To answer these questions, I’ve created some charts to show the impact of these decisions on your retirement nest egg. Following the charts, I’ll list some of the factors worth considering as you make your own retirement savings decisions.
Save 15% of Gross Income Toward Retirement
Albert Einstein is said to have quipped, “compound interest is the most powerful force in the universe.” Whether he actually said this is undetermined. But to this, I would add, “compound interest is definitely the most powerful force in a retirement account.”
To unleash this force you need two things: savings and time. The more savings and time you have, the more powerful the effect of compound interest. So what does the effect of compound interest have on saving 15% of your gross income?
A 15% Savings Rate Example
Check out this chart showing the growth of 15% savings on a $100,000 per year salary. I've assumed a 10% return, 3.1% inflation, and savings beginning at age 30:
There are several important observations to make here. First, the ending balance of just over $2 million is in today's dollars assuming a 3.1% inflation rate. The actual retirement savings balance after 35 years is over $6 million.
Second, notice that the chart is broken into three colors: yellow, blue, and purple. The yellow represents the actual amount of money invested. The blue represents the amount earned directly from the money invested (called simple interest). And the purple represents the amount earned from the simple interest (called compound interest). All of these numbers are adjusted for inflation.
Here's the key point: Given enough time, the compound interest earned will far exceed the amount invested or even the simple interest. That's the most powerful force in the known universe that Einstein was talking about!
Finally, note that the $2 million balance in today’s dollars is enough to withdraw about $80,000 a year for retirement. That’s exactly what you’d need if you were seeking to replace 80% of your income in today’s dollars. (I’ve written before about the 4% withdrawal rate rule for retirement accounts.)
A 10% Savings Rate Example
Now let’s see what happens if instead of saving 15%, you save 10%. Here’s the chart:
Notice that you still get the benefit of compounding. That's because the benefits of compounding depend on how long you invest and what return you earn. But of course, the more you invest, the more you end up with.
In this case, at a 10% savings rate, you end up with about $1.3 million in today's dollars. This is not enough to withdraw an amount equal to 80% of your pre-retirement income.
You may get Social Security benefits to make up some of this shortfall. But Dave Ramsey's view is we shouldn't count on Social Security. While I'm not as pessimistic on this point, ignoring Social Security in your retirement assumptions is certainly a conservative approach.
How to Decide
From this, we can conclude that a 15% savings rate for retirement is a reasonable approach, given all of the assumptions we've made. In making your own decision on retirement savings, you may want to consider these additional factors:
When you start saving for retirement: If you start saving for retirement at age 18, you may not need to save 15% (although it's a good habit anyway). At age 18, you have 47 years to invest before you're 65. At a 10% savings rate using the numbers above, your inflation-adjusted balance at age 65 is more than $3 million (more than $13 million in actual dollars!).
If you wait until you're 40 to begin, you may need to save considerably more than 15%. At that age, a savings rate of 15% yields less than $1 million in inflation-adjusted dollars. Even a 20% savings rate results in just under $1.3 million. So when it comes to retirement savings, one of the most critical success factors is to start saving as soon as you can. I should add that if you are in your 40s or older and have little retirement savings, there's no point in beating yourself up over it. Just start saving now.
Assuming a 10% return is generous: The above calculations assume a 10% return on investments. Change it to just 9.5%, and the numbers drop considerably. Many believe that annual returns of 10% will be unrealistic in years to come. If you're looking for predictions, you've come to the wrong place.
But I can say that sticking your money in a money market or "safe" bond account won't get you the returns most of us need for retirement. I've written extensively about asset allocation. In addition, here are two great books that have helped me a lot in formulating my investment plan: The Bogleheads' Guide to Investing (don't let the goofy title of the book fool you, it's a very good guide to investing) and All About Asset Allocation.
Invest Retirement Savings in Roth Accounts
I believe that for most people most of the time, Roth retirement accounts are best. Why? Well, let's first look at the numbers.
As with the above calculations, let's assume you start saving at age 30, retire at 65, and invest $15,000 annually for retirement. We'll also assume you are in the 25% tax bracket and (this is important) will be in the 25% tax bracket during retirement. Under these circumstances, which is best, a $15,000 investment in a Roth 401(k) or a traditional 401(k)?
The Roth 401(k) beats the traditional 401(k). But this test is unfair. Investing in the Roth 401(k) costs us more because we don't get an immediate tax break like we do with a traditional 401(k).
So let's further assume that we invest the tax savings we enjoy with a traditional 401(k) into a taxable investment account. Now which is best?
The traditional 401(k) balance improves, but it still doesn't catch the Roth 401(k) balance. Why? It doesn't catch the Roth 401(k) balance because the after-tax money invested in taxable accounts doesn't grow tax-free like the Roth 401(k) does.
The difference in these two account balances represents the taxes you pay on the earnings from your taxable account. If you could invest the tax savings from the traditional 401(k) into a Roth IRA, the two account balances would be identical.
Now, what if your tax rate goes down during retirement? Here is a chart assuming a 25% tax rate during your working years and a 15% tax rate during retirement:
The balances get closer, but the Roth still edges out the traditional 401(k). Why? Again, it goes back to the fact that the tax savings from the traditional 401(k) are invested in a taxable account, where taxes must be paid on all earnings.
If your tax rate goes up during retirement, the choice in favor of a Roth 401(k) becomes even more clear. If you'd like to play with these numbers and assumptions yourself, here is the Roth 401(k) versus Traditional 401(k) calculator that I use.
Now, let's put aside the numbers for a moment and consider some additional factors that are important to this decision:
- Future tax rates are unknown: We don't know what the tax rates will be a year from now, let alone 30 years from now. Many argue that they have only one way to go--up. Maybe, although the government can increase taxes without increasing the income tax rate. For my retirement investing decisions, I make no assumptions about future tax rates. How then, you may ask, do I make a decision between Roth and traditional retirement accounts?
- You can pick both: I invest in both Roth and traditional retirement accounts. Like so much in life, this is not an all-or-nothing choice. Since I don’t know where tax rates will go, I invest in both. My employer matches 401(k) contributions, and these matches must go into a traditional 401(k). Thus, I’ve started increasing the portion of my contribution that goes to a Roth 401(k). My goal is to direct 100% of my contributions to my designated Roth 401(k), while the matching contributions go to a traditional 401(k).
- Roth accounts bring certainty to retirement planning: One of the things I like about Roth accounts is that you know exactly what you have saved for retirement. With traditional retirement accounts, you have to make a guesstimate about taxes to know how much money you have to fund your retirement.
- Conversion to Roth IRAs: Roth 401(k) retirement accounts can be converted to Roth IRAs without any tax liability. I like this feature because Roth IRAs offer a distinct advantage over deductible IRAs and 401(k)s--no required minimum distribution during retirement. You can hold onto your Roth IRA for as long as want. It is a great way to pass on wealth to your children or grandchildren if that's one of your goals. If you'd like to read more about this feature of retirement accounts, here are two books I own that are very good on the subject of taking your money out of retirement accounts: The Retirement Savings Time Bomb . . . and How to Defuse It: A Five-Step Action Plan for Protecting Your IRAs, 401(k)s, and Other Retirement Plans from Near Annihilation by the Taxman and IRAs, 401(k)s & Other Retirement Plans: Taking Your Money Out.