Retirement planning is a multistep process that evolves over time. To have a comfortable, secure—and fun—retirement, you need to build the financial cushion that will fund it all. The fun part is why it makes sense to pay attention to the serious—and perhaps boring—part: planning how you’ll get there.
Retirement planning starts with thinking about your retirement goals and how long you have to meet them. Then you need to look at the types of retirement accounts that can help you raise the money to fund your future. As you save that money, you have to invest it to enable it to grow.
The last part of planning is taxes: If you’ve received tax deductions over the years for the money that you’ve contributed to your retirement accounts, then a significant tax bill awaits when you start withdrawing those savings. There are ways to minimize the retirement tax hit while you save for the future—and to continue the process when that day arrives and you actually stop working.
We’ll get into all of these issues here. But first, start by learning the five steps that everyone should take, no matter what their age, to build a solid retirement plan.
- Retirement planning should include determining time horizons, estimating expenses, calculating required after-tax returns, assessing risk tolerance, and doing estate planning.
- Start planning for retirement as soon as you can to take advantage of the power of compounding.
- Younger investors can take more risk with their investments, while investors closer to retirement should be more conservative.
- Retirement plans evolve through the years, which means portfolios should be rebalanced and estate plans updated as needed.
- Your career, family size, age of retirement, and post-retirement goals will all factor in to retirement planning.
How Much Do You Need to Save for Retirement?
Before anyone starts crunching the numbers on their retirement goals, they will need a good idea of how much money they need to save. Naturally, this will depend on many situational factors, such as their annual income and the age when they plan to retire.
While there is no fixed rule about how much money to save, many retirement experts offer rules of thumb such as saving about $1 million, or 12 years of one's pre-retirement annual income. Others recommend the 4% rule, which suggests that retirees should spend no more than 4% of their retirement savings each year in order to ensure a comfortable retirement.
Since everyone's circumstances are different, it is worth sitting down to calculate the ideal retirement savings for your own situation.
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Factors to Consider
As you begin to think about retirement, it is worthwhile to consider some of the factors that will affect your retirement goals. For example: what are your family plans? For many people, starting a family is a central life goal, but having children can also put a large dent in your savings. For that reason, the type of family you hope to have will play a factor in your retirement planning.
Likewise, it is also worth thinking about your plans for retirement, including any changes to your home or residence. Many people dream of travel during retirement, and while it can be an exciting adventure, extensive travel will eat away at your retirement savings faster than staying at home. On the other hand, moving to a country with an extremely low cost of living may allow you to stretch out your savings while enjoying a high living standard.
Finally, one should also consider the different types of tax-advantaged retirement accounts. Most Americans qualify for social security, but those benefits are rarely enough to support all of their expenses in retirement.
While pension funds were once the norm for skilled professionals, they have largely been replaced by self-funded plans like 401(k) or IRA accounts. Since these have a maximum contribution limit, your retirement strategy will depend on what types of tax-advantaged accounts are available to you.
Once you have thought these factors through, these are the next steps for planning your retirement:
1. Understand Your Time Horizon
Your current age and expected retirement age create the initial groundwork for an effective retirement strategy. The longer the time from today to retirement, the higher the level of risk that your portfolio can withstand. If you’re young and have 30-plus years until retirement, you can have the majority of your assets in riskier investments, such as stocks. There will be volatility, but stocks have historically outperformed other securities, such as bonds, over long time periods. The main word here is “long,” meaning at least more than 10 years.
Additionally, you need returns that outpace inflation so you can maintain your purchasing power during retirement. “Inflation is like an acorn. It starts out small, but given enough time, can turn into a mighty oak tree,” says Chris Hammond, a Savannah, Tenn., financial advisor and founder of RetirementPlanningMadeEasy.com.
“We’ve all heard—and want—compound growth on our money,” Hammond adds. “Well, inflation is like ‘compound anti-growth,’ as it erodes the value of your money. A seemingly small inflation rate of 3% will erode the value of your savings by 50% over approximately 24 years. Doesn’t seem like much each year, but given enough time, it has a huge impact.”
In general, the older you are, the more your portfolio should be focused on income and the preservation of capital. This means a higher allocation in less risky securities, such as bonds, that won’t give you the returns of stocks but will be less volatile and provide income that you can use to live on. You will also have less concern about inflation. A 64-year-old who is planning on retiring next year does not have the same issues about a rise in the cost of living as a much younger professional who has just entered the workforce.
You should break up your retirement plan into multiple components. Let’s say a parent wants to retire in two years, pay for a child’s education at age 18, and move to Florida. From the perspective of forming a retirement plan, the investment strategy would be broken up into three periods: two years until retirement (contributions are still made into the plan), saving and paying for college, and living in Florida (regular withdrawals to cover living expenses).
A multistage retirement plan must integrate various time horizons, along with the corresponding liquidity needs, to determine the optimal allocation strategy. You should also be rebalancing your portfolio over time as your time horizon changes.
You might not think that saving a few bucks here and there in your 20s means much, but the power of compounding will make it worth much more by the time you need it.
2. Determine Retirement Spending Needs
Having realistic expectations about post-retirement spending habits will help you define the required size of a retirement portfolio. Most people believe that after retirement, their annual spending will amount to only 70% to 80% of what they spent previously.
Such an assumption is often proven unrealistic, especially if the mortgage has not been paid off or if unforeseen medical expenses occur. Retired adults also sometimes spend their first years splurging on travel or other bucket-list goals.
“For retired adults to have enough savings for retirement, I believe that the ratio should be closer to 100%,” says David G. Niggel, CFP, ChFC, AIF, founder, president, and CEO of Key Wealth Partners LLC in Litilz, Pa. “The cost of living is increasing every year—especially healthcare expenses. People are living longer and want to thrive in retirement. Retired adults need more income for a longer time, so they will need to save and invest accordingly.”
As, by definition, retired adults are no longer at work for eight or more hours a day, they have more time to travel, go sightseeing, shop, and engage in other expensive activities. Accurate retirement spending goals help in the planning process as more spending in the future requires additional savings today.
“One of the factors—if not the largest—in the longevity of your retirement portfolio is your withdrawal rate. Having an accurate estimate of what your expenses will be in retirement is so important because it will affect how much you withdraw each year and how you invest your account. If you understate your expenses, you easily outlive your portfolio, or if you overstate your expenses, you can risk not living the type of lifestyle you want in retirement,” says Kevin Michels, CFP, EA, financial planner, and president of Medicus Wealth Planning in Draper, Utah.
Your longevity also needs to be considered when planning for retirement, so you don’t outlast your savings. The average life span of individuals is increasing.
Actuarial life tables are available to estimate the longevity rates of individuals and couples (this is referred to as longevity risk).
Additionally, you might need more money than you think if you want to purchase a home or fund your children’s education post-retirement. Those outlays have to be factored into the overall retirement plan. Remember to update your plan once a year to make sure that you are keeping on track with your savings.
“Retirement planning accuracy can be improved by specifying and estimating early retirement activities, accounting for unexpected expenses in middle retirement, and forecasting what-if late-retirement medical costs,” explains Alex Whitehouse, AIF, CRPC, CWS, president, and CEO of Whitehouse Wealth Management in Vancouver, Wash.
3. Calculate After-Tax Rate of Investment Returns
Once the expected time horizons and spending requirements are determined, the after-tax real rate of return must be calculated to assess the feasibility of the portfolio producing the needed income. A required rate of return in excess of 10% (before taxes) is normally an unrealistic expectation, even for long-term investing. As you age, this return threshold goes down, as low-risk retirement portfolios are largely composed of low-yielding fixed-income securities.
If, for example, an individual has a retirement portfolio worth $400,000 and income needs of $50,000, assuming no taxes and the preservation of the portfolio balance, they are relying on an excessive 12.5% return to get by. A primary advantage of planning for retirement at an early age is that the portfolio can be grown to safeguard a realistic rate of return. Using a gross retirement investment account of $1 million, the expected return would be a much more reasonable 5%.
Depending on the type of retirement account that you hold, investment returns are typically taxed. Therefore, the actual rate of return must be calculated on an after-tax basis. However, determining your tax status when you begin to withdraw funds is a crucial component of the retirement planning process.
4. Assess Risk Tolerance vs. Investment Goals
Whether it’s you or a professional money manager who is in charge of the investment decisions, a proper portfolio allocation that balances the concerns of risk aversion and returns objectives is arguably the most important step in retirement planning. How much risk are you willing to take to meet your objectives? Should some income be set aside in risk-free Treasury bonds for required expenditures?
You need to make sure that you are comfortable with the risks being taken in your portfolio and know what is necessary and what is a luxury. “Don’t be a ‘micromanager’ who reacts to daily market noise,” advises Craig L. Israelsen, Ph.D., designer of 7Twelve Portfolio in Springville, Utah.
“'Helicopter’ investors tend to overmanage their portfolios," Israelsen adds. "When the various mutual funds in your portfolio have a bad year, add more money to them. The mutual fund you are unhappy with this year may be next year’s best performer—so don’t bail out on it.”
“Markets will go through long cycles of up and down and, if you are investing money you won’t need to touch for 40 years, you can afford to see your portfolio value rise and fall with those cycles,” says John R. Frye, CFA, senior advisor at Carnegie Investment Counsel. “When the market declines, buy—don’t sell. Refuse to give in to panic. If shirts went on sale, 20% off, you’d want to buy, right? Why not stocks if they went on sale 20% off?”
The 2022 ceiling for assets in an estate that are exempt from federal estate taxes. Amounts above that limit are subject to estate taxes.
5. Stay on Top of Estate Planning
Estate planning is another key step in a well-rounded retirement plan, and each aspect requires the expertise of different professionals, such as lawyers and accountants, in that specific field. Life insurance is also an important part of an estate plan and the retirement planning process. Having both a proper estate plan and life insurance coverage ensures that your assets are distributed in a manner of your choosing and that your loved ones will not experience financial hardship following your death. A carefully outlined plan also aids in avoiding an expensive and often lengthy probate process.
Tax planning is another crucial part of the estate planning process. If an individual wishes to leave assets to family members or a charity, the tax implications of either gifting or passing them through the estate process must be compared.
A common retirement plan investment approach is based on producing returns that meet yearly inflation-adjusted living expenses while preserving the value of the portfolio. The portfolio is then transferred to the beneficiaries of the deceased. You should consult a tax advisor to determine the correct plan for the individual.
“Estate planning will vary over an investor’s lifetime,” says Mark T. Hebner, founder and president of Index Fund Advisors Inc. in Irvine, Calif., and author of Index Funds: The 12-Step Recovery Program for Active Investors. “Early on, matters such as powers of attorney and wills are necessary. Once you start a family, a trust may be something that becomes an important component of your financial plan.
“Later on in life, how you would like your money disbursed will be of the utmost importance in terms of cost and taxes,” Hebner adds. “Working with a fee-only estate planning attorney can assist in preparing and maintaining this aspect of your overall financial plan.”
What Is Risk Tolerance?
Risk tolerance is how much of a loss you’re willing to endure within your portfolio. Risk tolerance depends on a number of factors, including your financial goals, income, and age.
How Much Should I Save for Retirement?
One rule of thumb is to save 15% of your gross annual earnings every year. In a perfect world, savings would begin in your 20s and last throughout your working years.
What Age Is Considered Early Retirement?
Age 65 is typically considered early retirement. When it comes to Social Security, you can start collecting retirement benefits as early as age 62. But you won’t receive full benefits as you would if you wait to collect them at full retirement age instead.
The Bottom Line
The burden of retirement planning is falling on individuals now more than ever. Few employees can count on an employer-provided defined-benefit pension, especially in the private sector. The switch to defined-contribution plans, such as 401(k)s, also means that managing the investments becomes your responsibility, not your employer’s.
One of the most challenging aspects of creating a comprehensive retirement plan is striking a balance between realistic return expectations and a desired standard of living. The best solution is to focus on creating a flexible portfolio that can be updated regularly to reflect changing market conditions and retirement objectives.