Most retirement investment planning, at least when you?re in your early twenties, focuses on two accounts ? a 401(k) and an IRA, typically a Roth IRA. The contribution limits are $16,500 for the 401(k) and $4,000 for the IRA, higher if you are permitted a catch-up contribution due to your age. If you were to max out your contribution to both, that?s a hefty $20,500 a year towards your retirement. That?s a lot of money for anyone to be contributing and I?d argue that contributing $20,500 each year until you retire is too much. Unless you make a lot of money, contributing that amount will put a significant strain on your current lifestyle and that?s a tradeoff that you may not want to make.
Here?s how I approach my retirement planning.
Calculating How Much
How much will you need in retirement? Ask ten people and you?ll get ten numbers. They will all be wrong. I do something simple, I calculate how much money I need to live on today and use the 4% rule. The 4% rule is a retirement rule of thumb that says you can only spend 4% of your nest egg each year if you want it to last for the rest of your life. With appreciation and interest, a 4% drawdown is ideal. That means if you want $40,000 a year in income, you?ll need a $1 million in retirement savings. If you want $80,000 a year, that?s $2 million. Calculating how much you need will depend on your lifestyle, so that?s up to you.
From there, you?ll want to set the finish line at 65 (or whenever), and calculate how much you need to save each year in order to reach that number. Then, calculate how much those savings will grow given rates of appreciation (minus inflation). You can use whatever growth rate you feel comfortable with, I personally use 7% (and 3% inflation). That will give you how much you need to save each year.
Front Load Contributions
My strategy has been to front load my contributions. In the first few years I was working, I contributed as much as I possibly could to both my 401(k) and my Roth IRA. With investing, time is your best ally and you?ll want as much money in the pot as early as possible in order to take advantage of time. I maxed out my contribution for two years before tapering back because I wanted to buy a house. By going full throttle on contributions early, I was able to build up a nice nest egg that can grow on its own.
If you use this strategy, rather than equal contributions each year, remember to recalculate your annual savings needs so you don?t overshoot your target. If you need to save $8,000 a year annually and you contribute $20,000 now, your annual savings needs will go down significantly.
Get Free Cash
At a minimum, I will always contribute enough to get any company match on my 401(k). If your employer offers you a match of any kind, take advantage of it. My first employer offered an extra 3% if I contributed 4% (full match on the first 2%, half match on the next 2%) and I always contributed at least the full amount. Who turns down free money?
Taxes
One point I purposely overlooked was taxes. Contributions to your 401(k) are tax deductible but you pay income taxes on the disbursements during retirement. If you need $80,000 a year and it comes entirely from a 401(k), you?ll need to save for more because you?ll be taxed on that income. I conveniently ignored it because it complicates things and I just figured that any Social Security payments would help offset that tax so that the math would come out close enough. I could be wrong but for the sake of simplicity, that?s where we?re going.
So, are you saving too much?
(Photo: italintheheart)
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Source: http://www.bargaineering.com/articles/save-retirement-2.html
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