Making It Work Richard Quinn | July 30, 2019
I’M ONE OF THE fortunate Americans with a pension. I know firsthand the sense of financial security that comes with steady monthly income. Others don’t have it so easy. I worry a great deal about the majority of Americans—including my four children—who have no pension, and instead will rely on Social Security and their investments for their retirement income.
My fear: Even if these folks are saving regularly, they don’t really understand how to invest or how to manage their nest egg once retired. Consider a couple earning $60,000 a year who retire at age 66. The main breadwinner’s Social Security benefit might be $18,000 a year. Add spousal benefits, and we’re looking at $27,000 for the couple.
Their goal is to replace 100% of their income in retirement. That means our retired couple must generate investment income of $33,000 a year. To do that, they’d need retirement savings of $825,000, assuming a 4% withdrawal rate. What would it take to amass that much? They’d have to save $711 a month—or 14% of pretax income—for 40 years, assuming they earn a 4% annual after-inflation rate of return.
Here’s a closer look at what’s involved:
1. Moving parts. A calculation like this involves a host of variables: To reach your target nest egg, you may need more than 40 years. Stay flexible. Investment gains will vary from year to year and there’s a good chance your long-run after-inflation annual gain will differ from 4%. Saving more in the early years, when you’re single and with fewer financial commitments, will give a big boost to your nest egg. I target 100% income replacement. Others say 80% or even 70%. That sharply lowers the required savings rate. If your goal is a 70% replacement rate and you still get $27,000 from Social Security, you’d need to amass just $375,000, instead of $825,000. But before you aim that low, take a hard look at the lifestyle you want in retirement and what debts you may still be carrying at that juncture.
2. Saving diligently. While socking away 14% of income might seem daunting, it could be less onerous than you imagine. You may get an employer’s matching contribution in your 401(k) or 403(b) plan. If your employer kicks in just 3%, that lowers your required savings rate to 11%. Saving on a pretax basis will minimize the impact on your take-home pay. If you’re in the 22% tax bracket, every $100 tax-deductible contribution to your 401(k) reduces your paycheck by $78, not $100.
You might save out of pretax income when money is tight, while switching to after-tax Roth contributions when things are better, so you also have a pool of tax-free retirement money. Save automatically, both through your employer’s plan and by setting up automatic contributions to your favorite mutual funds. This will compel you to save before you get a chance to spend. You’ll then be forced to live on whatever remains—provided you don’t rack up the credit cards.
If your 401(k) has an auto-escalation feature, sign up. When you get a raise, your contribution percentage will automatically increase. Help your take-home pay situation by using a health savings account or flexible spending account for health care bills. By putting pretax money in one of these accounts, you save not only on income taxes, but also 7.65% for Social Security and Medicare payroll taxes. A health savings account could become a strategic part of your retirement plan.
Source: Making It Work – HumbleDollar