So you’ve been dreaming about the retired life ever since the day whatshisname in accounting swiped that leftover slice of pizza you were saving in the office fridge. You’ve probably already got retirement plans (ie, sleep til 10:00 AM most days, acquire roomy sweatpants for every occasion, and become the D.B. Cooper of sneaking burritos into multiplex matinees). But in order to get there, you’re going to need a strategy to make your particular Shangri-La a financial reality.
The best-of-all strategies is a fairly predictable one: make or inherit a pile of money large enough that you can coast 20, 30, even 40 years on the income thrown off by it. If you weren’t born rich, this will take significant work. But there are three fundamental steps that will set you on the right path.
Start early — as in right now. Saving like a maniac is great but it’s got to happen early. You won’t accomplish a heck of a lot if at 55 you decide it’s time to start saving for retirement. Creating a comfortable retirement out of something modest will require your savings to simmer for a very long time in an investment account, experiencing the magical power of compounding year in and year out. Play around with a compounding calculator like this one to get a feel for what time can do to money. Assuming a hypothetical, though historically reasonable 7% annual rate of return on an investment, a 25 year-old who manages to put $5,000 away every year will end up with almost $1.18 million by age 65. Put in that same $5,000 beginning at age 35, and she’ll only end up with $551,000 by 65. In fact, in order for that 35 year-old to end up with the identical $1.18 million by 65, she’d have to put away more than $10,000 a year to catch up to the early bird who started at 25.
Invest in stocks. So what’s the best way to harness that miraculous compounding power we reference above? Why, through investing in something that’s going to earn you some significant returns, and historically, the most reliable place for that is the stock market. One big disclosure that our very smart compliance folks insist upon: investing in stocks is speculative, and anyone who tells you otherwise is a big fat liar, so keep in mind that whenever you invest in stocks, you run the risk of losing a significant portion of your investment. That being said, historically, the annualized returns on the S&P 500 over the last 90 years have been just under 10%, which is a pretty stellar rate of return. One particularly effective way to take advantage of the natural growth of the market is by purchasing ETFs that track an entire economic sector or index, like the S&P 500. With such an investment, one price could buy you a tiny sliver of the 500 most valuable companies on the US stock market.
Beware fees, taxes. High management fees and taxes will both decimate your retirement investments, so make sure that you take advantage of all tax advantaged accounts and keep your investment management fees to a minimum. Before investing, take a deeper dive into these issues with an investing guide like this one.
If you’ve been disciplined from a young age, and retire with a nice chunk of change, you may choose to retire following the famous 4% rule, a guideline introduced by a financial advisor named William Bengen, who ran the numbers and figured out that if you withdraw 4% of your well-invested retirement portfolio annually and adjust for inflation, you will never, ever run out of money. Legend has it, Dracula kept his castle rent paid for 400 years using the 4% rule; it’s also how well-to-do mortals finance their retirement and then pass on their wealth.
So what does the 4% rule mean in real numbers? If you’ve spent a number of years in the workforce, you’ll be eligible to receive full Social Security benefits at age 67, but the current average payment is only $1,400 per month, or $16,800 per year. Financial advisors often suggest that in order not to feel deprived, you should be netting 70-80% of your pre-retirement income. So, if you’re used to making $75,000, you’ll want to be bringing in between $52,500 and $60,000 annually. If you’re going off the 4% rule, in order to make up that $35,700 to $43,200 Social Security won’t cover, you’d need to have a portfolio of $890,000 to $1.08 million. Used to making $150,000? Using the same calculations, you’d need to retire with a portfolio of $2.2 to $2.6 million. Easy peasy, right?
As the saying goes, nice work if you can get it—but very few can. According to a recent report from Stanford University’s Center on Longevity, as of 2014, almost a third of baby boomers, average age 58, had no money saved in retirement plans, and, of those in that group that had put money away, their median savings was only about $200,000. That same research institution analyzed 292 different retirement strategies and came up with one clear winner that they recommend for us not-nearly one percenters. The full 20-page report is definitely worth a read as you’re wargaming for your retirement, but here are the highlights of their proven winner, a plan they dubbed the “spend safely in retirement strategy.” In order to reach their conclusions, they took into consideration factors such as how to best use home equity, at what age one should quit work, when to start taking Social Security benefits, and, yes, how much cash you need to retire without having to crash on your kid’s futon when you run out of dough.
Delay taking Social Security as long as you can. Of the various retirement income generators (RIGs) the study looked at—from part time work, to investment income, to buying an annuity, to reverse mortgages—the study found that Social Security was the absolute most effective for tax-efficiency, protecting against inflation, and being immune to big retirement risks, like illness, or unexpected longevity that can lead to old folks running out of money. So, in most all cases, the primary wage earner in a household should delay taking Social Security until 70; currently the maximum benefit for a 62 year-old is $2,158, versus $3,698 for someone who holds out until 70—that’s about 70% more. The study found that Social Security will only account for ½ to 2/3 of total retirement income for those who start taking it at 65, while it accounts for ¾ to more than 85% of total retirement income for those who can hold out until age 70. Even if the earner retires at 65, using savings or other income to bridge income for five years appears to be the preferred strategy.
Let Required Minimum Distributions (RMDs) be your guide. Since the late eighties, company pensions, known in the retirement biz as defined benefit (DB) plans that would get you a monthly retirement check that would cover the electric bill and a couple trips to the grocery have grown increasingly scarce, replaced by 401(k)s and IRAs. These newer retirement plans are known as defined contribution (DC) plans, meaning you, rather than your employer, do most of the contributing. The Stanford researchers concluded that the best strategy for remaining above water throughout your retirement would be to make your 401(k) and various other retirement accounts behave like those old fashioned company pensions. Despite the fact that after you turn 59 ½, you’re free to withdraw as much as you like from 401(k)s and IRAs without penalty, you should instead take only the Required Minimum Distribution (RMD) annually. The RMD wasn’t designed as a retirement planning tool, but rather a way for the IRS to get their paws on the taxes you’ll pay when you take retirement account money out, but the Stanford number crunchers found that it proved a solid guideline (much like the 4% rule) to draw down a safe amount every year. The was RMD’s calculated is a bit morbid—it divides the amount in your retirement accounts by your remaining life expectancy; it starts at 3.65 percent at 70 and increases the older you get, so by your 115th birthday, if you still have $100,000 in your retirement accounts, you’ll be required to withdraw $52,631 of it that year. May we suggest that if you make it that long, you deserve to terrorize the neighborhood by peeling out at every opportunity in your brand new $52,000 cherry red Camaro.
Early retirement strategies
You don’t want to wait until you’re 70 to start hustling your fellow retirees at shuffleboard? Great, why not retire at 60, or even 50. Heck, the only impediment to keep you from retiring on your 30th birthday is having enough money to keep you afloat for 60 or so years. Life’s expensive, and the earlier you retire, the less time your retirement savings will have to experience the magical power of compounding. Here are a few of the major points for those aiming to exit the rat race early.
Save like a mofo starting right now— and invest much of it in stocks. We went over the power of saving and compounding above, but you’ll need to put that into overdrive. Again assuming a hypothetical, though not unheard of 7% annual rate of return on an investment in US equities, a 25 year-old who puts away $20,000 away every year will end up with almost $1.38 million by age 50. And what with that whole eggs-in-one-basket thing, diversification is incredibly important, and you should never invest solely in stocks. That being said, stock market history shows the short-term risk of investing in the S&P 500 dissipated over time, so if you’ve got a twenty-plus year investment horizon, the stock market’s a pretty appealing place to park your money. Be warned, though: Investments are speculative and it’s important to understand that past results should never be understood to be guarantees, but rather imperfect predictors of future performance. Again, you must keep your fees low, and max out all tax-advantaged accounts before investing elsewhere. A deeper dive on these issues can be found here.
Other ways to retire earlier? Eliminate credit card and other consumer debt. Consider renting over buying a home. Hold your head high while giving the valet the keys to your 2005 Honda Civic. Commit to a cheapskate lifestyle. Plan to retire in a country with a lower cost of living, ideally one with plentiful rum and coconuts.
Tax-free retirement strategies
Unlike the coworker in the next cubicle who lived to recount to you her previous nights dreams in great detail, taxes unfortunately don’t disappear when you retire. Most of the income you take—from the government, from pensions, 401(k)s, and traditional IRAs, is taxable. There are a few strategies that will help you legally outfox the tax man during retirement.
The 3 bucket strategy. Your mission during retirement will be to keep your cash flow at levels approximating to your pre-retirement income while not actually earning a salary. If you’re able to reduce your taxable income to almost nothing by capitalizing on existing tax law, even if you’re not drawing nearly as much money, it will feel as if you are since you’ll be forking over so little in taxes. The objective of the bucket strategy, otherwise known as tax diversification strategy (explained in more detail here) is to bring your taxable salary as close as possible down to the couple’s standard deduction of $24,000 (or $12,000 for singles) since not a cent of that income will be taxed. The three buckets you’ll be drawing from in order to make this work are a taxable bucket, consisting of investments and savings accounts, a tax-deferred bucket, which includes 401(k) and traditional IRA funds, and the tax-free bucket, which hold funds in accounts on which you’ve already paid taxes, like Roth IRAs and Roth 401(k)s. By withdrawing methodically from each account, you’ll be able to keep your marginal tax rate very low, as in this example, where a hypothetical codger was able to pay an effective tax rate of less than 3% on $100,000 of retirement income.
Roth Conversions. But wait, you might say. I was always told that in order to keep my tax burden low while I was working, I needed to be contributing the maximum amount to my tax-deferred accounts like 401(k)s and traditional IRAs. Now my tax-free Roth bucket is empty. How in the world can I retire with only two buckets? Help! This is where the above advice on holding off on taking Social Security until you’re 70 pays off. Say you retire at 65. For every year you’re not collecting that monthly check, your income will be very low. Based on the standard deduction, you’ll be able to convert as much as $24,000 of your IRA or 401(k) funds to a Roth without paying any taxes on it. Then, when you’re over 70 and collecting those (relatively) fat Social Security checks, you’ll be able to access that tax-free Roth bucket money to supplement your income stream without adding to your tax bill.