There are lots of ways to successfully plan for retirement. However, it’s easy to get caught up in the details, become distracted by worst-case scenarios, and lose confidence in whether or not you’re on the right path.
In this post, I’d like to help you by laying out how to plan for retirement using the following simple steps. By answering them honestly, you’ll create the foundation for a realistic retirement plan that you can begin to start using right away.
What Do You Imagine Your Retirement Will Be Like?
One of the most critical and yet overlooked steps in planning for retirement is to think about how you’ll want to spend it. Depending on when you separate from work, you might have 30+ years that you’re free to do with as you please!
Close your eyes and imagine what you’d do with all that time. Would you:
- Travel more often?
- Visit with family and friends?
- Volunteer and help a cause that you’re passionate about?
- Start a second career or launch your own business?
- Live pretty much the same way you do right now?
The direction you decide to take is extremely important because it will ultimately determine how much money you think you’ll need to cover your living expenses.
Where Will Your Retirement Income Come From?
For the majority of most Americans, your retirement will be funded with the money you save to what’s called your nest egg. Your nest egg is the collection of all your:
- Tax-advantaged retirement accounts (401k, IRA, etc.)
- Taxable investments (mutual funds, stocks, etc.)
- Any additional savings you have to sustain your living expenses once you’ve retired
Among the three, your tax-advantaged retirement accounts are going to give you the best advantages when it comes to building up your nest egg for the following reasons:
- Tax-deferred contributions. Tax-deferred retirement plans allow you to skip paying taxes on your contributions in the year that you earned them. That means more money can go into your nest egg and not to the IRS.
- Investing for growth. Because your 401k and IRA are investment accounts, they’ll be invested in funds that consist of various stocks and bonds. Assets like these enable you can take advantage of compound growth. That’s going to allow you to multiply your nest egg by several times what you put into it.
- 401k matching contributions. If you work for an employer that gives matching contributions, then it’s like getting free money just for being a good saver. Again, that’s going to help you reach your goals sooner.
In addition to your nest, there will be other sources of income you should take into consideration. These might include:
- Social Security benefits (available starting at age 62)
- Pension payments
- Cash-value life insurance
- Dividend payments
- Rental property income
- Side hustle income
To get the full picture, make a list of each one of these income sources that you can expect to receive. Be sure to include it as part of your overall plan.
How Much Money Will You Need to Save?
Once you have some idea of how much your living expenses will be in retirement and where the money will be coming from, the next step is to calculate how much you’ll need to save in your nest egg. This can be easily estimated using a helpful rule of thumb known as the 4 Percent Rule.
The 4 Percent Rule was a study that found that a retiree could safely withdraw up to 4 percent from their starting nest egg amount each year for at least 30 years with adjustments for inflation and not run out of money. Over the years, this guideline has gone through several modifications but most financial planners universally agree that it’s a great starting point for planning purposes.
Here’s how we can use the 4 Percent Rule to plan our retirement. Let’s say that you anticipate needing $6,000 per month. Using the 4 Percent Rule, we can easily calculate that our nest egg target should be:
($6,000 x 12) / 0.04 = $1,800,000
Keep in mind that if you expect to have other sources of income available when you retire, then you can reduce how much you’ll need to save in your nest egg.
For instance, let’s say in our earlier example that you can expect to retire right around the same time you’re also eligible to start collecting Social Security benefits. You also know from checking your Social Security account that you can expect about $2,000 per month. Therefore, your new nest egg total would be as follows:
[($6,000 – $2,000) x 12] / 0.04 = $1,200,000
When Would You Like to Retire?
The last step in this process is to determine when you’d like to actually become retired. This will depend on how much you’re willing to save each month and if those contributions will meet the goals you arrived at with the earlier questions.
The first thing to do is determine how much you have available to save each month. Some financial gurus recommend saving at least 10 to 15 percent of your gross monthly income. But saving more than this will of course help to speed up the process.
The other big variable is how your savings will be invested. If you invest conservatively, your returns will be stable but also low and slow to grow. Alternatively, investing aggressively will produce higher returns but will carry more risk. Your goal should be to strike a portfolio balance between these two types of investment extremes that you feel comfortable with.
Here’s an example of how this all works together. Let’s say your nest egg target is $1.2 million. How long before you’ll reach your goal?
- Saving $500 per month with an average annual return of 5 percent will take 49.1 years.
- Saving $1,000 per month with an average annual return of 5 percent will take 36.7 years.
- Saving $500 per month with an average annual return of 10 percent will take 31.9 years.
- Saving $1,000 per month with an average annual return of 10 percent will take 25.2 years.
If you’d like some assistance planning for retirement, then let Buxfer help you to get on track. Their Plans feature allows you to set long term goals and then test various inputs to see how they impact the outcome.
Image credit: Unsplash