How to Plan for Retirement [Step-by-step Guide]

Do you want to retire someday? Do you really need to plan for retirement? This comprehensive retirement planning guide will show you how to plan for retirement and actionable steps you can take TODAY.

Introduction to Retirement Planning

I had a commonly held belief that a vast majority of older adults are working out of sheer financial necessity. In the past I stumbled on news articles of older adults working low wage jobs just to stay afloat. Although this certainly is a reality for some people, is it as widespread and we might think it is?

Based on my research, the answer is (most likely) no.

The median net worth of households 65 and older surpass those of other age groups according to a 2009 Pew Study:

Furthermore, with nearly 80% of those aged 65 or older being homeowners, I would hypothesize that many would be mortgage free after paying their mortgage off after 30 years of working. Therefore, their living expenses during retirement could even decrease.

Although the median retiree left work at age 62, here are some people who are still working long after that:

• Joe Biden: Presidential Nominee – Age 77 – Net worth: $9 million
• Ruth Bader Ginsberg: Associate Justice of the Supreme Court – Age 87 – Net worth: $4.065 million
• Warren Buffet: CEO of Berkshire Hathaway – Age 89 – Net worth: $72.1 billion

They have more than enough money to retire comfortably. So why aren’t they sipping Pina Coladas at the beach?

I did some research and stumbled across a United Income White Paper. According to the Census Bureau and Bureau of Labor Statistics (BLS),  the percentage of retirement-age Americans who are working has doubled since 1985. 

The white paper concluded that “this trend has been especially pronounced among highly-educated segments of the population.”

Furthermore, “Improved health has been a key driver of this increased labor force participation, as retirement-age Americans are experiencing fewer work-related activity limitations.”

People may continue to work for a number of reasons including:

Psychological

• Feeling of accomplishment
• Prestige and respect from powerful positions
• Continue to meaningfully contribute to society
• Enjoy a familiar daily structure and are accustomed to their daily routines

Financial

• Bonus spending money never hurt anyone

Physical

• Keeping mind and body sharp by continuously using their wits and skill

So if people continue working later in life, why do I even need to plan for retirement?

There are still several reasons why you need to plan for retirement.

Options

It’s great to have options. Imagine having built a nest egg large enough where YOU can decide whether or not to continue working, based on YOUR terms, and not anybody else’s. You can take a few years off to care for your grandchildren, travel the world, or write a novel. If you want to go back to work, go for it. But when you have an adequate nest egg, working becomes a CHOICE rather than a NECESSITY. 

Health

Your health in the later stage of your life is not guaranteed. Can you say with absolute certainty that you’ll be healthy enough to continue working in your 70s or 80s? If you can’t continue, you will need to rely on your retirement savings and social security to pay for your living expenses.

How to Plan for Retirement: Calculations

To plan for your retirement, you need to calculate approximately how much money you need to not have to work ever again. 

First, calculate your yearly living expenses (more info on how to do that here).

Second, calculate your retirement TARGET. Do this by multiplying your yearly living expenses by 25 (the inverse of 4%). As a rule of thumb, you can live on approximately 4% of your nest egg every year and reasonably not outlive your money during a 30-year retirement. This number is your retirement GOAL.

Finally use a retirement planning calculator to calculate how much money you need to save every month to reach your goal.

Example:

Let’s say you are 30 years old and want to retire at the median retirement age of 62, which is 32 years from now.

You have $0 in savings.

Your living expenses are $2000 a month, or $24000 a year.

Multiply $24000 by 32 to get your retirement target of $768,000 (in today’s dollars).

Assuming a 5% after-inflation return rate (the long-term after inflation rate of the S&P is 7%. However, I’m using 5% to add some conservatism since you might have a more balanced portfolio of stocks and bonds.)

When you plug in the numbers into this retirement calculator, this will be your result:

You will need to contribute about $831.07 a month to hit your retirement goal of $768000 in 30 years at an after-inflation return rate of 5%. We’ve accounted for inflation by using an after-inflation return rate.

Types of common retirement plans

With so many different options, which is the retirement plan for you?

Here a few of the most common options according to the IRS website:

• Individual Retirement Arrangements (IRAs)
• Roth IRAs
• 401(k) Plans
• 403(b) Plans
• SIMPLE IRA Plans (Savings Incentive Match Plans for Employees)
• SEP Plans (Simplified Employee Pension)
• SARSEP Plans (Salary Reduction Simplified Employee Pension)
• Payroll Deduction IRAs
• Profit-Sharing Plans
• Defined Benefit Plans
• Money Purchase Plans
• Employee Stock Ownership Plans (ESOPs)
• Governmental Plans
• 457 Plans

So the choice is easy right?

Actually, yes… well, sort of! 

Some of these plans are only available to government workers, non-profits, or self-employed workers.

As many of these plans will not be offered by your employer, this will narrow down your options. You can sit down with your HR liaison to determine what options are actually available to you and how best to utilize them.

2 popular employer-sponsored retirement plans:

401(k):

The 401(k) is probably the most utilized and well-known of the retirement plans. Your contributions are pre-tax meaning you won’t pay tax on the contributions. However, your distributions (what your withdraw) will be taxed on BOTH the principal and earnings.

For example, let’s say in a monthly paycheck you made $5000 gross income. You decide to contribute $500 to your 401(k). This $500 will not be taxed. Only your remaining $4500 will be taxed.

When it’s time to withdraw from your 401(k), let’s say your contribution of $500 grew to $1500. You will have to pay ordinary income tax on the entire $1500 ($500 principal and $1000 earnings).

Roth 401(k):

Roth 401(k) is very similar to the standard 401(k) but instead, your contributions are post-tax and your distributions are tax-free. 

In a similar example, let’s say in a monthly paycheck you made $5000 gross income. You pay taxes on the entire $5000 before contributing $500 to your Roth 401(k). 

When it’s time to withdraw from your Roth 401(k), let’s say your contribution of $500 grew to $1500. You will not have to pay any taxes on the entire $1500.

The 401(k) and Roth 401(k) are employer-sponsored plans, so you can only utilize these plans if you work for an employer (i.e. not self-employed).

The contribution limit for 2020 for the 401(k) and Roth 401(k) in aggregate is $19,500. That means if you contribute $10,000 to your 401(k), you can only contribute up to $9,500 in your Roth 401(k).

2 popular non-employee sponsored retirement plans:

Individual Retirement Arrangement (IRA):

The IRA is similar to a 401(k) in that the contributions are pre-tax and the distributions are taxed on the principal and earnings.  

Roth IRA:

The Roth IRA is similar to a Roth 401(k) in that the contributions are post-tax and the distributions are tax-free.

The IRA and Roth IRA are not sponsored by an employer, meaning you can utilize them if you are employed or self-employed.

The contribution limit for 2020 for the IRA and Roth IRA in aggregate is $6,000. That means if you contribute $4,000 to your IRA, you can only contribute up to $2,000 to your Roth IRA.

You can typically open up an IRA account through your savings institution or brokerage.

Here is a handy dandy chart that compares the common retirement plans.

How to choose the right retirement plan

So how do you choose the right retirement plan for YOU?

Start by asking your HR department which options are available to you. Some of your options may include more uncommon plans like the 457 for government employees or the 403(b) for the non-profit sector.  So make sure you explore ALL of your options before  making a decision!

For simplicity, let’s say your only options were the 401K, Roth 401K, IRA, and Roth IRA. How should you invest?

You should ask yourself this:

Will you be making MORE income in retirement from distributions, than you are working? This is a hard question to answer since your income is uncertain and can change from year to year. 

But if you’re fairly confident you’ll be making MORE in retirement, then it makes sense to get taxed now (post-tax contributions) and have your distributions tax-free. Your options would be Roth 401K and Roth IRA.

Conversely, if you’re fairly confident you’ll be making LESS in retirement, then it makes sense to skip tax now (pre-tax contributions) and pay taxes later on your distributions. Your options are 401K and IRA.

If you have no idea what your tax situation is now vs later, you can even hedge your bets by putting money in both pre-tax and post-tax accounts.  

How to make the most of your retirement plan

The best way to make the most of your retirement plan is to contribute EARLY and CONSISTENTLY.

It’s no secret folks.

Those who invest early take greater advantage of compound interest and see their investments GROW, GROW, and GROW some more.

Consistency is key too: You’ll typically grow your investments more when you contribute consistently at regular intervals. 

According to a study by the Employee Benefit Research Institute:

“The average 401(k) plan account balance of the consistent participants grew at a compound annual average rate of 14.2 percent, from 2010 through year-end 2016, to $167,330. This was more than double the average account balance of $75,358 among all participants in the EBRI/ICI 401(k) database at year-end 2016.

The Bottom Line:

It’s a good idea to plan for retirement to give you the OPTION to enjoy retirement on the beach or to continue working if it continues to bring you satisfaction. Furthermore, you can’t predict your health in the future so it’s a good idea to have money in case your health requires you to stop working. 

Plan for retirement by calculating your living expenses, calculating your target retirement goal, and finally calculating how much you need to contribute each month to reach that goal.

Choose the right retirement plan by asking HR what are your options, and determine whether you want to contribute to post-tax accounts, pre-tax accounts, or BOTH!

Finally, make the most of your retirement investments by contributing EARLY and CONSISTENTLY. 

What are you waiting for? Get started today on your first step towards financial freedom! 

Let me hear from you!

Have you started your retirement planning? How’s it going so far?