Even if you truly love your work, the day will come when it’s time to punch out for the last time and start your retirement. When that time arrives, you’ll want to have a robust financial plan in place.
Your primary financial goal throughout your work years is to amass enough in savings to support that plan—to sock away enough money to support your lifestyle without a steady paycheck. But saving as much money as possible is just the beginning: You’ll also need to account for taxes, determine which investments will best grow your money, account for other sources of retirement income, and plan for retirement expenses.
- Save as much money as you can.
- Put your money in tax-advantaged retirement accounts.
- Invest your money in the markets, adjusting your asset allocation as you get older.
- Consider your retirement expenses and income needs.
- Use your savings and other income sources to meet those needs.
Saving money must be on your list of priorities. Most financial experts agree that you should save at least 10% of your income every year, and many suggest pushing it to 20% if you can. However, it’s not just about how much you save—it’s also about where you save it.
Over the last few decades, Congress has attempted to incentivize retirement savings by allowing for the creation of special tax-advantaged retirement accounts. The most popular is the 401(k), which is offered by most employers and allows you to contribute pre-tax dollars toward your retirement with every paycheck. Many employers also offer to match a certain percentage of your contributions, which essentially amounts to free money.
Other retirement accounts can be opened independent of your employer. The most popular is the Individual Retirement Account or IRA. The “Traditional” variety of these accounts is similar to the 401(k), in that money can be contributed pre-tax; donate a few thousand dollars to an IRA, and the money can be deducted on your taxes. The other variety of IRA is the Roth IRA, in which money is contributed post-tax—that is, you can’t take a tax deduction on it—but it grows in the account and can be withdrawn tax-free in retirement.
Investing Your Savings
It’s not enough to just save a bunch of money in a tax-advantaged retirement account. To make sure that your money grows and multiplies, you should invest it. It is good to keep enough money in savings and checking accounts to cover expenses and emergencies; however, if you keep more than this in savings, it will essentially shrink in value—savings accounts do not provide enough interest to keep pace with inflation.
The time value of money concept states a dollar earned today is worth more than one earned in the future—if that dollar is invested and can earn interest. If you have enough to cover expenses and emergencies, consider investing the rest.
So what should you invest in? There are volumes of information available on this topic. An accepted rule of thumb is the one in which your portfolio should consist of 100 minus your age in stocks, and the rest in mutual funds and bonds. The older you get, the more you should transfer to funds and bonds.
There are modern investors who state that this method is outdated, and should be replaced with 110 minus your age, or higher numbers for those with higher risk tolerances (the higher the number, the higher the risk). However, this depends entirely on your aversion to risk, investment goals, and your investment strategy.
Finding investments that will continue to perform over the long-term might work better for some investors. The market will always dip and rise again, so long-term value investments should not be discounted. In fact, for retirement purposes, they might be a great option.
Percentages aside, a mostly-stock portfolio is best to use when you’re younger, allowing you to make up any losses you might incur in the market. As you grow older, you should allocate more of your savings toward safer investments like bonds or metals, so you don’t risk losing a bunch of money in the market just before you retire.
Rather than directly play the stock market with your retirement savings, you’ll likely want to put most of your money in mutual funds, index funds, or exchange-traded funds. While some of these funds are actively managed by fund managers who try to “beat the market,” others are more passive in their approach. Whichever you choose, you can select investments through your 401(k) provider or the brokerage in which you set up your IRA.
Your Retirement Income and Expenses
The money that amasses in your retirement accounts will eventually form the basis of your retirement income; once you reach retirement age, you can begin withdrawing money from those accounts as income.
But 401(k)s and IRAs aren’t the only sources of retirement income. Some people—mainly those working in the public sector—will have a pension instead of a 401(k), providing them with a guaranteed income stream determined by their previous income and years of employment.
But pensions are becoming increasingly rare. What isn't rare (yet) is Social Security, which provides a regular check from the government; the longer you wait to start claiming it, the larger your check will be. Even though it comes from the government, you should still be aware that it’s subject to taxation.
Counting on Social Security for retirement is risky. It would be better to not count it into your retirement plan. This will keep you from an income shortage if the program runs out of funds—if it is still around by the time you do retire, it could be an unexpected income source for you.
Beyond that, there are other ways to set yourself up for retirement income. One such way is an annuity, a type of life insurance product that provides for guaranteed income over a given period of time.
A good financial plan will account for these various sources of retirement income. Consider how they meet your income needs before deciding. Since your expenses will likely look very different than they did in your working years, it is important to understand both.
By the time you reach retirement your home mortgage may be paid off, significantly decreasing your housing expenses. But the amount you spend on medical bills will likely go up as you get older. Your retirement plan should anticipate the switch in expenses you'll have in retirement, and make sure your various sources of income will cover them.