Your retirement years can be a lot more fun if you have plenty of money to spend. While you may not be able to live it up during your working years, you can spend that time setting yourself up to retire wealthy.
Different people have different standards for what wealth means to them. Here we'll define it as having more money than you need. So rather than picking some seven-figure dollar amount and saying, "When I have that much, I'll be wealthy," you should try to figure out how much income you'll need and then work backwards from there.
For example, let's say you've added up your expenses and decided that having $4,000 a month of income would be more than enough to cover your costs during retirement (and let's say your home will be paid off by then, so you won't need to factor in a housing payment). You look up your Social Security statement and see that you can expect to receive $1,300 a month in Social Security benefits. That leaves you $2,700 per month that you need to generate from your retirement savings, or $32,400 per year. Assuming you take an average of 3.5% of your entire retirement savings out of your accounts each year (a nicely conservative figure), you'll need just over $925,000 in your retirement savings accounts by the day you retire ($32,400 divided by 0.035 is $925,714.28). As you age, you'll be able to take more than 3.5% out of the accounts, but assuming a conservative withdrawal rate gives you a better safety margin when planning how much to save.
Building a wealth plan
In order to hit your retirement wealth goal, you need two things: time and money. Having more of one means you'll need less of the other. If you start saving really early, the extra time that your savings will have to grow means you won't need to save as much to hit your goal. For example, say your goal is to have $1 million when you reach age 65. If you start saving at age 25 and assume an average 7% annual return on your savings, you'll only need to save $4,681 per year to reach your goal. But if you don't start saving until age 45, you'll need to save $22,797 per year. By starting at age 25, you'd only need to save a total of $187,240 to hit a balance of $1 million; starting at age 45, you'd have to save $455,940 to reach the same goal. You can figure out how much you need to save to reach your own wealth goal by using a saving calculator.
You can't hop in a time machine and tell your younger self to save more money, so if you've waited to start saving, you'll just have to set aside a little more money each month in order to enjoy a wealthy retirement. This may mean you'll need to sacrifice a little now in order to indulge yourself later. Start by cutting back on expenses that you don't really want or need (like that gym membership you never use anyway), and if that's not enough, consider finding new sources of income to increase the amount you're able to save.
Hitting your savings goals
Let's say you're 35 years old and want to have $1 million by the time you turn 65. You break out a savings calculator and discover that you'll need to save $9,894 per year, or $824.50 per month, to hit your goal. You scrape a few expenses out of your life and talk your boss into giving you a small raise, which will allow you to start saving that much money every month. Now what do you do with that money?
By far the best place to save your retirement money is in a tax-advantaged retirement account. Because these accounts allow you to reduce your taxes in a variety of ways, they'll make it easier for you to save enough to hit your goals. Your basic options for retirement savings accounts are tax-deferred accounts (which include traditional IRAs and 401(k)s), which allow you to take tax cuts on your contributions, or Roth accounts, which give you the tax savings at the time you withdraw the money. Both types of retirement savings accounts also give you tax breaks on the investments you hold in the accounts; you won't be required to pay capital gains taxes on investments that you sell at a profit, and dividends and interest inside these accounts won't be taxed as they come in.
To give you an idea of how much these tax-advantage accounts can help, consider the example of a single saver in the 25% tax bracket. If he contributes $10,000 to his 401(k) in 2017, his taxable income for the year will be lowered by $10,000, meaning he'll save $2,500 in taxes. And a Roth account can not only save you from paying taxes on your withdrawals, but it can help keep your Social Security benefits from being taxed, too.
Speaking of investments, if you want to hit an average return of 7% per year, the bulk of your retirement savings money needs to be invested in stocks. When in doubt, you can use the standard formula of 110 minus your age to determine the percentage of your portfolio that should be in stocks. For example, a 35-year-old saver should have about 75% of his investments in stocks.
While the stock market is riskier than bonds or cash equivalents, it's the only investment that gives you those kinds of returns on an average basis. And when you're saving for the long term, the risks of stock market investing tend to even out.
Consistency is key
Creating a savings plan and finding ways to save enough money will get you started, but the hard part is continuing to save that much money month after month and year after year. It's a good idea to use tools that will automate this process, making it easier for you to be save money consistently. If you have a 401(k) account from your employer, you can have contributions automatically taken out of your pre-tax paycheck; IRA holders can set up an automatic transfer from their bank to the IRA. And remember two things: First, as your income goes up over the years, hitting your savings goals will become easier; and second, when you retire, you'll be able to relax and enjoy your hard-earned wealth.
The $16,122 Social Security bonus most retirees completely overlook If you're like most Americans, you're a few years (or more) behind on your retirement savings. But a handful of little-known "Social Security secrets" could help ensure a boost in your retirement income. For example: one easy trick could pay you as much as $16,122 more... each year! Once you learn how to maximize your Social Security benefits, we think you could retire confidently with the peace of mind we're all after. Simply click here to discover how to learn more about these strategies.
The Motley Fool has a disclosure policy.