may help you
find the answer:
- At what age do you plan to retire? The younger you retire,
the longer your retirement will be, and the more money you'll need to carry you
through it.
- What is your life expectancy? The longer you live, the
more years of retirement you'll have to fund.
- What rate of growth can you expect from your savings now
and during retirement? Be conservative when projecting rates of return.
- Do you expect to dip into your principal? If so, you may
deplete your savings faster than if you just live off investment earnings.
Build in a cushion to guard against these risks.
Build your retirement fund: Save, save, save
When you know roughly how much money you'll need, your next
goal is to save that amount. First, you'll have to map out a savings plan that
works for you. Assume a rate of return that you are comfortable with, and
then determine approximately how much you'll need to save every year between
now and your retirement to reach your goal.
The next step is to put your savings plan into action. It's
never too early to get started (ideally, begin saving in your 20s). To the
extent possible, you may want to arrange to have certain amounts taken directly
from your paycheck and automatically invested in accounts of your choice [e.g.,
401(k) plans, payroll deduction savings]. This arrangement could help reduce the risk of
impulsive or unwise spending that could threaten your savings plan — out of
sight, out of mind. If possible, save more than you think you'll need to
provide a cushion.
Understand your investment options
You need to understand the types of investments that are
available, and decide which ones are right for you.
If you don't have the time, energy, or inclination to do
this yourself, hire a financial professional. He or she can explain the
options that are available to you, and can assist you in selecting investments
that are appropriate for your goals, risk tolerance, and time horizon.
Use the right savings tools
The following are among the most common retirement savings
tools, but others are also available.
Employer-sponsored retirement plans allowing employee
deferrals [such as 401(k), 403(b), SIMPLE, and 457(b) plans] are powerful savings
tools. Your contributions come out of your salary as pre-tax contributions
(reducing your current taxable income) and any investment earnings are tax
deferred until withdrawn. These plans often include employer-matching
contributions and should be your first choice when it comes to saving for
retirement. Both 401(k) and 403(b) plans can also allow after-tax Roth
contributions. While Roth contributions don't offer an immediate tax benefit,
qualified distributions from your Roth account are free of federal (and possibly state) income taxes.
IRAs, like employer-sponsored retirement plans, feature
tax-deferral of earnings. If you are eligible, traditional IRAs may enable you
to lower your current taxable income through deductible contributions.
Withdrawals, however, are taxable as ordinary income (unless you've made
nondeductible contributions, in which case a portion of the withdrawals will
not be taxable).
Roth IRAs don't permit tax-deductible contributions but
allow you to make tax-free withdrawals under certain conditions.
With both types, you can typically choose from a wide range of investments to
fund your IRA.
Annuities are generally funded with after-tax dollars, but
their earnings are tax deferred (you pay tax on the portion of distributions
that represents earnings). There is generally no annual limit on contributions
to an annuity. A typical annuity provides income payments beginning at some
future time, usually retirement. The payments may last for your life, for the
joint life of you and a beneficiary, or for a specified number of years
(guarantees are subject to the claims-paying and financial strength of the issuing insurance
company).
Note:
In addition to any income taxes owed, a 10% premature distribution penalty tax may apply to taxable distributions made from
employer-sponsored retirement plans, IRAs, and annuities prior to age 59½, unless an exception applies. 1Calculated from Consumer Price Index (CPI-U) data published by the U.S. Department of Labor, January 2024 |