Although most of us recognize the importance of a sound retirement portfolio, few of us embrace the nitty-gritty work involved. With thousands of investment possibilities, complex rules governing retirement plans, and so on, most people don’t even know where to begin.
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Determine your retirement income needs
Many experts suggest that you need at least 60 to 70% of your pre-retirement income to enable you to maintain your current standard of living in retirement.
But this is only a general guideline. To determine your specific need, you may want to estimate your annual retirement expenses.
Use your current expenses as a starting point, but note that your expenses may change dramatically by the time you retire. If you’re nearing retirement, the gap between your current expenses and your retirement expenses may be small. If retirement is many years away, the gap may be significant, and projecting your future expenses may be more difficult. Remember to take inflation into account. The average annual rate of inflation over the past 20 years has been approximately 3%.
Does your Retirement
Look like this???
Calculate the Gap:
One you have estimated your retirement income need, take stock of your estimated future income need, take stock of your estimated future assets and income. These may come from Social Security, a retirement plan at work, a part-time job, and other income sources. If estimates show that your future assets and income will fall short of what you need, the rest will have to come from additional personal retirement savings.
Build your retirement fund: SAVE, SAVE, SAVE
When you know roughly how much money you’ll need, your next goal is to save that amount. First, you’ll have to map out a savings plan that works for you. Assume a conservative rate of return (e.g. 5 to 6%), and then determine approximately how much you’ll need to save every year between now and your retirement age to reach your goal.
The next step is to put your savings plan into action. It’s never too early to get started (ideally, begin saving in your 20's). To the extent possible, you may want to arrange to have certain amounts taken directly from your paycheck and automatically invested in accounts of your choice (e.g. 401(k) plans, payroll deduction savings). This arrangement reduces the risk of impulsive or unwise spending that will threaten your savings plan. If possible, save more than you think you’ll need to provide a cushion.
FIGURE OUT HOW MUCH YOU'LL NEED TO SAVE
By the time you retire, you’ll need a nest egg that will provide you with enough income to fill the gap left by your other income sources. But exactly how much is enough?
The following questions may help you find the answer.
At what age do you plan to retire? The younger you retire, the longer your retirement will be, and the more money you’ll need to carry you through it.
What kind of lifestyle do you hope to maintain during your retirement years?
What is your life expectancy? The longer you live, the more years of retirement you’ll have to fund.
What rate of growth can you expect from your savings now and during retirement? Be conservative when projecting rates of return.
Do you expect to dip into your principal? If so, you may deplete your savings faster than if you just live off investment earnings. Build in a cushion to guard against these risks.
Use the right savings tools
The following are among the most common retirement savings tools:
Employer-sponsored retirement plans like 401(k)s and 403(b)s are powerful savings tools. Your contributions come out of your salary as pretax contributions (reducing your current taxable income) and any investment earnings grow tax deferred until withdrawn. Some 401(k) and 403(b) plans also allow employees to make after tax “Roth” contributions. In addition, employer-sponsored plans often offer matching contributions, and may be your best option when it comes to saving for retirement.
IRAs also feature tax-deferred growth of earnings. If you are eligible, traditional IRAs may enable you to lower your current taxable income through deductible contributions. Withdrawals, however, are taxable as ordinary income (except to the extent you’ve made nondeductible contributions).
Roth IRAs don’t permit tax-deductible contributions, but allow you to make completely tax-free withdrawals under certain conditions. With both types, you can typically choose from a wide range of investments to fund your IRA.
Annuities are generally funded with after-tax dollars, but their earnings grow tax deferred (you pay tax on the portion of distributions that represents earnings). There is also no annual limit on contributions to an annuity.
Note: Distributions from retirement plans, IRAs, and annuities prior to age 59 1/2 may be subject to a 10% penalty tax unless an exception applies.