What Percentage Should You Save?

Posted On April 24, 2021 By Scott Stratton, CFP(R), CFA In Retirement Planning /

One of the key questions facing investors is “What percentage should you save of your income?” People like a quick rule of thumb, and so you will often hear “10%” as an answer. This is an easy round number, a mental shortcut, and feasible for most people. Unfortunately, it is also a sloppy, lazy, and inaccurate answer. 10% is better than nothing, but does 10% guarantee you will have a comfortable retirement?

I created a spreadsheet to show you two things. Firstly, how much you would accumulate over your working years. This is based on the years of saving, rate of return, and inflation (or how much your salary grows). Secondly, how much this portfolio could provide in retirement income and how much of your pre-retirement salary it would replace.

The fact is that there can be no one answer to the question of what percentage you should save. For example, are you starting at 25 or 45? In other words, are you saving for 40 years or 20 years? Are you earning 7% or 1%? When you change any of these inputs you will get a wildly different result.

10% from age 25

Let’s start with a base case of someone who gets a job at age 25. He or she contributes 10% of their salary to their 401(k) every year until retirement. They work for 40 years, until age 65, and then retire. Along the way, their income increases by 2.5% a year. Their 401(k) grows at 7%. All of these are assumptions, not guaranteed returns, but are possible, at least historically.

In Year 1, let’s say their salary is $50,000. At 10%, they save $5,000 into their 401(k) and have a $5,000 portfolio at the end of the year. In Year 2, we would then assume their salary has grown to $51,250. Their 401(k) grows and they contribute 10% of their new salary. Their 401(k) has $10,475 at the end of Year 2.

We continue this year by year through Year 40. At this point, their salary is $130,978, and they are still contributing 10%. At the end of the year, their 401(k) would be $1,365,488. That’s what you’d have if you save 10% of your 40 years of earnings and grow at 7% a year. Not bad! Certainly most people would feel great to have $1.3 million as their nest egg at age 65.

How much can you withdraw once you retire? 4% remains a safe answer, because you need to increase your withdrawals for inflation once you are in retirement. 4% of $1,365,488 is $54,619. How much of your salary will this replace? The answer is 41.7%. We can change the amount of your starting salary, but the answer will remain the same. With these factors (10% contributions, 2.5% wage growth, 7% rate of return, and 40 years), your portfolio would replace 41.7% of your final salary. That’s it! That could be a big cut in your lifestyle.

What percentage should you replace?

41.7% sounds like a really low number, but you don’t necessarily have to replace 100% of your pre-retirement income. To get a more accurate number of what you need, we would subtract the following savings:

You weren’t spending the 10% you saved each year to your 401(k)
7.65% saved on FICA taxes versus wage income
Some percentage saved on income taxes, depending on your pre- and post-retirement income.
Your Social Security Benefit and/or Pension Income
Have you paid off your mortgage, or have other expenses that will be eliminated in retirement?

Many people will only need 75% to 80% of their final salary in retirement income to maintain the same standard of living. If their Social Security benefit covers another 20%, then they would only need a replacement rate of 55% to 60% from their 401(k).

Time Value of Money

The biggest factor in compounding is time. In our original example of 40 years of accumulation, the final portfolio amount was $1,365,488. However, what if you only save for 30 years? Maybe you didn’t start investing until 35. Perhaps you want to retire at age 55 and not 65? Either way, at the 30 year mark, the portfolio would have grown to $666,122. By saving for another 10 years, your accumulation will more than double to $1.365 million.

Here’s a chart that is perhaps a more useful answer to the question of what percentage you should save. It depends on how many years you will save and what percentage of your income you want to replace.

Income Replacement	50%	60%	70%
in 40 Years	12.0%	14.4%	16.8%
in 35 Years	15.7%	18.8%	22.0%
in 30 Years	20.9%	25.1%	29.2%
in 25 Years	28.5%	34.2%	39.9%
in 20 Years	40.3%	48.4%	56.4%

How do you read this? If you want to replace 50% of your income in 40 years from now, starting at zero dollars, you need to save 12% of your income. Actually, this is pretty close to the 10% rule of thumb. But no one says “If you are starting at age 25 and are planning to save for the next 40 years, 10% is a good rule of thumb”. What if you are starting later? Or, what if you want to have your portfolio replace more than 50% of your income.

As you reduce the accumulation period, you need a higher contribution rate. For example, at the 50% replacement level, your required contribution increases from 12% to 15.7% to 20.9% as you go from 40 to 35 to 30 Years. And if you are planning to retire in 20 years and have not started, you would need to save 40.3%.

Similarly, if you want your portfolio to replace more than 50% of your income, the percent to contribute increases as you stretch to 60% or 70%. These figures are quite daunting, and admittedly unrealistic. But one thing that may help slightly will be a company match. If you contribute 10% and your company matches 4% of your salary, you are actually at 14%. Don’t forget to include that amount!

What can you do?

We’ve made some conservative assumptions and perhaps things will go even better than we calculated. For example, if you achieve an 8% return instead of 7%, these contribution requirements would be lower. Or if the inflation rate is lower than 2.5%. Or if you can withdraw more than 4% in retirement. All of those “levers” would move the contribution rate lower. Of course, this cuts both ways. The required contribution rate could be higher (even worse), if your return is less than 7%, inflation higher than 2.5%, or safe withdrawal rate less than 4%.

If you want to consider these factors in more detail, please read the following articles:

If you’d like to play around with the spreadsheet, drop me an email ([email protected]) and I’ll send it to you, no charge. Then you can enter your own income and other inputs and see how it might work for you. While our example is based on someone who is starting from zero, hopefully, you are not! You can also change the portfolio starting value to today’s figures on the spreadsheet.

The key is this: Begin with the End in Mind. The question of What percentage should you save depends on how long you will accumulate and what percent of income you want to replace in retirement. Saving 10% is not a goal – it’s an input rather than an outcome. Having $1.3 million in 40 years or $2.4 million in 35 years is a tangible goal. Then we can calculate how much to save and what rate of return is necessary to achieve that goal. That’s the start of a real plan.

You don’t have to try to figure this out on your own. I can help. Here’s my calendar. You are invited to schedule a free 30 minute call to discuss your situation in more detail. After that, you can determine if you’d like to work with me as your financial advisor. Sometimes, it isn’t the right fit or the right time, and that’s fine too. I am still happy to chat, answer your questions, and share whatever value or information I can. But don’t use a Rule of Thumb, get an answer that is right for your personal situation.

Retirement Withdrawals Without Penalty

Posted On September 16, 2020 By Scott Stratton, CFP(R), CFA In Retirement Planning /

If you have multiple retirement accounts, when can you start withdrawals without penalty? This is very important if you want to retire before age 59 ½ and be able to access your money. The rules vary by the type of account, so advance preparation can make it easier to plan your withdrawals.

In our retirement income planning, we carefully choose the order of withdrawals. This can make a big difference in your tax bills. It’s also helpful to have multiple types of accounts so you can select from capital gains, tax-deferred accounts, and tax-free accounts. Let’s start with the early retirement penalties, by account type.

Five Retirement Plans with Different Rules

401(k) and 403(b): 10% penalty on distributions prior to age 59 ½.
A 457 Plan can be accessed after you retire without penalty, regardless of your age. This is the easiest plan for accessing your money.
Traditional IRA: 10% penalty for distributions prior to age 59 ½. This also applies to a SEP-IRA.
SIMPLE IRA: 10% penalty prior to age 59 ½. Additionally, any distributions within the first two year of participation are subject to a 25% Penalty. Ouch. Don’t do that.
Roth IRA. 10% penalty on earnings before age 59 ½, AND the five-year rule. You must have had a Roth open for five years before taking penalty-free withdrawals. So, if you open your first Roth at age 57, you’d have to wait until age 62 to get the tax-free benefit. However, you can access your principal at any time without tax or penalty. It is only when you start drawing down your earnings that the tax and penalty might apply. To withdraw tax-free and penalty-free, you must be over 59 ½ and have had a Roth for at least five years.

Exceptions to the Penalty

For 401(k) and 403(b) Plans: if you are at least age 55 and have separated from service, the penalty is waived. This means that if you retire between 55 and 59 ½, you can access your account without penalty. You would lose this exception if you roll your money into an IRA.
72(t) / Substantially Equal Periodic Payments (SEPP). If you are before age 55 and want to access your 401(k), 403(b), or Traditional IRA, you can take Substantially Equal Periodic Payments and waive the penalty. This means that you commit to taking the same amount from your account, annually, for at least five years or until age 59 ½, whichever is longer. Even if you later don’t want or need the distribution, you must continue to withdraw the same amount.
You may be able to avoid the 10% Penalty on an IRA or 401(k)/403(b) distribution if you qualify for these exceptions:
- Total and Permanent Disability
- An IRS Levy
- Unreimbursed Medical Expenses in excess of 10% of AGI
- Qualified Military Reservists called to Active Duty
There are some exceptions which are available to IRAs (including SEP and SIMPLE), but not allowed from a 401(k) or 403(b). For these exceptions, you may want to roll your 401(k) into an IRA to qualify.
- Qualified higher educational expenses
- Qualified first-time homebuyers, up to $10,000
- Health insurance premiums paid while unemployed

Full List from IRS: Exceptions to Tax on Early Distributions

Using Exceptions and Planning Your Income

I’m happy to let people know about these exceptions for retirement withdrawals without penalty before age 59 1/2. However, you should be very careful about tapping into your retirement accounts in your 30’s, 40’s or 50’s. This money needs to last a lifetime. I sometimes hear of people who take from their 401(k) accounts to buy a car or build a pool. And they have no idea that taking $50,000 now is stealing $400,000 from their future. Here’s the math: At 8%, your money will double every 9 years. That’s the Rule of 72. $50k will become $100k in 9 years, then $200k in 18 years, and $400k in 27 years. (Yes, this is a hypothetical rate of return, not a guarantee.)

The order of withdrawals does matter when planning your retirement income. While we can work to avoid the 10% penalty before age 59 ½, distributions from “Traditional” retirement accounts are still taxable as ordinary income. It’s often better to access your taxable accounts first. When eligible for long-term capital gains rate, that will be lower than IRA distributions which are taxed as ordinary income. And you have a cost basis on a taxable position, so only a portion of your sale ends up as a taxable gain.

Many retirees avoid touching their retirement accounts until they have to take Required Minimum Distributions. RMDs used to be at age 70 ½, but now are age 72. If there are years when you are in a low tax bracket (sabbatical, retired, year off, etc.), it may make sense to do a partial Roth Conversion. Start shifting money from a tax-deferred account into a tax-free account and save yourself on future taxes.

Once you reach age 72, you could be subject to a lot of taxes from RMDs. That’s the problem with being too good at waiting to start distributions from your retirement accounts. You’re creating a bigger tax bill for yourself later. While you are accumulating assets, it pays to plan ahead and know when and how you will be able to actually access your accounts. Have a question about retirement withdrawals without penalty? Let me know how I can help.

Unplanned Retirement

Posted On May 31, 2020 By Scott Stratton, CFP(R), CFA In Retirement Planning /

With job losses this year reaching 40 million, many Americans are being forced into an unplanned retirement. Maybe they wanted to work until age 65 or later and find themselves out of work at age 60 or 62. Job losses due to Coronavirus layoffs may be the most common reason today. However, many people also enter early retirement due to their health or to care for a spouse or parent.

Each year, the Employee Benefits Research Institute publishes a Retirement Confidence Survey Report. Here are some findings from their 2020 report published in April:

48% of current retirees retired earlier than they had planned. Only 6% retired later than they originally planned.
Less than one-half of workers have tried to calculate how much money they will need to live comfortably in retirement.
Of workers who reported their employment status would be negatively effected by the Coronavirus, only 39% felt confident that they will have enough money to last their entire life.

Half of all retirees retired at a younger age then they had planned. That statistic has remained very consistent over the years. In the 1991 report, it was 51%. This is a reality that more people should be preparing for. If you want to retire at 65, 70, or “never”, will you be prepared if you end up retiring at 64, 60, or 55? Certainly, if you enjoy your work, keep on working! But sometimes, the choice is not ours and people find themselves in an early, unplanned retirement.

If you have lost your job or just want to be better prepared should that happen, you need to plan your retirement income carefully.

Unplanned Retirement Steps

You should begin with a thorough and accurate calculation of your spending needs. Not what you want to spend but what you actually spend. Determine your health insurance costs until age 65 and for Medicare after age 65, including Part B premiums, and Medicare Advantage or Medigap coverage, and Part D prescription drug coverage. Read more: Using the ACA to Retire Early.
Reduce your expenses. This will require setting priorities and determining where you can do better. Still, there may be some low hanging fruit where you can save money with little or no change in your lifestyle. Read more: Cut Expenses, Retire Sooner
Calculate your sources of retirement income. Read more: When Can I Retire?
Be careful of starting Social Security at age 62. This is very difficult for people to not access “free money”, everyone wants to do it. Be sure to consider longevity risk and the possible benefits of spending investments first and delaying Social Security for a higher payout later. Read more: Social Security, It Pays to Wait
Consider going back to work, even part-time, to avoid starting retirement withdrawals. The more you delay your retirement, the more likely you will not run out of money later. Here’s the math on why: Stop Retiring Early, People!

Be Prepared for the Unexpected

I think the best way to survive an unplanned retirement is to achieve financial independence at an early age. If you could retire at 50, plan to work until 65, and end up retiring at 60, it’s no problem. This requires saving aggressively and investing prudently from an early age. And that’s why retirement planning isn’t just for people who are 64. Retirement planning should also be for people who are 54, or 44, or even 34. Plan well, and an early retirement could be a good thing. It’s your chance to begin a new adventure!

If – surprise! – you do happen to be facing an unplanned retirement, let’s talk. We can help you evaluate your options for retirement income and establish a process and budget. Our retirement planning software can help you make better informed decisions, including when to start benefits, how much you can withdraw, and if you have enough money to last your lifetime.

It certainly is a shock to people when they end up retiring earlier than they had originally planned. However, it is very common and about half of all retirees are in the same situation. Unfortunately, not everyone who has an unplanned retirement will be having the comfortable years they had hoped. Basing your retirement on the assumption that you will work until age 70 or later may not be realistic. It could even set you up for failure if you end up needing to retire early. Whatever your age, retirement planning is too important to not seek professional help.