While you’re considering health care benefits options during your “open enrollment” period, you should also take stock of your retirement savings strategy. Are you saving enough to cover your retirement needs? The answer depends on many factors, including your expected living expenses, bucket list items (such as travel and hobbies) and potential medical and long-term care costs.
Also be aware that many employers have embraced “auto-enrollment” and “auto-increase” as a way to help employees who fail to enroll in their company 401(k) plans or who don’t contribute enough to their retirement plans. These provisions often coincide with the company’s open enrollment period.
Traditional 401(k) vs.
Some employers offer an after-tax Roth 401(k) option. These plans combine elements of traditional 401(k) accounts for employees and the Roth IRA concept for individuals. Contributions to an employee’s Roth 401(k) account are made with after-tax dollars rather than pre-tax dollars. Thus, an employee loses a key current tax benefit of 401(k)s.
On the plus side, when an employee withdraws funds from the account, qualified distributions are completely exempt from income tax, just like qualified distributions from a Roth IRA. In contrast, regular 401(k) distributions are taxed at ordinary income rates.
So, the choice between contributing to a traditional 401(k) vs. a Roth 401(k) largely comes down to when you want to take the tax hit on your retirement savings — now or when you retire. It also depends upon whether you think your income tax rate will be higher than, lower than, or the same as today when you retire. If your effective tax rate will be lower during retirement than it is now, you might be better off with a traditional 401(k).
Minimize the Guesswork
There are only limited opportunities during the year — including open enrollment season or a major change in your personal circumstances — for employees to make changes to their health care benefits. But most companies allow you to update your retirement plan contributions throughout the year.
When deciding how much to contribute each pay period, many employees pick a round number, like 10% of their paycheck. But this isn’t a one-size-fits-all decision, and it may fluctuate over time. You’ll periodically need to review your contribution level and adjust it for major life changes, such as the birth of a child, a period of unemployment or a windfall from the lottery.
Start the process by estimating your desired retirement income. Do you want to maintain your current lifestyle or downsize certain items, such as housing and clothing budgets? Other expenses — like retirement contributions and childcare costs — typically disappear during retirement. On the flip side, medical care and travel expenses generally rise as you (and your spouse if you’re married) get older. Your retirement plan provider’s website may offer online modeling tools to help with this exercise.
It’s important to factor inflation into your savings plan. For example, the median annual U.S. household income is $62,000 today. If that’s your targeted retirement income and you expect to retire in 25 years, you’ll need approximately $130,000 annually to have the same purchasing power (assuming a 3% annual rate of inflation).
How to Reach Your Target
Next, estimate how much of your targeted annual retirement income will be funded by Social Security and other sources of income. Continuing with the previous example, let’s suppose you estimate that your annual income from these other sources will be $65,000. That means your retirement savings will need to provide the remainder ($130,000 – $65,000 = $65,000).
So, how big will your “nest egg” need to be when you retire? If you want to receive $65,000 per year for 30 years, you’ll need to have about $1 million in your account when you retire, assuming a 5% annual rate of return during retirement. (This calculation is somewhat oversimplified. You might want to receive more than $65,000 per year to account for inflation during retirement.)
The size of your desired retirement nest egg can be used to estimate the amount you should be setting aside in your 401(k) today. Another key factor is your current age. The younger you are, the less you’ll need to contribute to reach your goal.
For example, if you’re currently 40 years old and just starting to accumulate your $1 million retirement nest egg, you’ll need to put $1,234 per month into your retirement savings account, assuming a 7% rate of return (compounded monthly) and a retirement age of 65. But, if you’re 25, you’ll need to set aside only $381 per month to reach your target under the same assumptions.
What if you already have a retirement nest egg started? Let’s assume you’re currently 40 years old, and you already have $100,000 in your 401(k). In this case, you’ll need to put $528 per month into your retirement savings account to reach your $1 million target, assuming an 7% rate of return (compounded monthly) and a retirement age of 65.
Thanks to the power of compounding (earning investment returns on your investment returns), if you’re relatively young and set aside as much as you can, you’ll probably do well.
If your employer provides a matching contribution based on a percentage of what you contribute, it would reduce your monthly out-of-pocket contribution. Financial necessity often dictates that younger people start out with a relatively modest contribution rate and increase it over time. But, if you’re able to save aggressively when you’re young, thanks to compounding you might be able to ease off on your savings rate when you get older.
Note: When planning ahead, be aware that the retirement age for full Social Security benefits is no longer 65 for most people. It now depends on when you were born. For example, if you were born in 1958, full retirement age is currently 66 and 8 months old. If you were born in 1960 or later, it’s 67 years old.
Evaluate Your Risk Tolerance
A final consideration is how much investment risk you can tolerate. The younger you are, the more risk you can probably handle because you have more time to recover from investment losses. But, if you’re risk averse and tend to hastily sell investments when prices fall, you might be more comfortable with a lower-return investment option that offers a buffer against volatility — even if it requires you to contribute more each month.
Target date funds, the most popular kind of 401(k) investment, are designed to start off heavily invested in higher-risk stocks, then gradually shift toward lower-risk bonds as you near your targeted retirement age.
For More Information
When planning for retirement, it’s important to crunch the numbers — but you also want to avoid “paralysis by analysis.” By learning the basic principles of retirement saving and investing, you’ll be equipped to ask smart questions about the customized recommendations you receive. Then you can make your decisions with greater confidence.
Contact your financial advisor for more detailed information. He or she can address any questions left unanswered by your retirement plan provider’s website and online modeling tools. You owe it to your future self to play it smart today.