- A Roth IRA is a tax-advantaged way to save for retirement.
- Setting financial goals can help you save enough for retirement.
- One day your earnings will exceed your annual contributions because of the magic of compounding.
When you save for retirement in your 401(k), traditional IRA, and Roth IRA accounts, are you working toward a specific investment goal or are you maxing out your annual contributions just to minimize your tax bill?
The answer to this question is more important than it might seem. When you save and invest money, you should have a target in mind and a portfolio designed to ensure your future financial health. Until you establish such a goal, there is no objective way to know if you are saving enough.
The number of Americans who do not know how much they need to retire, according to Northwestern Mutual’s 2019 Planning & Progress Study.
If you have not yet determined an investment goal, you can estimate how much money you’ll need in your nest egg to fund the retirement lifestyle you want. Here’s how.
Step 1: Estimate How Much Income You Need in Retirement
This step is tricky because you are estimating project expense levels for a life you are not currently living. To keep it simple, many financial planners recommend using 80% of your current income as a yardstick. For our example, we’ll assume an income of $10,000 per month, which at 80% is $8,000, or $96,000 a year.
Step 2: Subtract Expected Monthly Social Security and Pension Benefits
You can find this information in your annual Social Security Earnings Record and your company’s human resources department. Subtract these benefits from your expected monthly retirement income from Step 1. If you have other sources of guaranteed income—such as monthly annuity payments—subtract those, too.
For our example, we assume monthly Social Security and pension income will be $4,000 per month. This reduces the income needed at retirement to $4,000 per month or $48,000 per year.
Step 3: Factor In Time Horizons
There are three numbers to be concerned with here: your current age, your expected retirement age, and the number of years you expect to live after you leave work.
You can use life expectancy charts to determine how long you can be expected to live as a retiree, but it can be just as easy to consider the longevity of your close relatives, and then round up.
For our example, we’ll assume a current age of 35, an expected retirement age of 65, and that you’ll probably live for 20 years in retirement.
Step 4: Determine the Rate of Return on Investment (ROI) You Expect on Your Retirement Assets
Of course, there is no way to do this scientifically, but the long-term ROI in the stock market is about 8%. You can expect a lower rate of return on your retirement assets once you retire since, in all probability, your investments will be relatively conservative.
For our example, we assume an ROI—or interest rate—of 8% until retirement, and 5% after that.
Step 5: Account for Inflation
It is a good idea to account for inflation as it can have a major effect on the outcome of your plans. For our example, we assume a 3% inflation rate.
Step 6: Put It All Together
Here's what we have so far:
- Required yearly retirement income: $48,000
- Current age, 35; retirement age, 65; and years in retirement, 20
- Rate of return: 8% before retirement; 5% during retirement
- Annual expected inflation rate: 3%
You can use an online calculator to do the math. Using the figure from our example, you will need to accumulate approximately $1.97 million to retire at age 65 with 80% of your current income.
Now you have a goal to shoot for with your retirement investments—$1.97 million. When you make contributions, you will know how close you are to reaching your goal. Saving for retirement seems like a daunting task with an end goal far into the future. You have to be incredibly disciplined with your savings month after month, year after year—until you hit retirement age. You also the willpower to avoid jumping into hot stocks or risky sectors of the market and, instead, maintain your portfolio diversification.
Planning to never retire is not a realistic retirement plan, you may be forced into retirement unexpectedly.
But as difficult as saving for retirement can be, there’s one part of retirement saving that’s on your side: compound interest.
Your Retirement Ally: Compound Interest
Even if you are contributing the max to your Roth IRA and are incredibly disciplined in doing so year after year, your contributions alone will not be enough to build that retirement nest egg. That’s where compound interest is so important.
Compound interest is the interest that accrues on your contributions and the accumulated interest of that principal. It’s interest on the interest you’ve earned in the past. Compounding interest allows an invested sum to grow at a faster rate than simple interest, which is calculated just on the principal alone.
Let’s look at an example using $12,000 in annual contributions (we assume that you and your spouse each contribute $6,000 a year to a Roth IRA).
If your $12,000 deposits earn 8%, the simple interest for that year would be $960. Your accounts would collectively end the year at $12,960. The next year, the combined balance would be $25,920.
Now let’s say your Roth IRAs earn interest at an 8% compounded rate. At the end of the first year, you would have the same balance as if you earned simple interest: $12,960.
But at the end of year two, instead of $25,920, you would have $26,957 because of the extra interest you earned on the first year's interest. Not a huge difference yet, but still more than the simple interest would earn.
Of course, the more years that pass, the greater the effect of compounding. Here’s what happens to your earnings over the next five years:
- Year 1: $960
- Year 2: $2,957
- Year 3: $6,073
- Year 4: $10,399
- Year 5: $16,031
Magic for Retirement Funds
In Year 5, your account growth suddenly exceeds your annual contributions. As your account continues to grow, that increase gets larger and larger, eventually adding $67,746 to your account in Year 10. That’s 564% more than your annual contribution.
Granted, this is based on a fixed rate of return of 8% for 10 years in a row. In real life, the stock market and your investments will not see such steady returns. Some years you'll see 25% growth, while others could be 15% losses. Still, 8% is the long-term return on investment (ROI) in the stock market, so it's a reasonable average to target.
Over time, your contributions will exceed what you put into the account on an annual basis. But just because your account grows more than $12,000 in a year doesn’t mean you stop making contributions. A key component of growth is having a large contribution base. So stay dedicated and keep funding the account (to the max, if you can) every year.
The Bottom Line
Will a Roth IRA be sufficient for you to build your $1.97 million nest egg? Probably not, since you can only contribute up to $6,000 a year.
A Roth has valuable tax advantages (tax-free withdrawals in retirement and no required minimum distributions (RMDs)), but it is only one part of a well-rounded retirement savings plan. If you have a 401(k) with your employer, that is another good option—particularly if your employer offers matching contributions.
You only get one shot at retirement planning, so it can be helpful to work with a qualified financial planner or advisor. An advisor will help you set goals for retirement and develop a plan to reach them.