Part 21 (1/2)

- Say you make $50,000 a year but spend $60,000. In that case, your income understates your lifestyle by $10,000 a year. If you based your retirement needs on your income, you wouldn't come close to supporting your lifestyle.

- On the other hand, if you make $50,000 a year but only spend $25,000, basing your retirement needs on your income would lead you to save much more than you need.

As you can see, estimating how much you'll need in retirement by looking at your current income doesn't make much sense. It's one of those rules of thumb-like ”buy as much house as you can afford”-that can actually do more harm than good. There's a real danger that by following this advice, you won't have enough saved for retirement. But just as bad, there's a chance you'll have saved too much, meaning you missed out on using money to enjoy life when you were younger.

Instead of estimating your retirement needs based on your income, it makes more sense to base them on spending. Your spending reflects your lifestyle; your income doesn't. The next section explains how to do that.

TipYou can get a rough estimate of the Social Security benefits you'll receive using this Quick Calculator: tinyurl.com/socsec-calc. For a much more accurate estimate of your future benefits, check the Social Security statement you receive in the mail every year.

A Better Way If you're going to base your savings goals on how much you'll spend in retirement, you've got to have a way to gauge your future spending. Will your expenses increase or decrease? That depends in large part on your health and your plans. If you get sick or travel a lot in retirement, for example, your expenses may go up. In general, though, your expenses will likely stay about the same. According to the Employee Benefit Research Inst.i.tute's 2009 Retirement Confidence Survey (RCS): - 49% of retirees spend less in retirement than before (26% spend much less) - 35% spend about the same as before retirement - 14% spend more in retirement (though 7% say their expenses are only ”a little higher”) Overall, 65% of Americans spend about the same or only slightly more or less in retirement. That means their pre-retirement expenses are a good predictor of their post-retirement expenses.

NoteYou can download the full EBRI report for free from tinyurl.com/EBRI-rcs. It's filled with tons of data about Americans' att.i.tudes toward retirement-and the realities of being retired.

Expenses often drop in retirement because your kids are out of the house; your mortgage is gone-or nearly so (one of the surest steps toward retirement security is to pay off your mortgage); you have no commuting costs or other work-related expenses; and, ironically enough, you no longer have to save for retirement. Sure, you'll have other expenses-especially health care-but if you've been smart and planned ahead, you should be in good shape.

Make no mistake: You will need a sizable nest egg for retirement-especially if you have ambitions to travel or want to golf every day. In fact, you should save as much as you can. But don't be snookered by the constant refrain that you need 70% of your pre-retirement income. That's nonsense-base your savings goals on your projected expenses instead.

The moral here? Don't panic-you can save enough for retirement. In Retire Well on Less Than You Think Retire Well on Less Than You Think (Times Books, 2004), Fred Brock writes: (Times Books, 2004), Fred Brock writes: Most people can retire from wage slavery sooner than they think if they are willing to pay a relatively painless price for their freedom: a simpler, downsized life and, perhaps, a move to a less expensive part of the country-and it doesn't have to be remote or far away.

The key is to live within your means now, which lets you boost your cash flow so you can acc.u.mulate savings for later in life.

Retirement Calculators Enough theory! You're probably ready for some hard numbers. In that case, you can get a quick estimate of how much you'll need to save by heading online. There are hundreds of retirement calculators scattered across the Web, and each one is a little different. Because this is all a guessing game, no one calculator is necessarily better than any other, but here are a few I've found especially insightful: - T. Rowe Price has an excellent calculator that bases its results on your spending needs: tinyurl.com/TRO-rcalc.

- The Motley Fool has two useful calculators, one that estimates your retirement expenses (tinyurl.com/fool-rexp) and one that lets you see if you're saving enough (tinyurl.com/fool-enough).

- Bankrate's retirement calculator (tinyurl.com/BR-rcalc) bases its results solely on your savings. (MoneyChimp.com has a similar-but simpler-calculator at tinyurl.com/MC-rcalc.) - Choose to Save has a ballpark estimate tool (tinyurl.com/ballparke) that you can use online or off. It's the best of the calculators that use income instead of expenses.

For a great combination of simplicity and complexity, check out FireCalc.com. This site may seem overwhelming at first (there's a lot of text to read), but it's actually fairly elegant. What it does is give you an idea of just how safe or risky your retirement plan is based on how it would have withstood every market condition we've ever faced since 1871. All you do is enter how much you've saved, how much you think you'll spend every year, and how many years you expect to live in retirement. Then FireCalc spits out a percentage telling you how likely your retirement plan is to succeed: 0% means that it never would have worked in the past, and 100% means it always would have succeeded.

NoteIn How to Retire Early and Live Well How to Retire Early and Live Well (Adams Media, 2000), Gillette Edmunds shares his formula for calculating retirement needs based on current expenses. His formula takes taxes, inflation, and investment returns into account. It's too math-y for this book, but if you'd like to calculate things by hand, track down a copy at your local library or used book store. (Adams Media, 2000), Gillette Edmunds shares his formula for calculating retirement needs based on current expenses. His formula takes taxes, inflation, and investment returns into account. It's too math-y for this book, but if you'd like to calculate things by hand, track down a copy at your local library or used book store.

Looking at the results from just one retirement calculator isn't very useful. But if you compare the numbers and recommendations from several, you can get a pretty good idea of how much you'll need to save for the retirement you want. If your results are anything like mine, you may feel a little overwhelmed. In that case, make a commitment to start saving for retirement today.

Tipa.n.a.lyzenow.com has lots of great info about sensible retirement planning. The site doesn't include a calculator, but it offers plenty of free downloadable spreadsheet templates so you can run your own numbers, as well as tons of articles about retirement planning.

Why You Should Start Saving Today If you're young, you may not think you need a retirement account-you can worry about that later, right? Besides, you have better things to do with that money, like taking a trip to Vegas with your friends. But the hard truth is that, no matter what your age, you should start saving now.

According to the 2009 National Retirement Risk Index from the Center for Retirement Research, 51% of Americans are ”at risk of being unable to maintain their pre-retirement standard of living in retirement” (tinyurl.com/CRR-nrri). Part of the reason is that these folks didn't plan ahead and set aside enough when they were young.

”The amount of capital you start with is not nearly as important as getting started early,” writes Burton Malkiel in The Random Walk Guide to Investing The Random Walk Guide to Investing. ”Procrastination is the natural a.s.sa.s.sin of opportunity. Every year you put off investing makes your ultimate retirement goals more difficult to achieve.”

An article about retirement in the February 2010 issue of Consumer Reports featured a survey of more than 24,000 of the magazine's readers. The findings won't surprise you: ”Satisfied retirees planned early and lived within their means,” the article noted. Those who started saving in their 30s had an average of almost $400,000 more than those who started in their 50s and 60s. Even readers who started in their 40s typically had $200,000 more than those who waited till later in life.

The bottom line: Save early and often. People come up short of cash in retirement because they put off saving. As you'll see in a moment, the secret to getting rich slowly is the power of compounding. When you're young, time is your greatest ally. Even modest returns can generate real wealth if you start early and stick with your plan.

Frequently Asked Question: Finding Cash to SaveI know saving for retirement is important, but I can hardly find the money to pay my bills, let alone to sock away for my golden years. How can I possibly set money aside for retirement?Saving for retirement is crucial, but if your current financial situation is precarious, it's more important to find a way to make that more stable first-to improve your cash flow (see The Power of Positive Cash Flow The Power of Positive Cash Flow)-and then then worry about the future. This isn't license to ignore retirement savings; it's just a reminder to take care of today before tomorrow. Be sure to: worry about the future. This isn't license to ignore retirement savings; it's just a reminder to take care of today before tomorrow. Be sure to: - Stash some cash for emergencies. Before you save for retirement, save for the present. Without a rainy-day fund, even small disasters can sidetrack your savings for months (or years). See Chapter7 Chapter7 for tips on where to put the money. for tips on where to put the money.

- Pay off your credit card debt (see Chapter4 Chapter4). At the very least, make significant headway on your debt and have a plan for getting rid of it all.

After you finish paying off your debt, saving for retirement is easy: Take the amount you were putting toward debt reduction each month and-instead of spending it on Stuff-stick it in a retirement account. You've already developed the habit of using the money to improve your financial life; this is just another way to do it!

The Power of Compounding On its surface, compounding is innocuous-even boring. How much does it matter if you start saving now? Will it truly make that much of a difference?

In the short term, compounding doesn't make a huge difference. But remember what you learned in the last chapter: Investing is all about taking the long view. Short-term results aren't as important as what will happen over 20 or 30 years.

Imagine you make a one-time, $5,000 investment when you're 20 years old. a.s.suming the return on that investment is 8% per year (in real life, you're never going to find an investment that guarantees this much, but bear with me), even if you never touch the investment again-never add or withdraw any money-you'll have nearly $160,000 by the time you retire at age 65. But if you wait until you're 40 to make your single investment, that $5,000 would grow to only $34,000. As you can see from this example, time is the main ingredient in compounding.

You can get even more out of compounding through systematic investing (see All-in-one funds All-in-one funds). It's great that a single $5,000 investment can grow to $160,000 in 45 years, but it's even more exciting to see what happens when you make saving a habit. If you invest $5,000 each year for 45 years (for a total of $225,000 invested) and the money earns an 8% return every year, your savings will grow to over $2.24 million-nearly 10 times what you invested!

NoteIn real life, there's no way to earn a guaranteed 8% per year. As you learned on How Much Do Stocks Actually Earn? How Much Do Stocks Actually Earn?, the stock market returns an average of 10% per year-but this average is not normal. Because stock market returns fluctuate wildly, if you invested $5,000 into a stock-market index fund every year for 45 years, you could have anywhere from less than $1 million to well over $4 million when you retired, even if your average return was exactly 8%. Confused? Just remember that, even with the power of compounding, you need to watch your progress and make course corrections along the path to retirement.

To make compounding work for you: - Start early. The sooner you start, the more time compounding has to work in your favor, and the wealthier you can become. (The next best thing to starting early is starting now.) - Stay disciplined. Make regular contributions to your savings and retirement accounts, and do what you can to increase your deposits as time goes on. (This is part of paying yourself first-see Get in the game Get in the game.) Don't sabotage yourself by cas.h.i.+ng out your retirement account when you move from one job to the next. And don't be tempted to sacrifice your future well-being for a few more bucks today.

- Be patient. Don't touch the money; compounding only works if you let your investments grow. You can think of it like a s...o...b..ll of money: At first your returns may seem small, but eventually they become enormous.

TipTo learn more about compounding, check out the compound-interest calculator at Money Chimp tinyurl.com/MC-compound).

A Brief Guide to Retirement Accounts A lot of people believe that wealth is something that happens all at once, through inheritance or winning the lottery or magically picking the right stock. But in reality, you get rich slowly. The road to wealth is like a marathon: It's a long race, and the best approach is measured, even paces. To help yourself win this ”race,” it's important to make the most of your retirement accounts.

When you put money in a regular investment account like the ones discussed in Chapter12 Chapter12, you're using after-tax money: You earned the money through your job, paid tax on it, and then used it to buy stocks and bonds. And when you sell your investment, you'll have to pay taxes on the returns the account earned. (Depending on how you invest, you may also have to pay taxes on dividends and capital gains along the way.) One of the great things about retirement accounts-investment accounts specifically for retirement savings-is that they let you put off income taxes until a later date (that's why they're called tax-deferred), meaning you get to hold onto and profit from your money longer. And a Roth IRA (which you'll learn about shortly) lets your money grow tax-free!

There are lots of places to put your retirement savings, so it can be difficult to know where to start. Each person's situation is different, but most folks can follow these simple guidelines: 1. If you have a 401(k) or similar program at work, contribute to get the employer match (Disadvantages of 401(k)s). If your employer doesn't match contributions, go to the next step.

2. If you qualify, open a Roth IRA (Learning to Love Roth IRAs) and contribute as much as you can (up to the maximum allowed).

3. If you have money left, put as much as you can into your 401(k) (see Funding Your Future with a 401(k) Funding Your Future with a 401(k)).

4. Once you've done all of the above, then put your money in regular investment accounts (see Chapter12 Chapter12). You might also consider paying down your mortgage.

Following these steps is one the best ways to take control of your financial future. The following pages cover each step in more detail.

Funding Your Future with a 401(k) According to the Congressional Research Service, nearly half of American workers partic.i.p.ate in retirement plans offered by their employers (tinyurl.com/CRS2007pdf). About one-third of these folks have defined-benefit plans, while two-thirds have defined-contribution plans.

With a defined-benefit plan-which most people simply call a pension-when you retire, you receive a fixed monthly payment for the rest of your life. (The amount you get paid is based on how long you worked for the company and how much you earned.) With a defined-contribution plan, on the other hand, your benefits aren't fixed; they're based on how much you (and your employer) put into the plan and what kind of returns your investments earned.

The 401(k) is a specific type of defined-contribution plan that, over the past couple of decades, has become much more common than traditional pension plans. (The name 401(k) comes from the section of the tax code that defines these plans.) Let's look at the pros and cons of 401(k)s.

NoteThere are a variety of defined-contribution retirement plans out there. For-profit companies offer 401(k) plans, while nonprofit organizations and governments offer 403(b) plans. And if you work for the federal government, you may have access to the Thrift Savings Plan. Though these plans aren't identical, they're similar, so you can generally apply the advice in this chapter about 401(k)s to other defined-contribution plans, too.

Advantages of 401(k)s 401(k)s have a lot going for them. For one, they make contributing to your retirement automatic: Once you sign up for your company's 401(k) plan, your retirement saving comes directly out of your paycheck. You can ”set it and forget it,” only making changes when you want to increase (or decrease) your contributions. This takes the human element out of the equation, preventing you from gumming things up (and that's a good thing-see Being on Your Best Behavior Being on Your Best Behavior).

Even better, your contributions and earnings are tax-deferred. In plain English, that means you don't have to pay taxes on the money you put into a 401(k) until you withdraw it. You're not taxed on the profits (the returns the account earns) until then, either. This is a big advantage over a regular investment account. For example, if you earn $50,000 per year and you put $5,000 into your 401(k), your taxable income drops to $45,000; if you're in the 25% tax bracket (see Know what you owe Know what you owe), say, that would save you $1,250 in taxes. And you won't be taxed on that $5,000 contribution (or any returns it earns) until you take the money out at retirement, so your investment has a chance to grow even faster than in a regular investment account.

But the biggest advantage of 401(k)s is the employer match: Many companies match at least a part of what their workers set aside for retirement. IBM, for example, currently matches employee contributions dollar for dollar up to 6% of their income! Most company matches aren't so generous, but they're still worth taking full advantage of. In effect, you can give yourself a raise by taking advantage of the employer match-though you won't see the effects of the ”raise” until you retire.