How much money should you invest in your 401k or IRA retirement account? Ten percent? Fifteen percent? How much money do you need to set aside for retirement?
The answer depends on how much you'll get from your pension, rental income, royalties, Social Security and other forms of retirement income.
For the purpose of this article, we'll assume you have no other sources of retirement income. This assumption will allow us to focus solely on your contributions to a retirement savings account.
The Earlier You Start, The Less You Need to Contribute
As a rule of thumb, the younger you start, the smaller of an amount you can get away with contributing. Let's look at some examples.
Let's assume you're 30, you earn $50,000 a year, and you want to retire at age 65. You have zero saved so far. You want to live on 85 percent of your pre-retirement pre-tax income when you retire (which is $42,500 per year).
To reach your goal, you'll need to amass a nest egg of $2 million ($2.06 million, to be exact) by the time you retire. That may sound like a lot, but remember: 35 years from now, $2 million will be worth far less than $2 million today, thanks to inflation. Also, remember, that money needs to last you for a long time -- possibly as long as 35 years, if you live to be 100.
How do you reach $2 million? If you're a 30-year-old with $0 saved, who wants to live on today's equivalent of $42,500 per year in retirement, you'll need to save $600 per month. That assumes you invest in 70 percent stocks, 25 percent bonds and 5 percent cash, and the markets perform on average.
Let's assume you're 40, you earn $50,000 a year, you want to retire at age 65, you have zero saved so far, and you want to live on today's equivalent of $42,500 a year in retirement. In other words, we're assuming the same scenario as Example 1, with the only variable being age.
Using the same investment assumptions as we did in the example above, you'll need to save $1,000 per month. In other words, waiting for a decade to start saving forces you to almost double your savings rate in order to reach the same goal.
(Using the same set of assumptions, but changing the variable so that you start saving at age 20, you'd only need to save about $375 a month. If you saved $1,000 a month starting at age 20, you'd have $8.4 million by the time you retire.)
Why Such Variation?
This variation is due to the power of compound interest, which Albert Einstein called "the most powerful force in the universe."
Compound interest is a term that describes the interest/gains on your investments earning more interest. In other words, the interest builds on itself. (Click on the link for a more detailed explanation).
The younger you are when you start saving, the more time your investments can compound. If you wait until you're older, you need to save more in order to compensate for the lost time.
How Did You Calculate That?
I calculated this using Fidelity Investment's My Plan online retirement calculator. By typing your age, your desired retirement age, your investing style, and the amount you've already saved, the calculator will compute how much you should save per month in order to reach your retirement savings goals. As a disclaimer, this model calculator provides only a rough directional result that should not be acted upon or relied on.
Are There Any Rules of Thumb?
Here are a few guidelines to help you decide how much to save for retirement:
1: Maximize Your Employer Match. If your employer matches your retirement contribution, take full advantage of the match -- even if you have high-interest debt. Credit card debt might cost you 25 percent in interest; the company match provides a guaranteed 50 - 100 percent "return."
(What's a company match? Let's say your boss chips in 50 cents for each dollar you contribute, up to a certain amount. This is called a company match. You'll get a 50 percent "return," so to speak, on your money, because every $1 you invest automatically becomes $1.50.)
This is why retirement saving should be your top priority, even higher than paying off credit-card debt or paying for your children's college tuition.
2: Weigh the Pro's and Con's of Roth vs. Traditional
"Roth" retirement accounts, such as a Roth 401k and Roth IRA, allow you to contribute after-tax money. You pay taxes on your income now, but you avoid taxes when you withdraw it in retirement, including taxes on capital gains.
Traditional retirement accounts, like the traditional 401k offered by most employers, allow you to contribute pre-tax dollars. You avoid taxes now, but you get hit with a tax bill in retirement.
Your age, income, and assumptions about present vs. future tax rates will determine whether a Roth vs. a traditional setup is right for you. Read more about Roth retirement accounts, talk to a tax professional, and give it some careful thought. Your tax bill is one of the biggest expenses you'll ever have -- on par with your mortgage payment -- so it pays to carefully consider your tax strategy when you're planning retirement.
3: Increase Your Percentage According to The Decade You Start
There's no single rule regarding the percentage of your income that you should put aside for retirement. The percent varies based on the age at which you start saving.
If you're 20 years old, earn $50,000 a year, and save 10 percent of your income -- $5,000 per year -- into a retirement account, you'll more than reach your retirement goals.
But if you're 30 when you start saving, 10 percent won't be enough. You'll need to save 15 percent of your income (about $7,200 per year) to meet your retirement goals.
If you start at age 40, you'll need to save 24 percent of your income, or $12,000 per year, to reach your goal.
Start at age 50, and you'll need to save nearly half your income -- $2,000 a month, or $24,000 a year -- to reach your goal.
4: Don't Take Extra Risk to Compensate for Lost Time
If you started saving for retirement later in life, you might be tempted to take on extra-risky investments in order to compensate for the lost time. Don't do this. Risk is a two-way street: you might win big, but you might lose more. And at a later age, you have less time to recover from a loss. (Check out 7 Tips for Saving for Retirement with a Late Start.)
The only way to compensate for lost time is by saving more. Here are some tips on how to find ways to save.
Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as tax advice, investing advice and/or legal advice. While I have made every effort to include accurate and complete information, I cannot make any guarentees, and laws and codes change frequently. Always consult with a tax professional and legal professional.
The data in this article is cited from Fidelity Investment's My Plan online calculator. This model calculator provides only a rough directional result that should not be acted upon or relied on. Neither About.com nor the author of this article takes any responsibility for the accuracy of the calculations. Always consult a financial professional for retirement advice.