Now that we've outlined how to calculate the money you'll need for retirement, we need to figure our where that money will come from.
While employment income seems like the obvious answer, there are actually many sources of funds you can potentially access to build your retirement nest egg. Once you lay them all out clearly, you can then determine how much money you'll need to save every month in order to reach your retirement goals.
There are typically several sources of retirement savings for the average individual. These include the following:
1. Employment Income
As you progress through your working life, your annual employment income will probably be the largest source of incoming funds you receive – and the largest component of your contributions to your retirement fund.
For your retirement plan, simply write down what your after-tax annual income is. Then subtract your annual living expenses. The amount left over represents the discretionary income you have at your disposal. Depending upon how the numbers work out, you may be able to save a large portion of your employment income toward your retirement, or you may only be able to save a little. Be sure to use a budget and include all your recurring expenses. One way to ensure you save the projected amount for retirement is to treat the amount you plan to save as a recurring expense. (For more on this topic, see The Beauty of Budgeting.)
Regardless, figure out the maximum amount of employment income that you can contribute to your retirement fund each year. Also, if you are able to work part time during your retirement years, include this information in your retirement income calculations. For example, let's assume that Alison's after-tax earnings are $34,000, and her living expenses are $2,000 per month, or $24,000 per year, and that she will not be working during her retirement.
Thus, Alison has $10,000 per year of discretionary income. She can choose to contribute all of this money to her retirement plan, or she can contribute a portion of it to her retirement fund and spend the rest on a vacation or something else she desires. What we know is that funds available for retirement from her employment income max out at $10,000.
For U.S. residents, disposable income that is earmarked for retirement savings can be deposited to an after-tax account, where earnings are added to your income and taxed each year; or to a retirement account, such as a Traditional IRA, where earnings are tax-deferred, or a Roth IRA, where deposits are with after-tax income but earnings could be tax-free. Money in an after-tax account will not be taxed again during retirement. The amount in a Traditional IRA may be taxed at your ordinary income tax rate for the year you withdraw the amount. (To learn more about IRAs, read the Roth IRAs tutorial and Traditional IRAs tutorial.)
2. Social Security
As we mentioned earlier, Social Security benefits can provide a small portion of your retirement income. By visiting the SSA website, you can estimate your retirement benefits (in today's dollars) by using the site's online calculator.
You may not want to include Social Security benefits in your retirement estimates because, as we already mentioned, the entire projected amount may not be available by the time you retire. Alternatively, you may wish to include them at a portion of their value, say 50%, to be on the conservative side.
Either way, figure out what your estimated Social Security benefits are expected to be in today's dollars and add them to your list of retirement income sources. You won't be able to use this money to build your nest egg, but it will help to fund your living expenses when you're retired and reduce the size of nest egg you will need.
In John's example, his Social Security benefits were estimated to be about $1,300 per month, in today's dollars.
3. Employer-Sponsored Retirement Plan
You may or may not participate in a retirement plan through your employer. If you don't, you will need to focus on other income sources to fund your retirement. If you do participate in an employer plan, contact your plan provider and obtain an estimate of the fund's value upon your retirement. (For more on this topic, see Making Salary Deferral Contributions – Part 1 and Part 2.)
Your plan provider should be able to give you an estimated value (in today's dollars) of your retirement funds in terms of a monthly allowance. Obtain this number and add it to your list of retirement income sources.
Similar to your Social Security benefits, the funds from your employer plan can help cover your living expenses during your retirement. However, most employer plans have rules regarding the age at which you can start receiving payments. Even if you quit working for your company at age 50, for example, your employer plan may not allow you to begin receiving payments until age 65. Or they may allow you to begin receiving payments early, but with a penalty that reduces the monthly payment you receive. Talk to your plan provider to determine what rules apply to your employer plan and consider them when you are making your retirement plan.
4. Current Savings and Investments
Also consider your current savings and investments. If you already have a sizable investment portfolio, it may be sufficient to cover your retirement needs all by itself. If you have yet to begin saving for your retirement or are coming into the retirement planning game late, you will need to compensate for your lack of current savings with greater ongoing contributions.
For example, with John's retirement plan he already had a $100,000 retirement fund at age 40. Reasonably assuming this fund grows at a real rate of return of 6% per year until he is 65, John will have about $429,200 in today's dollars by the time he is 65. Depending on his other sources of income, this could be enough to fund his retirement so that John does not have to contribute large amounts of his ongoing employment income.
If you do have current savings and investments, be sure to include only the portion you expect to have left over by the time you have reached retirement. Don't include any portions you're planning to leave for your children or spend on other assets, such as a summer home, which will make the funds unavailable for covering your living expenses.
5. Other Sources of Funds
You may have other sources that will be available to fund your retirement needs. Perhaps you will receive an inheritance from your parents before you reach retirement age or have assets, such as real estate, that you plan to sell before retiring.
Include these funds in your retirement projections only if they are certain to appear. You may be expecting to realize a large inheritance from your parents, but they may have other plans for their surplus savings, such as donating them to charity.
Other unexpected cash inflows may also come along as you build toward your retirement, such as lottery winnings, gifts, raises or bonuses, etc. When you do happen to receive these additional cash inflows, consider adding them to your retirement fund. It's also fine to include the planned sale of real estate to when you estimate your retirement funds (at a conservative price).
Adding Up Your Income Sources
Finally, make a list of how much you expect to have from all your available income sources and add them up.
Let's continue with John's sample retirement plan. Remember, all figures are in today's dollars. John's retirement income sources are:
- $10,000 maximum annual retirement contributions from his $45,000 after-tax earnings.
- John has $1,300 per month in estimated Social Security benefits. To be on the safe side, we won't include these in our calculations.
- John does not have a company pension plan.
- John has $100,000 of current savings and investments. At a reasonable 6% real rate of return for 25 years, his savings should grow to $429,200.
- John does not have any other sources of funds he can conservatively expect to add to his retirement funds. He might win the lottery, but he's not banking on it.
As we outlined earlier, John would need a nest egg of $850,000 (in today's dollars) to fully fund his retirement goals with the peace of mind that any Social Security shortfalls won't derail his plans.
Since his current savings and investments can realistically be expected to provide only $429,200 (in today's dollars) by the time he reaches his retirement age, John will need to rely on his other funding sources to reach his retirement goal.
This leaves him needing to build additional savings of $420,800 (in today's dollars) by the time he is 65 years old. Given his annual income, John will have to make periodic contributions to his retirement fund and build it up over the next 25 years.
To calculate this, let's track his progress over the 25-year period:
Assuming the 6% annual growth rate and a constant annual contribution, we find that John needs to contribute $7,236 per year, or about $600 per month, in order to meet his retirement goal.
This is a relatively high level of ongoing contributions. While John can meet his contribution requirements given his $10,000 available annual income, he may wish to adjust his plan to leave himself more discretionary income.
John may consider revising his retirement plan so that his annual contributions are smaller. He could do this by choosing to include 50% of his estimated Social Security benefits, instead of our initial decision to assume no Social Security benefits at all. Or he may decide it's acceptable to leave only half of his retirement nest egg to his children, instead of the full $850,000. Alternatively, John could lower his required retirement income from $40,000 to, say, $35,000 and run the numbers again.
Any of these options would allow him to lower his monthly contribution amounts to a more manageable level. At the end of the day, it's important that whatever retirement plan you devise for yourself, you are able to stick to it. If your plan will require large monthly contributions, it's unlikely you'll be able to stick to it over the long term in order to make it work.
In John's case, another entirely reasonable solution to his plan would be to work part-time during his retirement years. By adding even $12,000 of annual retirement income, John's financial picture would change substantially and his required annual contributions would be lowered considerably.
The key is to remain conservative in your financial estimates (i.e., don't assume 20% annual investment returns or large inheritances from your parents) and settle on a plan that is feasible and sufficient for your needs.
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