Hoping Social Security will keep you afloat in retirement? Prepare to be disappointed. For the average worker who waits until Full Retirement Age (FRA) to claim benefits, Social Security replaces only about 40% of working income. You'll get even less if you start collecting your benefits early.
That fact leaves you with two basic strategies for retirement. You could figure out how to cut your living expenses by 60% to live on Social Security alone. If that sounds enormously unpleasant -- and it should -- you can take the alternate path, which involves boosting your retirement with other sources of income. Here are three steps to get you started.
1. Budget and downsize now
Your retirement readiness plan should include some cost-cutting measures, and sooner rather than later. Start by creating a budget that reduces your current living expenses by 5% or 10%. You'll take the savings and funnel them into your retirement account.
The extra retirement contributions help you shore up your finances, but the budgeting practice is equally important. In our working years, many of us can get by without a strict budget because we use credit cards and annual raises to recover from overspending. In retirement, you have far less room for error. Overspend and you'll ultimately have to pull more money from your savings, which depletes your future earnings power and threatens your long-term solvency.
If you can learn how to budget and control your spending now, it takes a lot of pressure off your retirement savings later.
2. Save to a 401(k) or IRA
Both 401(k)s and IRAs have perks that make retirement saving easier. Your contributions to your 401(k) and traditional IRA are often tax-free, and your earnings in both accounts are tax-deferred. The tax deduction on contributions lowers the cost of your savings. For example, when you deposit $500 to your 401(k), your actual cost for that deposit is $500 less tax.
The tax deferral on your earnings in these accounts also expedites your wealth momentum. If you had these funds in a taxable account instead of a 401(k) or IRA, you'd be taxed each year on your dividends, interest, and capital gains. In a tax-advantaged account, though, the money stays invested and working for you over time. Cumulatively, a 401(k) or IRA can defer tens of thousands of dollars in taxes over the 30 years or so that you save for retirement.
Many 401(k)s additionally have employer matching contributions. These are deposits your employer makes to your retirement account based on how much you contribute. They're essentially free money.
If you or your spouse have access to a 401(k) at work, use it. Aim to save 10% to 15% of your income, or more if retirement is within 10 years. The IRS allows you to contribute up to $19,500 to a 401(k) in 2021, or up to $26,000 if you are 50 or older. Note that those caps apply only to your own contributions and not your employer match.
If you have no 401(k), max out your IRA contributions. In 2021, you can deposit up to $6,000 in your IRA, or up to $7,000 if you are 50 or older.
Since the IRA contribution limit is fairly low, you'll want to supplement your IRA deposits with savings to another account. A taxable brokerage account can do the job. Just keep your annual tax burden low by staying away from income-producing securities in this account. You can also minimize capital gains by buying stocks instead of funds, and then holding them for the long term.
3. Invest in dividend payers
High-quality dividend-paying stocks are a good fit for retirement portfolios for a couple of reasons. The first is obvious: Dividend-payers produce cash. The more cash your portfolio produces, the less reliant you are on selling stocks to fund your retirement distributions. Selling stocks at the wrong time can lead to realized losses. But even when the timing is good, selling stocks -- and withdrawing the cash proceeds -- does shrink your future earnings potential.
Many dividend-paying stocks also routinely raise their dividends each year. In your retirement years, that increasing income can help you manage the inflation in your living expenses that naturally occurs over time.
Keep your dividend payers in your 401(k) or IRA to avoid paying taxes annually on the income. And make sure you are automatically reinvesting those dividend payments while you're still working. That helps grow your income-producing share count faster. Once you retire, you can turn off the reinvestment and just collect the cash.
Supplementing your Social Security
Social Security on its own will leave you with a large gap between your income and expenses in retirement. You can narrow the gap in part by streamlining your living expenses. But to avoid a major lifestyle downgrade, you'll have to create other sources of retirement income. Start building those sources now by saving as much as possible to your tax-advantaged accounts and investing in dividend payers that can generate cash for you indefinitely.