I'm turning forty this year, and finally ready to start saving for retirement. If I contribute the maximum to my 401(k) every year, will I be okay?
First, congratulations. Sometimes making the first move is the hardest of all, so I applaud your decision. Also, you ask an excellent and often overlooked question. It's understandable for us to assume that the government-allowed maximum 401(k) contribution (in 2014 it's $17,500 for those under 50, or $23,000 for those 50 or older) would be sufficient—and sometimes it is. The reality, though, is that there is no magic number that works for everyone. To get a more reliable assessment, you have to take a deeper look.
First think about how much you'll want to spend each year
Just like at any other time of life, there is a huge range in retirement lifestyles. However, when we look at national statistics, we can see that retired households spend about 80% of what working households spend. This makes a lot of sense when you consider that although some costs such as mortgage payments and work-related expenses may go down, others such as travel, entertainment and health care may go up. So as a general guideline, I always recommend planning to spend just about the same amount in retirement that you're spending now.
Next, crunch your numbers
So is saving $17,500 a year enough? Here's a way to do a quick estimate.
Say that you'll want to spend $80,000 a year in retirement and that you expect to receive $30,000 in Social Security benefits. Your portfolio will need to generate the $50,000 difference.
The "4 percent guideline" states that you can safely withdraw 4 percent of your portfolio's value in your first year of retirement, increase that amount every year for inflation, and have a 90 percent level of confidence that your money will last for thirty years.
The corollary of this guideline is that your portfolio should be roughly 25 times larger than your first year's withdrawal. In this example, $50,000 x 25 equals $1.25 million. That's the amount you will need to have saved on the day you retire.
Now it's time to pull out the financial calculator. If you're starting from zero, want to retire in 25 years (when you're 65) with a $1.25 million portfolio, and estimate that you can earn an average return of 6 percent, you'll need to sock away about $21,500 a year. In other words, the government max of $17,500 is a little shy of your goal.
Of course your situation may be very different. You may want to retire earlier (or later), or anticipate earning a higher or lower return. And we haven't factored in variables like your current savings or the impact of inflation.
However, this can give you an idea of a good first step. At some point, though, it would be a good idea to do a more precise calculation, perhaps with the help of a financial advisor. If you do work with an advisor, he or she can talk to you about your expectations and priorities, run different scenarios, and craft a personalized plan.
Be sure to count in an employer match
Many employers will match a portion of your 401(k) contributions, in effect bumping up the amount that you can save every year. For example, if you currently earn $80,000 a year, and your employer matches up to 5% of your salary, that could mean an additional $4,000 per year of savings. Add that to your personal contribution of $17,500, and you're right on target to meet your overall retirement savings goal.
A final thought
Finally, I highly recommend that you put any savings beyond your 401(k) contributions on automatic. That way you won't be tempted to spend this money—and you will have the satisfaction of knowing that you are paving the way for a financially secure retirement.