Does retiring with $1 million in the bank sound good? For most people, it conjures up visions of a comfortable lifestyle during their retirement years.
While it might be debatable whether $1 million is truly enough these days, it’s a benchmark most people understand and one to which many aspire. The question is, “How do you get there?”
Basic Steps to Retire with $1 Million
Fidelity has studied millionaires who actually amassed their fortunes using a workplace 401(k) plan—and who earned less than $150,000 per year. They found that these 401(k) stars did it by following some very basic guidelines.
An Early Start
It takes time to save $1 million dollars. Most people do it over several decades. The average age of millionaires in the Fidelity study was 59. Most of them began saving and investing in their 20s.
Those who were most successful tried to save between 10 percent and 15 percent of earnings. Many 401(k) plans only require about 3 percent. Those who saved the most made a conscious effort to save more—much more.
If your employer offers a match, save enough to get the maximum amount but don’t stop there. In the Fidelity study only 28 percent of the balances of big savers came from employer matching. The rest came from the employees themselves and their earnings on investments.
Salary as a Guide
Fidelity still says a good savings target is eight times your pay at age 67. Some people may need more—up to 10 to 12 times annual salary in savings. The idea is to save enough to ultimately generate that million-dollar jackpot.
Compound Interest Is Your Friend
Another key component to saving a lot of money is recognizing the value of compound interest or “interest paid on interest.” If you invest $500 per month at 10 percent, by the end of the first month you will have $504.17. That’s nice but not all that impressive.
By the end of the first year, however, because all your interest was reinvested and earned interest, instead of $6,000 (12x$500) you will have $6,335.14. Thanks to the magic of compounding, after 10 years, the total is $103,276.01, not the $60,000.00 you would have had if you stuck $500 under a mattress each month.
Finally, after 30 years, investing just $500 per month, your account would be worth $1,139,662.66.
The Role of Fees
Unfortunately, that $1.1 million mentioned above does not take fees into account. Fees are costs you pay to have your savings invested, and those costs can be staggering. An analysis by Nerdwallet found that over a 40-year span the loss of value of principal due to a 1.02 percent management fee ranges from 6.4 percent at the 10-year mark to 25.1 percent after 40 years. The range for an ETF portfolio with a 0.09 percent expense ratio over the same period was from 0.6 percent to 2.5 percent.
The reason the percentage of loss is important is because the total fees you pay rise as your account balance rises. Second, the amount lost to fees is not reinvested and never becomes part of that magic compound-interest machine.
How you invest matters and can help keep fees down. Index funds, for example, have much lower fees than actively managed funds. Studies have shown that over several 5- and 10-year periods, about 80 percent of actively managed funds underperformed market-indexed funds and ETFs.
Consider a Roth IRA
With a Traditional IRA, your contribution goes in “before taxes.” Your investment plus earnings grows, tax free, until you retire and begin withdrawing funds. At that time, you pay taxes on your withdrawals at your regular income tax rate. Therefore, in addition to any reduction in that $1.1 million nest egg you might experience due to fees, there’s also the amount you will pay in taxes.
You can avoid the later-in-life tax burden by investing in a Roth IRA. Funds placed in a Roth account go in “after taxes.” In short, you pay the taxes up front and there are no taxes on principal or earnings when you withdraw funds at retirement.
Don’t Forget the Roth 401(k)
If your employer offers a Roth 401(k), that may also be worth considering. A Roth 401(k) has the same (no taxes at withdrawal) advantages as a Roth IRA, but may also include employer matching (aka “free money”). There’s a twist to employer matching with a Roth 401(k). Employer matching contributions are generally considered to be made “pre-tax.” Those funds are accounted for separately and taxed upon withdrawal at retirement.
A Roth 401(k), unlike a Roth IRA, does have required minimum distributions (RMD) at age 70½. On the other hand, there is no income limit for participation with a Roth 401(k) as there is for a Roth IRA. And the contribution limits for a Roth 401(k) are much higher than for a Roth IRA. For more on the Roth 401(k) see: Why Roth 401(k)s Give Retirees More Purchasing Power
Your Road to $1 Million
If you take saving seriously, start early and save more than most people, having a million dollars at retirement is not only possible, it’s likely. A well-designed portfolio featuring index-type investments with low fees is important.
Consider the Roth IRA and the Roth 401(k) if one is available to you. Most people save a percent of their salary. Doing so with after-tax dollars provides you with the opportunity to see big tax savings in retirement. Finally, as with all financial matters, consult a trusted financial advisor before making major decisions involving money.