Social Security benefits will provide a source of income during retirement years, but in most cases, it will not be enough to offset all the necessary retirement expenses of an individual. This is why the structure and performance of your own retirement savings plan are so critically important.
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There are four key elements to achieving a successful retirement savings plan.
Start saving as early as possible.
Even investing a small amount at an early age can be beneficial given the wonders of compounded investment returns.
Prudently maximize the rate of return on your retirement savings.
One potential pitfall is that you are overly conservative when investing your retirement funds. To illustrate, traditional bank savings accounts today offer an interest rate of less than 1 percent. Such a low yield will make it difficult to accumulate adequate retirement savings down the road.
Conversely, investing too aggressively may be disastrous given the extreme volatility of the potential returns. Perhaps a more prudent approach is to invest your retirement funds in a diverse stock index fund where historically, the annual rate of return could exceed 6 percent over a long period of time.
Understand, however, that the stock market will likely experience periods of significant volatility during the life of the portfolio. Therefore, as one is nearing retirement, they should work with their financial planner to optimize their plan, perhaps investing more conservatively to protect the retirement savings from future, additional downward market fluctuations.
Take advantage of tax-deferred retirement savings accounts.
One option is to open a traditional Individual Retirement Account (IRA) which currently allows you to save $6,000 a year, or $7,000 if you are 50 or older. The contributions to an IRA may be tax-deductible, depending on your level of income.
Another option is if your employer allows you to put pretax dollars into a 401(k) account. The maximum contribution to a 401(k) plan in 2019 is $19,000 or $25,000 if you are 50 or older. The beauty of these retirement accounts is that income taxes are not paid until withdrawals are made. As a result, the earnings accumulate tax-free.
Always get the employer match.
An employer might match as much as 50 percent of your annual contribution, so if your contribution is $10,000, they will add $5,000, tax-free.
The difference these steps can make
Let's start with the worst-case scenario and see what we can learn from it.
Let's assume a person wants to retire at age 67, but only starts saving for retirement at age 47. To worsen matters, this person contributes $10,000 into a traditional bank savings account earning 1 percent interest.
At age 67, there will only be $226,996 in this person's savings account. This could be problematic because the average life expectancies for a 67-year-old male and female in the United States are 16.49 and 18.89 years, respectively. Yet this account will only last 1.51 years if this person's annual retirement expenses are $150,000.
There are three problems in this scenario: 1) this person started too late; 2) the annual rate of return is only 1 percent, and 3) it was put into the savings account using after-tax dollars.
Now let's modify the scenario and see what occurs when this same person starts saving for retirement at age 30. Furthermore, assume this person annually contributes $10,000 into a 401(k) plan that invests in a stock index fund that will generate an average annual rate of return of 6 percent.
Now at age 67, there will be $1,435,403 in the 401(k) account. This time, the savings will last 14.3 years, if the annual retirement expenses are $150,000.
Let's continue to modify the scenario, assuming the employer will match 50 percent of the contribution. So instead of this person just contributing $10,000 to their 401(k) plan, the total annual contribution will be $15,000, given the employer match of $5,000.
Now at age 67, there would be $2,153,104 in the 401(k) account. This would be enough to cover 33 years of retirement expenses, assuming annual retirement expenses of $150,000.
In the end, it is critical to first take time to determine how much you believe you will need to live comfortably through your retirement years.
You should then strive to create a successful retirement plan by making contributions to a tax-deferred retirement account, if possible, investing as early as possible, trying to generate a reasonable rate of return and if available, taking advantage of plans that allow for employer-matching contributions.
Raymond C. Radigan is head of private trust at TD Wealth. Ray is responsible for managing the trust activity across the TD Bank footprint from Maine to Florida. He oversees the Trust Advisors who bring TD Wealth's full range of investment options to U.S clients to support the management and distribution of their assets. He also oversees the Wealth Strategists, who provide guidance to our clients as they formulate their financial and estate plans.