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What Percentage of Your Salary Should Go Towards Retirement?

27 January 2015 in Investing Insights

The annualized growth rate of the S&P 500 over the past 50 years was 8%. To help put this into perspective, let’s say someone received a $10,000 inheritance in 1965. Instead of simply putting the money into a savings account that earned very little interest, he/she decided to invest in a portfolio that closely tracks the S&P 500 Index. If that investment went untouched until today, that one time deposit could equal $470,000, assuming no fees or expenses. Investing in the market can certainly be a wise decision, but how can one know how much to invest?

 

HOW MANY YEARS DO YOU HAVE LEFT TO SAVE?

One of the major factors to determine how much to contribute each month is the number of years you have left to save. Someone who is 60 years old and is just starting to think about saving for retirement will likely have to save an astronomical rate each month just to accumulate a meager amount of money by age of 65.

If, however, that same person had started investing at the young age of 23 years old, the monthly contribution percent needed would be far less. Starting at this age, a 5% contribution each month might be sufficient for a golden retirement for his/her late 60’s. But obviously, the higher the savings rate, the better.

The Power of Compounding Interest

Why is it that an early investment is so much more beneficial than a late one? Some people inaccurately think that saving $10,000 a year for 5 years should equal the same as contributing $1,000 a year for 50 years. The difference is actually quite dramatic. If you look at the math of compounding interest, an early contribution is often far more beneficial than a late one.

For example, with an average interest gain of 8% per year, 50 years’ worth of $1,000 contributions would equate to approximately $620,000.

Contributions of $1000 per year for 50 years:

power-of-compound-interest

Source: http://www.daveramsey.com/article/investing-calculator/lifeandmoney_investing/#/entry_form

Alternatively, how close to the $620,000 dollar mark would a late contributor get who is saving $10,000 over five years? Not close at all. Using the same interest rate as in the example above, after five years, the result would only be roughly $63,000.

Contributions of $10,000 for Five Years:

compound-interest-2

Source: http://www.daveramsey.com/article/investing-calculator/lifeandmoney_investing/#/entry_form

Compounding interest really is an amazing phenomenon. Interest compounded on itself begins growing so quickly that even Albert Einstein called it the 8th wonder of the world. If you wish to accumulate great wealth for your retirement, it is best to start sooner rather than later.

First determine at what age you plan to retire. Next, calculate how many years that is from now. That number, whether it’s 10, 20, or even 40 years from now, greatly impacts the potential earnings by your retirement age. Due to the effects of compound interest, it’s incredibly important to know that number to figure out how much you should be contributing to your retirement fund each year.

HOW MUCH MONEY DO YOU WANT FOR RETIREMENT?

The next important factor in deciding what percentage to contribute toward retirement is how much you want by the time you stop working. If you decide that you would like $2 million instead of $500,000, your contributions must obviously go up.

Another common question is, “How do I know how much I’ll need by the time I retire?” With the rising cost of healthcare, inflation, and other unforeseen costs, that “nest egg” number can be difficult to figure out. However, it’s still possible to estimate how much money you will want in retirement and then prepare an action plan accordingly to help reach your goal.

Studies have shown the average costs of a retiree can approach approximately 75% of what they were used to when they were working (known as the replacement rate). However, inflation and the rising costs of healthcare could hinder this replacement rate and will likely meet or surpass your income needs of today. In other words plan on needing at least the same amount of income in retirement that you are receiving today to cover all of your future expenses.

Next, multiply your yearly income by the number of years you expect to live during retirement. To provide some perspective on this, a 65 year old man has approximately a 20% chance of living to age 90, and a 65 year old woman has roughly a 33% chance of living to age 90. While you may not be able to define the specific age with certainty, you may be more comfortable projecting for a retirement fund that could last at least 25 years. As an example, someone who plans on retiring at age 65 and living to age 90 with expenses of $50,000/year could aim for a retirement fund of $1.25 million (25 years of retirement x $50,000/year = $1.25 million).

HOW TO CALCULATE YOUR CONTRIBUTION PERCENT

After determining your desired retirement fund total, backtrack to discover how much money you should be contributing each year. Simply open up a retirement calculator and enter in your current savings, the interest percent you expect to earn, the amount you would like to contribute each month, the number of years you plan to contribute, and the number of years you have until retirement. Take a look at the result. Is this value far below your anticipated needs in retirement? If so, then you may want to evaluate your needs again, including increasing the monthly contribution in the calculator until it reaches your desired total.

Once your numbers are in place, there is really only one thing left to do. Take a look at the monthly amount that you ended up with in the calculator. Multiply this amount by 12 to get your yearly contribution, and then divide it by your total yearly salary. This is the amount that you should be contributing out of every paycheck.

If you start funding your retirement at a young age, this percent might be as little as 5%. If you are older and need to play catchup on your retirement fund, then your percent might be 25% or more. Whatever the case may be, it’s better knowing now versus later what it could take to hit your goals.

ADJUST YOUR NUMBERS ACCORDINGLY

It is entirely possible that your desired contribution percent is far higher than you can realistically afford. If this is the case, you may want to consider finding ways now to reduce expenses and increase your savings and earnings, or adjust your retirement plans in a way that projects a more realistic lifestyle based on your life expectancy. Delaying action and postponing retirement planning could lead to financial stress and difficulties later in life that could have otherwise been avoided. Planning and preparation will help you live a more comfortable retirement.

Every investor is unique when it comes to their retirement goals, time horizons, risk tolerance, and investing interests. Discover your Investing DNA today and get tailored portfolio ideas based on your individual preferences.

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  1. Jacob
    4 Feb at 5:56 pm

    I currently save 30-40% of my after tax savings for retirement and I contribute $5,000 to my 401k to take advantage of employee match. One day the match will be gone!

    Reply
    • Kevin
      25 Feb at 11:43 pm

      Jacob you must be living with your parents or is one of those people featured on Extreme Cheapskate. If I don’t pay rent I could save up that amount too.

      Reply
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  3. krystle
    3 Mar at 6:35 pm

    I also save about 30 to 40 percent per year and contribute 5500 to my Roth and I do the match via my company. It can be done. I pay rent, also. I’m an immigrant, so I guess I’d fit in that cheapskate category? And I cook my own food a lot and only buy books. Every once in a while, I eat a nice dinner, but I don’t need that much.

    Reply
  4. Nork
    14 Mar at 7:28 pm

    Saving is a losers game. Spend it before they tax it, inflation steals it, Wall Street robs you of it, or health or old age bills you for all of it. Wall Street just wants your money for their games and profits. I know this is like telling a born again religious nut that there ain’t no God, but once the Federal Reserve loses control, nothing you have saved will be worth anything.

    Reply
    • RSoames
      8 Oct at 11:52 pm

      I’m guessing you haven’t seen what life is like for the millions of elderly people who live in poverty because they took this approach. It would be worth visiting some of them, and that will cure you of this incorrect notion really fast.

      Reply
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  6. Gary Weigh & Associates Pty Ltd
    9 Aug at 11:50 pm

    Thanks for the advice! Saving is one of the best solutions to achieve quality retirement. The earlier you start planning for retirement, the better. The best time to start is now.

    Reply

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