Retirement planning is a journey, not a destination.
Retirement planning is a broad term that refers to financial strategies designed to help set you up for a comfortable and secure retirement. A good retirement plan can put you in a position to have enough money to cover all of your living expenses in retirement for decades. In this article, we'll explore the importance of smart retirement planning and what steps you should take to get yourself on the road to a worry-free retirement.
Why should I plan for retirement?
Good news! On average, we are living longer and are able to remain healthy and active well into our sunset years.
Now the not-so-good news: Many Americans haven’t saved enough to retire in their 60s with the confidence that their money will last. The Center for Retirement Research at Boston College and the Consumer Financial Protection Bureau have both estimated that approximately 50% of retirees have cut back on their spending, or will be forced to do so, due to dwindling resources.
Far too many retirees end up relying on Social Security to cover the majority of their living expenses, only to find out the hard way that it isn't nearly enough. Social Security is only designed to replace about 40% of the average worker's salary after they retire, but more than one in five married couples and 45% of single retirees depend on it for more than 90% of their income in retirement.
The bottom line is that you don't necessarily need to plan. Millions of Americans don't. But if you want to enjoy your retirement and be financially comfortable after you leave your job, retirement planning is essential.
Social Security is only designed to replace about 40% of the average worker's salary after they retire. Many retirees drastically downgrade their lifestyles due to inadequate savings.
Things to consider when planning for retirement
- When will you retire? Will you work until 65, or do you plan on working longer than that? Or do you have a goal of retiring early?
- Where will you live? Are you going to stay in your current home or downsize? Do you want to stay in the same area or retire somewhere warm or closer to relatives?
- How will you pay for living expenses? Social Security isn't likely to be enough all by itself, so will you have a pension? A 401(k)? Do you have lots of money in savings or other investments?
- What about medical costs? Once you turn 65, you're eligible for Medicare, but you'll still have to worry about out-of-pocket expenses or purchase a Medigap supplemental insurance plan. Or, if you plan to retire before 65, you'll need to arrange for healthcare until you reach Medicare eligibility.
How much money do you need to retire?
How much do you need to retire comfortably? $1 million? $2 million?
Unfortunately, there's not a one-size-fits-all answer to this question. You can check out our guide to determining how much you need to retire, but here are the basic steps to follow:
- Determine your retirement income needs, as discussed earlier.
- Subtract your expected Social Security benefits and any pensions you expect to receive.
- To apply the often-used 4% rule of retirement, multiply the result by 25 to get a good estimate of how much savings you should aim for.
How to save and invest for retirement
As previously mentioned, Social Security isn't likely to be enough to fund your retirement income needs all by itself since it is designed to replace about 40% of the average American's income. The typical retiree needs about 80% of their pre-retirement income to maintain the same standard of living after they leave the workforce for good.
How much do you need to save each month?
The amount you need to save depends on your current age, your target retirement age, and how much you’ve already accumulated. But as a starting point, most Americans would do well to save 15% of their annual incomes over the course of their careers.
You don't need to get there right away. Saving 15% of your income might sound intimidating when you're first starting out. At a bare minimum, if you have a retirement plan at work, you should start by contributing enough to take full advantage of your company's matching contributions.
If you don’t have an employer-sponsored plan, saving 6% of your income (the average retirement contribution rate) is a good place to start, and work your way up from there. Try increasing your allocation by 1% of your salary each year until you reach your desired contribution rate, or start boosting your contribution rate whenever you get a raise.
Types of retirement plans
When it comes to saving for retirement, where you save is just as important as how much you save. It isn't enough to simply take 15% of your salary and stick it in a savings account. You need to invest.
Here's why. Let's say you save $5,000 per year for retirement starting when you're 30. If you put that money in a savings account paying 1% interest, you can expect to have about $208,000 when you're 65. On the other hand, if you put it into investments in a retirement plan and achieve a 7% average annual return, you'd have close to $700,000.
There are several great options that allow you to save and invest for retirement in a tax-advantaged way:
- 401(k), 403(b), 457, Thrift Savings - These are retirement plans offered by employers to their workers and typically provide a selection of mutual funds to invest in. If your employer offers matching contributions, you should absolutely take advantage.
- Pensions - Pensions are also known as defined benefit plans because they provide a predictable amount of income every month for life. Unfortunately, they are becoming quite rare, but many employers (especially in the public sector) still offer them.
- IRAs - IRA stands for individual retirement account, and they are available in two main varieties, the traditional IRA and the Roth IRA. The big difference between the two is the tax treatment, but both types allow savers to put their money to work in virtually any stocks, bonds, or mutual funds.
- SIMPLE IRAs, SEP IRAs, Solo 401(k)s - These are special types of retirement accounts available to self-employed individuals.
Asset allocation: What should you invest in?
Once you open an account, you have to choose what to invest in. We believe that stocks are the best long-term investments. But any money you need in the next three to five years should be in cash or bonds, including a five-year “income cushion” for retirees.
Taxes in retirement
Taxes are a fact of life for most retirees, just like they are for most workers. However, it works a little differently when it comes to retirement income.
For starters, Social Security is taxable, but only for retirees who have substantial income from other sources. Hopefully you will have other sources of income, so you should keep in mind that as much as 85% of your Social Security benefits can be considered taxable income.
Withdrawals from retirement accounts like 401(k)s and traditional IRAs are considered to be taxable income. The exception is Roth IRAs and any Roth 401(k) accounts you might have, from which qualified withdrawals are not taxable.
Finally, it's important to note that states treat retirement income differently. Most states don't tax Social Security benefits at all, and some states have big exemptions for other types of retirement income as well.
The next steps to take
To be as direct as possible, planning a retirement strategy is something that every American should start doing as soon as possible. Your money will never have as much long-term growth power as it does now, and the earlier you start investing, the less you'll have to save to reach your target.
Of course, not everyone wants to go it alone. If you need assistance figuring out your asset allocation, determining when you can retire, or planning your retirement income strategy, you should seek the advice of a Certified Financial Planner or other qualified professional to point you in the right direction.