The money you sock away in an IRA or 401(k) plan shouldn't just sit there doing nothing. Rather, you're supposed to invest that money so it grows into a larger sum over time.
The great thing about IRAs and 401(k)s is that investment growth in these accounts is either tax-deferred or tax-free, so you won't be liable for gains on your returns year after year. As such, you'll be able to reinvest those gains.
But how much of a return can you expect your retirement savings to generate? If you set your expectations too high, you could wind up with a serious financial shortfall on your hands by the time your senior years roll around.
Don't be too optimistic
You might assume that your retirement plan will deliver an average annual 9% or 10% return over time, because that's comparable to the stock market's average. But if your savings don't perform quite as well, you could end up with a lot less retirement income than expected.
Say you contribute $300 a month to your savings over a 40-year period and expect your retirement plan to deliver an average annual 9% return during that time. If that happens, you'll end up with just over $1.2 million in savings, which is quite an impressive sum.
But what if your investments don't do as well? What if you only average a 7% average annual return? In that case, you'll be looking at about $719,000 in retirement savings, and while that's still a nice sum of money, it's not $1.2 million.
Furthermore, if you invest your long-term savings in target date funds, you may end up with an even lower return. Many 401(k) plans default to a target date fund when you don't go in and select your own investments, and a lot of target date funds err on the side of investing conservatively. The result? You may not see the return on your money you're banking on.
So what is a realistic rate of return for your retirement savings? It absolutely depends on the investments you choose and your tolerance for risk. In fact, there's really no way to predict what return your savings will end up generating over time, so a better bet is to not fall back on a generous return, and instead, make an effort to save more each month. Going back to the above example, if you contribute $500 a month to a retirement plan over 40 years instead of $300, and your investments don't give you an average annual 9% return but rather, a 7% return, you'll still wind up with about $1.2 million to your name by virtue of those larger monthly contributions.
At the end of the day, growing wealth for retirement is a matter of contributing substantially to your IRA or 401(k) and making smart investment choices. But sometimes, things can backfire even if you do the latter, so don't assume you'll snag a specific return on investment. Instead, track your plan's performance and adjust your contributions as needed so you don't wind up short on funds by the time your career comes to an end.