Planning for retirement isn’t something a lot of people think about. Everybody worries about retirement, but few people plan well for it. The tendency is to believe younger people neglect retirement planning. However, there are quite a few older people who are guilty of this as well. One thing I think we can all agree upon is that retirement planning is important.
I understand why this is an intimidating subject. For one, there is a lot of complex-sounding terminology that comes with retirement accounts. When people start talking about contribution limits, Roth, and investment, it can indeed start to sound confusing. But it doesn’t have to be.
There are simple, basic principles that anyone can follow. And guess what? You don’t need a degree in finance to retire well! Anyone can retire with dignity when they plan properly.
When should I start planning for retirement?
The answer to this question is easy! You need to begin planning for retirement as early as possible. It’s never too early to start! Plus, waiting too long makes retirement planning difficult. Of course, one of the first places you should start is with a budget. When you have a budget, you can start to take control of your money.
Some of your money should always go to both long-term and short-term goals. I consider retirement to be a long-term goal, so you will need to determine how much to contribute based on your income.
How much should I contribute to retirement?
Once you are out of debt, you should contribute 15% of your gross (before tax), yearly income into a retirement account. For example, let’s say you make $50,000 a year before taxes. That means your yearly retirement contribution should be $7,500.
Notice that I said once you are out of debt. That’s because having a lot of debt restricts your cash flow. Imagine again that you have a $50,000 yearly income. Let’s say you also have a $350 monthly car payment, $300 student loan payment, and a $250 credit card payment. That doesn’t give you much room for retirement contributions. Get rid of that debt and use that extra cash flow to plan for retirement.
So, why save 15% of your yearly income? Because in most cases, saving 15% will easily make you a millionaire by the time you retire. Using our previous example of contributing $7,500 a year comes out to a monthly contribution of $625. We’re going to assume you have an average return of 10%. After 30 years, you will have $1.4 million saved for retirement. And this assumes your income doesn’t change! As your income increases, so should your contributions.
What are some of the options for retirement Planning?
Glad you asked! The very first place you should look is with your employer. Many companies offer a 401(k), 403(b), 457, or some kind of investment vehicle. Don’t focus too much on those numbers. They are all pretty much the same.
There are also Individual Retirement Accounts, or IRAs. These are good extra investment vehicles. We’ll dive into these more, but first there is some terminology I want to define for you.
Traditional vs. Roth options
Most retirement plans include either traditional or Roth options. So what are they? These terms refer to the tax benefits you receive. With the traditional option, your contributions are pre-tax. This means tax-deferred earnings until you withdraw the money.
Roth is the opposite of traditional. Instead of using pre-tax money, contributions to Roth options are after-taxes. This means the money grows tax-free. Oh, and did I mention you don’t have to pay taxes on it ever again? That’s right! Once you retire, you can withdraw as much as you like without paying more taxes.
Investments, bonds, and mutual funds
Retirement accounts generally have options for investments. That means you get to choose where to invest and how to best grow your money. As you scroll through your options, two of the biggest investment options are bonds and mutual funds.
Bonds are essentially loans to other companies. While they often produce a more sure income, the rate of return you get is often low.
Mutual funds are typically the better option. Essentially, mutual funds are the opportunity to invest in multiple companies by purchasing only one fund. This means even if one company fails, there will be others to pick up the slack.
Mutual funds come in a lot of different varieties. But the ones I recommend for your retirement portfolio are growth, growth and income, aggressive growth, and international. You may also see these as large-cap, mid-cap, small-cap, and international.
I’ll tell you this right now. Company matches are pure gold. A company match means your employer matches the amount you put into a company-sponsored retirement account. For example, let’s say your employer says they match contributions of 3%. That means if you put 3% of your paycheck into retirement, then your employer will also put in 3%. It’s literally free money!
Of course, not all employers have matches. You’ll need to check with your company and see.
All retirement accounts have limits on how much you can contribute. Currently, in the year 2020, the yearly contribution limit for a traditional or Roth 401(k) is $19,500. Once you’re over 50, you can contribute an extra $6,500 every year as a “catch up” contribution.
The traditional and Roth IRA contribution limit is $6,000 a year. Once you’re over 50, you have the option of contributing $7,000 a year.
As a side note, you can have more than one IRA, but your contributions cannot total more than $6,000. That means you can’t open multiple IRAs and put $6,000 in each of them every year. If you try it, the IRS will be on you faster than a jackrabbit on a hot date. However, you CAN have both a 401(k) and an IRA.
How do I begin planning for retirement?
Finally, we’re ready to begin looking at the process of retirement planning! Below I’ve outlined some simple steps to ensure your retirement security.
1. Calculate your income and make a budget
A wise person once told me that if you fail to plan, you plan to fail. Getting on a budget will allow you to plan how much you need to contribute to retirement. Again, I recommend contributing at least 15% of your gross income into retirement. You’ll need to calculate how much that is.
To figure it out, take your yearly income and multiply it by .15. This will show you how much you need to contribute each year. After that, take that number and divide it by 12. That will tell you how much to contribute each month. It should look something like this:
50,000 X .15 = 7,500 (yearly amount)
7,500/12 = 625 (monthly amount)
Now you’ll know how much to contribute to retirement each month!
2. Start with your company match
Check with your employer and see if they offer matching contributions. If so, start there. The match is free money. Therefore, you don’t want to miss out.
If they allow you to contribute to a Roth option and still receive the match, then I would encourage you to take it. Note that your employer’s contribution will always go into the traditional option. That’s because they won’t pay your taxes for you (nor should they). Still, it’s free money and you don’t want to miss it.
As another side note, you do not want to consider the match as part of your 15% total retirement contribution. Instead, consider the match to be a bonus.
3. Consider opening up a Roth IRA
I’m a big advocate for Roth IRAs. I discovered that the mutual funds in my company 403(b) weren’t performing very well. So, I opted to contribute up to my company match and put the rest of it in a Roth IRA. My financial advisor was able to find excellent mutual funds that perform very well, so I’m a pretty happy camper!
If you have a spouse, you get a little bit of a bonus with IRAs. This is because both you AND your spouse can open up a Roth IRA. That means you can each contribute $6,000 per year, which comes out to $12,000! Try to max out both IRAs if you can!
4. Choose your investments
This is really important. You will want to choose your investments carefully and wisely. Previously, I mentioned four types of mutual funds: growth, growth and income, aggressive growth, and international. Put 25% in each of those funds. Also, find the funds that have the best average rate of return since their inception. It’s better to look for older funds since they’ve stood the test of time.
For your company retirement account, you may have limited options. Therefore, I recommend choosing the best ones you can find and invest in those. If those funds aren’t high performers, open up a Roth IRA and contribute as much as you can to that. Once you are able to do your company match and max out the Roth IRA, go back to upping your contribution to your company plan until you get to 15%.
If you need help with choosing your investment options, I recommend working with a financial advisor. Check out one of Dave Ramsey’s SmartVestor Pros and find an investment professional in your area.
5. Remember the retirement order of operations
Your company match comes first. Always start with the free money. Second is the Roth option. The money will grow tax-free and you can withdraw it tax-free when you retire. Finally, traditional contributions come last. I recommend taking the traditional option only if the Roth option is not available to you.
There you have it! Match, Roth, traditional. Remember that and your money will grow like a weed!
The wonder of compound interest
So, what’s the point in all of this? Why bother planning for retirement at all? Let me introduce you to the eighth wonder of the world: compound interest.
What on earth does that mean? To put it simply, it means you earn interest on the interest as money grows. For example, let’s say you invest $1,000 and it earns 10% at the end of the year. Well, now you have $1,100, which earns 12% the next year. Now it has grown to $1,232, and it will continue to grow as time goes on.
To give another example, let’s say you and your spouse each open up Roth IRAs and max them out every year. That will come out to $12,000 a year. Furthermore, let’s say you are both starting to contribute at age 30 and continue contributing to age 67. How much will you have?
Over the course of 37 years, if your investments average 10%, you will have more than $4.6 million in retirement. You would be multi-millionaires! Let’s also look at a “what if” scenario. Pretend that the average rate of return ends up being 6% after 37 years. What then? You’re still millionaires with more than $1.6 million! This assumes no change in contribution over your entire life. However you look at it, you can still become a millionaire.
How much do I need to retire?
That’s a good question! And to answer it, you’ll need to figure out your dreams and your goals. What do you want to do in retirement? Do you want to travel? Spend time with the grandkids? Open up a business?
Chris Hogan has an excellent tool to help you answer those questions. His R:IQ tool will ask you a few questions to determine the amount you need to retire well. After you get your R:IQ, you’ll be able to set some goals for your retirement.
What if I need help planning for retirement?
Sometimes we need help navigating this mess called life. And there’s no shame in that! So it may be worth your time to work with a financial advisor. A good financial advisor has the heart of a teacher and can help your money grow big time!
I encourage you not to put this off. Waiting too long can create an insecure financial future for you and put undue stress on your family.
Make a change. Take control of your finances today!