When you’re making your retirement contributions, are you working toward a specific investment goal in your 401(k), Traditional IRA and/or Roth IRA—or are you mostly maximizing your annual contributions as a way of minimizing your tax liability in the current year?
The answer to this question is more important than it seems at first glance. While you’re saving and investing money, there should be a target you’re hoping to reach, a certain portfolio size that confirms that you’re on target for your life after work. Until you establish such a goal, there’s no objective way to know if you’re adequately funding the kind of retirement you hope to have. (Also, if you don’t already know it, you don’t get a tax deduction for your Roth IRA contribution and may not get one for your Traditional IRA if you’re above a certain income level and have a retirement plan at work—or your spouse does.)
If you haven’t set an investment goal up to this point, there are steps you can take to help you establish the amount of money you’ll need in retirement investments to fund the retirement lifestyle you desire. Below, we’ll outline the steps, and work an example with the Roth IRA Calculator on this site that can help you set and work toward your own retirement investment goal.
Step 1: Determine the Monthly Retirement Income You’ll Need
This step can get really involved, if only because you’re attempting to project expense levels for a life you’re 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.
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 the monthly retirement income you expect to need, as calculated in Step One. For our example, we’ll assume monthly Social Security and pension income will be $4,000 per month, which reduces the income we’ll need 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 the work world behind. 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 family members, and then round up. For our example, we’ll assume a current age of 35, an expected retirement at age 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 further expect a lower rate of return on your retirement assets once you retire, since in all probability you’ll have your money in more conservative investments. For our example, we’ll assume an ROI—or interest rate—of 8% until retirement, then 4% after retirement.
Step 5: Account for Inflation and Income Taxes
You have to account for both inflation and income taxes on future income and investments, as they will have a major effect on the outcome of your plans. Fortunately our Roth IRA Calculator does the work for us and automatically accounts for both. It uses a 3.26% annual assumption for inflation, and adjusts the marginal tax rate based on the income figures used.
Step 6: Put It All Together in the Calculator
Now you have your raw numbers:
- Needed yearly retirement income, $48,000 (from Step Two)
- Current age, 35; retirement age, 65; and years in retirement, 20 (from Step Three)
- Rate of return, or interest rate, during retirement of 4%, and leading up to retirement, 8% (from Step Four)
- Annual expected inflation rate, 3.26% (as supplied by the Roth IRA Calculator)
- Marginal tax rate (as calculated by the Roth IRA Calculator)
Upon entering the numbers from the first three items above, the Roth IRA Calculator shows that you need to accumulate about $1,728,085 by age 65 in order to provide for 80% of current income in retirement. On the surface an amount exceeding $1.7 million can seem overwhelming, but the calculator indicates:
“That means a monthly contribution of $1,159.51 for Roth, or $1,473.34 for traditional savings (the Roth contributions are lower because there is no tax on withdrawals if you are at least 59½ and in the plan for at least 5 years). Watch out though! $1,159.51 monthly exceeds the $5,500-a-year Roth IRA contribution limit by $8,414.11.”
As you can see, the Calculator tells you exactly how much you need to put into retirement investments each year over and above the maximum Roth contribution.
PRESTO: Your Retirement Investment Goal!
Now you have a goal to shoot for with your retirement-years investments—a little over $1.7 million. When you make contributions, you’ll know how close you are to reaching our goal, and what steps might be needed to move up to where you want to be. In fact, you have established a long-term goal—$1.728 million—and an annual contribution goal that gets you to it—$5,500 in a Roth IRA, and $8,414 in other investments, such as a 401(k). When you have specific retirement numbers on hand, you’re working toward a set goal that will afford you a certain lifestyle by the time you reach retirement age.
Saving for retirement seems like a daunting task with an end goal far off in the future. You have to be incredibly disciplined with your savings on a monthly basis for month after month, year after year, until you hit retirement age. You need the wisdom to avoid jumping into hot stocks or sectors of the market and instead hold to your portfolio diversification.
But as difficult as saving for retirement can be, there is one part of retirement saving that is on your side: compound interest.
Your Retirement Ally: Compound Interest
Even if you’re contributing the max to your Roth IRA and are incredibly disciplined in doing so year after year, your contributions alone won’t be enough to make that retirement nest egg goal. That’s where compound interest comes to the rescue.
Investopedia defines compound interest as Interest that accrues on the initial principal (that is, the amount you deposit or invest in an asset) and on the accumulated interest of that principal. It’s interest on interest you’ve earned in the past. Compounding of interest allows an invested sum to grow at a faster rate than simple interest, which is calculated just on the principal alone.
Compound Interest’s Effect on Retirement Funds
Let’s look at an example, using $10,000 in annual contributions (let’s say both you and your spouse are contributing $5,000 each to your Roth IRAs).
If your $10,000 deposits in both Roth IRAs earned interest at a 7% rate, the simple interest for that year would be $700. Your accounts would collectively end the year at $10,700; the next year, it’d be $21,400. Now let’s say they’re earning interest at 7% compounded rate. If your accounts grow to $10,700 the first year, and you contribute an additional $10,000 and you again earn 7% growth, you would earn $1,400 in simple interest (the interest on the $20,000 in contributions) plus $49 in compound interest (the 7% growth of your $700 growth from the previous year), for a total of $1,449. Your total account balances would be $21,449.
A compound growth of $49 seems really small, and it is to start. But over time, it will multiply dramatically and eventually surpass what you contribute annually. Here’s a chart of this in action (click for full size):
As you can see for the first 10 years, the total growth on your contributions is less than $10,000. But watch what happens:
- Year 1: $700
- Year 2: $1,449
- Year 3: $2,250
- Year 4: $3,108
- Year 5: $4,026
- Year 6: $5,007
- Year 7: $6,058
- Year 8: $7,182
- Year 9: $8,385
- Year 10: $9,672
- Year 11: $11,049
In Year 11 your account growth suddenly exceeds the amount of your annual contributions. And as your account continues to grow, that increase gets larger and larger, eventually adding $66,122 to your account in Year 30. That’s 561% more than your annual contribution. Granted, this is based on a fixed rate of return of 7% for 30 years in a row. In real life, the stock market and your investments will not see this type of return. Some years you will see 25% growth, others 15% losses.
But eventually, over time, your contributions will exceed what you put into the account on an annual basis. And just because your account grows $10,000 in a year doesn’t mean you stop putting in 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.
This article is by Kevin Mulligan. Kevin has been utilizing a Roth IRA to save for retirement since 2008.