Too many Americans' basic retirement knowledge is severely lacking. Do you know how Social Security benefits are calculated? Is one type of retirement account better than others? And what's the "4% rule" of retirement? These are things all American adults should know and understand, so here's a quick overview.
1. The "4% rule" -- what you need to know
Experts often quote retirement "rules" that are designed to help people save for retirement. Perhaps the most common is the "4% rule," which holds that, once you retire, if you withdraw 4% of your retirement savings in the first year, and then give yourself annual cost of living adjustments every year thereafter, there's a strong chance that your money will last as long as you do.
This is a decent guideline, but isn't a rock-solid rule by any means. For example, if you have mostly fixed-income investments, and inflation rises faster than expected once you retire, your annual increases could quickly eat away at your savings. On the other hand, if you have, say, half of your portfolio in stocks, and the market performs exceptionally well, you may be able to withdraw significantly more than 4% and maintain (or even grow) your savings.
The actual feasibility of the 4% rule depends on several factors, including the types of investments you own, how well the market performs after you retire, inflation, and interest rates, just to name a few.
My point is that the 4% rule is useful as a guideline while you're planning for retirement, and can help determine your personal savings goal. However, once you retire, your actual withdrawal rate should be adaptable to changing circumstances.
2. Prioritize your retirement savings correctly
Generally speaking, there are three main types of retirement savings vehicles. Here they are in descending order of priority:
- 401(k) contributions your employer will match: At the absolute minimum, you should be contributing enough to your 401(k) in order to take full advantage of your employer's matching contributions, if available. This should go without saying, but too many people don't do this. This type of retirement savings should be your top priority.
Even if your employer's matching program isn't great -- a 25% match rate, for example -- you should still embrace this offer of free money. Even in this scenario, you're getting an instantaneous 25% return on your investment, and most employers have more generous matching rates of 50% or 100%.
- 401(k) contributions beyond your employer's match, and other tax-advantaged accounts: IRAs, 401(k)s, and similar tax-advantaged accounts are next in order. The tax-free compounding will help your money grow quickly, and these accounts also offer tax benefits on contributions or withdrawals.
For the 2015 tax year, you're allowed to choose to defer $18,000 of your salary into your 401(k) ($24,000 if you're over 50), and $5,500 into an IRA ($6,500 if over 50). An IRA is great for investors who want the freedom to choose any stocks, bonds, or mutual funds they want; but if choosing your own investments doesn't sound like fun, there's nothing wrong with boosting your 401(k) contributions. After maxing out your employer's contributions, these accounts should be your next priority.
- Regular brokerage accounts: These accounts don't have the tax benefits mentioned above, but there are still some good reasons why you might want to keep some savings in a regular brokerage account.
For example, you can withdraw your money at any time, for any reason, which makes this an option for money you don't want tied up until you're at retirement age. And you can contribute as much as you want to; so if you max out your IRA contributions and still want to buy certain stocks, a standard brokerage account may be the way to go.
3. How does Social Security determine my benefit?
I recently published an article detailing several little-known Social Security facts, but one that I didn't mention is the basic calculation method for Social Security benefits.
Many other fixed-benefit plans (like pensions) are generally calculated using the last few years of earnings. In contrast, Social Security uses your highest 35 years of earnings (indexed for inflation) when determining your benefit. The Social Security Administration provides a worksheet to help you calculate your average monthly income for benefit purposes, and once you arrive at yours, a formula is applied to calculate how much you'll get.
For those retiring in 2015, benefits are calculated by this formula:
Notice that the formula is structured to favor lower-income individuals. For example, someone whose average monthly earnings were $800 could expect a $720 monthly benefit check. However, someone who earned twice that much ($1,600) could expect a $991 benefit, just 38% more.
The main takeaway is that, by having a fairly accurate idea of how much you can expect from Social Security, you can determine how much income you'll need from your 401(k) and other savings.
This is by no means an exhaustive list of what you need to know about retirement. As I mentioned earlier, the more you know about retirement topics, the more likely you'll be to make smart decisions.
You should also know what an IRA is, the difference between Roth and traditional IRAs, how to choose 401(k) investments, and the importance of starting as early as possible, just to name a few topics. Keep learning as you go along, and you could be handsomely rewarded for the time you spend.