How much should you be saving for retirement and what’s the most effective way to do it?
Knowing how much you should save for retirement and whether you are on-track, are questions for everyone.
The Best Approach to Saving for Retirement
Let’s focus on three questions:
- How much you need to save per paycheck?
- Are you on track?
- What are the most effective strategies to consistently save money?
My answers are imprecise because the future is uncertain — we don’t know how long we will live, our future living expenses, or what our future investment returns will be.
To complicate things further, your savings rate depends on many factors. Consider these:
- Women need to save more because you have a longer life expectancy. Also, many women opt out of the workforce to have and raise children and if so, it means fewer years of paying into Social Security and contributing to your 401K. If that’s the case, you need to save more to make up for those years.
- Higher income earners need to save more because Social Security replaces a smaller percentage of your income, the more you earn. So, high income earners will receive proportionally less from the Social Security benefit.
- Pre-tax retirement accounts are not worth as much as a Roth because when you withdraw the funds, you will owe taxes to the government. Thus you need to save more compared to a Roth which will be distributed tax free.
- Life expectancy and retirement age are more intuitive. The longer your retirement period lasts, the more funds you’ll need.
- Your Social Security benefit. Obviously, the more you receive from Social Security the less you’ll need to cover with other savings.
How Much Should I Be Saving Each Paycheck?
Assuming you save continually throughout your working lifetime, here’s about how much you should save based on the age at which you begin:
If you wait until your forties to begin saving, your retirement goals become more challenging, but are still achievable. You will need to reduce your current spending and you may also need to work more years before beginning retirement.
How Much Do I Need To Have Saved At Various Ages To Be On Track For Retirement?
This table answers that question:
Higher income earners need to save a higher percentage of their income simply due to the progressive benefit structure of Social Security — it replaces a lower percentage of income for higher earners.
To orient you around this table:
- If your income is $80,000 and you are at the retirement age of 67, you need $680,000, along with Social Security, to maintain your current standard of living — 8.5x your income; if your income is $120,000, you need 10x your income. At incomes greater than $120,000, the multiple of savings you would require would go up a bit more.
- If your income is $50,000 and you are currently 40 years old, $100,000 of savings would put you on track for your retirement saving target.
- The 40-year savings rate is the amount you’d need to save each paycheck to achieve these targets, assuming you did so continually for 40 years.
- Keep in mind that these targets assume you now spend all of your income, other than what you are saving for retirement. If you don’t spend your full income, then you will need proportionally less at retirement for your indicated income simply because you have a lower cost of living than your current income allows.
If you have a pension, these calculations change and you need to accumulate less savings than indicated in the tables.
How are these numbers determined? Financial planners usually assume that you’ll need a certain percentage of your previous income during your retirement — 75% is a good target. And, they will also assume that Social Security benefits will replace a portion of your income — let’s say 40%, depending on your income level and how many years you paid into the system. Because we don’t know when we’re going to die, we cannot count up the number of years of support you’ll need. Instead, we would determine how much an annuity would cost that would provide the replacement income needed. From that, we can derive these target percentages.
Anytime is a good time to begin to save for retirement. The longer you put it off, the steeper the hill you’ll have to climb.
What if you’re not on track right now? To maintain your standard of living in retirement, you’ll need to do a combination of spending less now (so you can save more) and work more years. Those two changes have big positive effects on your retirement security and can get you back on track. You will have more years to save, you can delay when you claim Social Security, and you’ll have fewer years in retirement to support yourself.
How Should I Most Effectively Save?
When it comes to saving money, you should go on automatic pilot with passive saving?
What do I mean by this?
- see it
- think about it
- exert any effort
Instead, you effortlessly pay yourself first.
If you are already thinking that payroll deductions are the most effective approach, then your instincts are spot-on.
When you contribute to a 401K plan, you are already passively saving. 401Ks are imperfect in some ways but for this purpose, they are great. Who reduces their 401K payroll deduction once it is set? No one ever. As Ron Popeil, America’s greatest pitchman says, “You set it and forget it.”
Some employers allow you to make other payroll deductions and if so, you should take advantage and divert money from every paycheck directly to whatever purpose you prioritize. You may have sub-accounts for various goals — vacation, wedding, Roth IRA, housing, holiday gifts, car, emergencies, etc. I endorse any mental accounting tricks or behavioral hacks that can fool your brain into consistently saving.
If you cannot do payroll deductions or are self-employed, the second best approach is to set up your bank account to do automatic transfers from your checking to your savings account the day after each paycheck is deposited. Every day the money sits visibly in your checking account is another opportunity to spend it, so quickly transfer it out.
If your employer does not have a 401K (or has a poor one with no match, high fees, or poor investment choices), you may want to set up a payroll deduction and contribute directly into a Roth IRA, instead of your 401K.
In addition to passively saving, you should be mindful of two other strategies to increase your savings. First, when your income increases, you must restrain the growth in your expenses and cost of living. You need to create a mindset of living within your current means and then saving most of any increases in your income. Similarly, when you receive a windfall — e.g., from a tax refund or work bonus — get in the habit of saving those funds, rather than spending them on something for which the psychic joy will be short lived.
Keep your saving on automatic pilot and you’ll develop sound financial habits.