Got an email from a friend. He wants to know whether he is saving enough for his retirement. I did a quick analysis for him and thought it might be worthwhile to share the analysis with interested readers who might be pondering about the same question.
Goal: withdraw $5000 monthly after retirement
Question: How much should I save each month to reach that goal?
Background information:
Age: 40
Planned retirement age: 60
Annual Income: Take home pay is $84,000 after taxes, health insurance and 401(k) contributions
Roth and regular 401(k): $220K
Current contribution to 401(k): $17,500 with half to a Roth 401k and half to a regular 401k.
Savings: nothing material
Part 1: Analysis:
First, I will use his retirement needs to determine his saving goals. Then, I will reverse the direction and calculate how much he would have for retirement if he saves at various levels.
1. From retirement needs => saving needs
How much does he need to retire?
Years in retirement: 50 (retire at 60 and live till 110, better overestimate)
Return rate: 5% (lower than the normally assumed 7%, just want to be conservative)
Withdraw amount: $5000 monthly (this is probably way more than he actually needs based on his current monthly expenses. However, I understand the psychological benefits of overestimating this number).
How much he needs to retire: $1,100,000 (I did not include the social security pay in calculations).
How much should he save while working?
Current 401(k) Balance: $220,000
Years to retirement: 20 (240 months)
Annual return: 6% (assumed)
He needs to save about $900 per month ($10,800 per year) to reach his retirement goal of $1.1m.
How he is doing now: He is currently saving $17,500 a year, which would be about $1.35m when he retires at 60. So he is doing well if all of our assumptions are accurate.
However, life is full of uncertainties. The numbers above are very sensitive to assumptions.
Iteration 1: Change annual return to 4% a year for both retirement and saving periods.
How much he needs to retire: $1.3m
How much he need to save while working: $27,500 yearly or $2,292 monthly. (Not saving enough!)
Iteration 2: Retire at 50 instead of 60
How much he needs to retire: $1.15m
How much he needs to save while working: $55,000 yearly or $4,583 monthly. (Not saving enough!)
Iteration 3: Retire at 55 instead of 60
How much he needs to retire: $1.12m
How much he needs to save while working: $25500 yearly or $2,125 monthly. (Not saving enough!)
2. From savings => retirement fund
His current take home pay is $7000 per month.
Current Non-discretionary Monthly Spending:
Apartment Management Fees: $600
Mortgage payment + Homeowner Insurance + Property Tax: $2200
Cable: $110
Church Contribution: $400
Subway to work: $70
Grocery and other misc. items: $800
Total fixed monthly expenses: $4,180
Discretionary Spending:
Travel: $5,000 per year
Clothing + Gifts: $4,840 per year
(Note: This is why I said earlier that he probably overestimated his post-retirement monthly expenses. Without mortgage, his spending is only $1,870 a month without discretionary spending and $2,690 with discretionary spending.)
Total Savings: ($7,000-$4,180)x12 – $9,840=$24,000 per year.
After including the $17,500 contribution to 401(k):
Years to $1m: 10-11 years
Years to $1.5m: 15 years
Years to $2m: 18-19 years
Iteration 1: Cut his spending for discretionary items to $5,000
Total Savings: ($7,000-$4,180)x12 – $5000=$28,840.
After including the $17,500 contribution to 401(k):
Years to $1m: 9-10 years
Years to $1.5m: 14 years
Years to $2m: 17-18 years
Iteration 2: Increase his spending for discretionary items to $15,000
Total Savings: ($7,000-$4,180)x12 – $15000=$18,840.
After including the $17,500 contribution to 401(k):
Years to $1m: 11-12 years
Years to $1.5m: 16 years
Years to $2m: 19-20 years
Iteration 3: Spend everything he takes home.
Total savings: 0.
After including the $17,500 contribution to 401(k):
Years to $1m: 15-16 years
Years to $1.5m: 21-22 years
Years to $2m: 25-26 years
The numbers tell a clear story: Saving buys him time. The more he saves, the quicker he reaches financial independence.
Part 2: Recommended Actions
(1). Put all 401(k) contributions into a traditional 401(k).
By doing this, he can save more taxes because contributions to the traditional 401(k) is tax deductible. With a marginal tax rate of 33%, we are talking about saving more than $2800 in tax every year, which means additional $2800 to his savings account. What happens if tax rate increases in the future? It is highly likely. However, there will be ways that will allow him to take his money out of traditional 401(k) without paying too much tax, definitely not in his current tax bracket of 33%. Check this post by gocurrycrakcer for why he may never need to pay taxes again after he retires.
(2). Open a Roth IRA account and max it out every year.
Capital growth in a Roth IRA is tax free and if needed, his contributions (not the growth part) can be withdrawn without penalty. For these reasons, Roth IRA strictly dominates a taxable investment account. So I would not put money in a taxable account before I max out the Roth IRA.
(3). Open a taxable investment account to host his savings.
I would keep just about three-six months expense in my bank account as emergency fund and park the rest of my money in index funds in an investment account.
(4). Track expenses and stick to budgets.
Based on the numbers he gave me, he should have had some savings by now. The fact he has no savings made me suspect he is overspending without realizing it. So I suggest that he starts logging all his expenses and sticks to the budget for discretionary items.
Overall, I think he is doing a reasonable job in his retirement savings. If plan well, invest wisely and save a bit more, he will be financially independent in about 12 years (assuming he really needs $5000 per month after retirement).
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