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November 6, 2020

The guide to retirement

Retirement can mean many things to many people. Freedom. Travel. Family. Peace. Even boredom. Whether you daydream about it in the middle of a particularly unexciting meeting, or wake up in a cold sweat about the day when the golden handcuffs finally come off, retirement can be a deeply personal topic. You may have visions of traveling to exotic locations, trying new hobbies (or making time for old ones), or finally just…doing…nothing. No matter how unique and special your plans for after retirement might look (and we encourage you to really think out of the box for this one), the actual planning of how to get there will look similar to your peers. Whether you’re right out of college or bookmarking summer homes, it can be helpful to have a guide or checklist to follow along with when it comes to planning for retirement.

Retirement in the modern sense started almost 150 years ago. The American Express Company established the first corporate pension in the U.S. in 1875. Workers who made it received up to a maximum of $500 per year in retirement. And yet, every new generation has added something new and refined the concept of retirement.

The person who is well prepared has already won half of the battle

 Portuguese Proverb

So now that we know that retirement (at any age or income) is an inevitability, let’s start planning for it:

The Plan:

  1. Do a current status check
  2. Figure out when you can/want to retire
  3. Estimate your retirement expenses
  4. Calculate how much $$ you’ll need to retire
  5. Figure out how much to save and break it down
  6. Understand basic account types and savings vehicles
  7. Master how to manage your retirement investments
  8. Prepare to the best of your abilities, but know that life happens
  1. Do a current status check

You can’t begin planning if you don’t know where you stand with your current financials. This can be an emotionally exhausting process for some people, especially if they’ve been avoiding looking at their credit card statements or savings account balances for a while.

In 2019, Bankrate.com analyzed that the typical American household has an average of $8,863 in an account at a bank or credit union. The average balance on a credit card? $6,200. It’s understandable that the average American does not want to spend anxious hours poring over the state of his or her financials, but it is absolutely necessary. If you’re unsure where to begin, start by:

  1. Creating an emergency fund
  2. Paying off high interest debt
  3. Lowering expenses in a few key areas
  4. Calculating your net worth

2. Set a retirement date (or month, or year)

It doesn’t have to be super exact, but having a general approximation of when you want to retire can give you your timeline for retirement planning. Your plan at 5 years, 10 years, 20 years, or 30 years will look very different. An estimation will help you figure out how much you need to start saving now.

To give you some context, the official retirement age for Social Security benefits is 67. While you can start claiming partial Social Security benefits as early as age 63, by doing so you sacrifice part of your benefits. If you’re not ready to retire at 67, your benefits will actually increase if you delay Social Security to age 70.

3. Estimate your retirement expenses

With FIRE (Financial Independence, Retire Early) terminology seeping into ‘regular’ retirement planning, you might have heard of the different ‘levels’ of retirement. There’s fat FIRE, lean FIRE, barista FIRE, and probably more by the time you read this article. What this essentially refers to is that your retirement expenses can vary depending on your needs and wants.

There’s a good chance your current expenses are higher than what your expenses will be in retirement. This is due to both lifestyle changes and the fact that most governments provide a specified amount of money to eligible seniors on a monthly or annual basis. For example, if 30% of your current salary goes toward your mortgage, your place of residence might be paid off by the time you’re ready to retire. After you pay off your mortgage, your only expenses concerning housing would be maintenance and taxes.

Start with a calculator that can help you estimate realistic retirement expenses, like this one and this one. While there are probably a lot of things you haven’t decided yet, there are a few expenses you can expect like housing, food, transportation, and taxes. Other factors that will impact your cost of living in retirement:

  1. Taxes
  2. Where you live
  3. If you own a home
  4. Health insurance costs
  5. Benefits and government supplementary income

Even if you’re planning to move or travel for a large part of your retirement, having a baseline figure can be helpful to begin planning. Multiply that annual expenses number by the difference between your planned age of retirement and the average lifespan in your country to get an estimate of the total amount of money you’ll likely need in retirement.

=(Average lifespan for your gender in your region – your target retirement age) * annual expenses in retirement

4. Calculate how much $$ you’ll need to retire

Now that you have a ‘goal’ figure for retirement in mind, it’s time to do some quick math. If you estimate that you’ll need around $1 million to retire and you have 25 years to go, the annual savings number you should be aiming for isn’t necessarily $40,000 (whew!). Compounding returns is the term used to describe the cumulative effect of growth on your investments. Here’s a calculator that can help you figure out what your true savings goal should be.

Still confused about how compounding returns work? Let’s go with an example: suppose you started with an initial investment of $1,000 and assume that your investment will grow 10% every year. This is what your returns would look like every year:

Year 1: $1,000 x 10% = $1,100

Year 2: $1,100 x 10% = $1,210

Year 3: $1,210 x 10% = $1,331

Year 4: $1,331 x 10% = $1,464.10

Year 5: $1,464 x 10% = $1,610.51

5. Break down your savings goal

The retirement goal you come up with may seem overwhelming at first glance. No one, not even you, should expect yourself to be able to achieve retirement savings in a short period of time. Take your savings goal and divide it into monthly or biweekly chunks. Then automate as much of this amount as you can.

Even with the best intentions, you may quickly realize that after fixed expenses and the occasional splurge, not much is left over every month to transfer to your retirement account. Read our article on budgeting systems to find a method that works for you, but generally you should aim to max out your contribution percentage to a retirement account through your employer if available and pay yourself first every time you receive a cash inflow.There’s a popular Chinese proverb that says: “The best time to plant a tree was 20 years ago. The second-best time is now.” Basically, in the context of retirement, this means that if you want a secure future, the best time to act is now. Here’s JP Morgan’s estimate on how much to save by age:

Remember that this is just a guide. Your goals and needs may be different than the average, so adjust accordingly.

6. Understand basic account types and savings vehicles

You now have some decisions to ponder over on how to save and invest the money for your retirement. It’s not enough to let the money collect in a savings account, especially with very low interest rates in the near future (link to interest rates article). Instead, you can use different types of investment vehicles (types of accounts) and asset classes to cater your retirement savings to your life.

  1. High Yield Savings Accounts(HYSA): Savings accounts can be great for emergency funds and short-term goals like saving up for a house, but are not suited to retirement saving. The yield offered by even the most generous HYSAs is simply not enough to keep up with long term inflation.
  1. IRAs: IRAs simply stand for Individual Retirement Accounts (let’s demystify financial terms while we’re on the topic). There are multiple types of IRAs, but as a beginner you should familiarize yourself with two: traditional IRAs and Roth IRAs.

Traditional IRAs are tax-deferred retirement savings accounts. This means that you only pay taxes on the money you’ve saved in this account (plus all the capital gains, interest and dividends) only when you take money out of the account in retirement. Deferring taxes means all the sources of income we just mentioned – your dividends, interest payments and capital gains – can compound each year without being hindered by taxes for many years. 

Roth IRAs are very similar to traditional IRAs with one key difference: the timing of taxes. You fund a Roth with after-tax dollars, meaning you’ve already paid taxes on the money you put into it. So you don’t get a tax advantage when you deposit the money, but instead you get a tax advantage when you withdraw in retirement. That’s right, you don’t pay any taxes when you withdraw money from this account in retirement. Same as the traditional IRA, this account lets your money grow and multiply within the account for many years.

  1. 401(k) plans: A 401(k) plan is a retirement plan offered to you through your employer. 401(k)s are the most common kind of defined contribution retirement plan.

Here’s how it works: You decide how much you want to contribute (there’s usually a limit set by your employer), and your employer puts the money into your individual account on your behalf. That’s it – you don’t have to do any transfers yourself, the investment happens through payroll deduction. The amount comes straight out of your paycheck and goes into your account automatically. Your paycheck will be smaller as a result – though not as small as you might think, thanks to the tax benefits involved. You do have to remember, however, to log in to your account and pick an investment strategy. Read more about 401(k)s here (link to our 401k article)

  1. HSAs: According to healthcare.gov, an HSA is a type of savings account that lets you set aside money on a pre-tax basis to pay for qualified medical expenses. By using untaxed dollars in a Health Savings Account (HSA) to pay for deductibles, copayments, coinsurance, and some other expenses, you may be able to lower your overall health care costs. You have to have a specific kind of a health plan, an HDHP, in order to qualify, but if this is an option for you read more here.
  1. Taxable investment accounts: You could use a regular investment account and designate it your ‘retirement’ account to bypass all the other complicated account types. But, a) they’re not that complicated and b) you could be losing out on some major money by going this route. Depending on where you live, how much you earn, and how long you’ve held these assets, you could be taxed 0-20% on capital gains. That’s a big variable, and of course can change on almost an annual basis.

Life insurance: Signing up for life insurance is one of those things you have to figure out as an adult, along with assembling IKEAikea furniture and making doctor’s appointments. Some life insurance plans let you build a cash reserve within your plan at a tax-advantage, but you should only do this if you’ve already maxed out your other accounts. A financial planner will be able to guide you to the right kind of life insurance for you, but make sure to ask the financial planner if they are a fiduciary. A fiduciary is obligated to act in your best interest at all times. A financial ‘advisor’ who is not a fiduciary could be selling products that aren’t that great for you but provide a commission for them, and they are not obligated to tell you about their commissions. Beware and do your research.

Quick note: Take advantage of employer matching

Because employers will often match a portion, or in some cases, 100% of what an employee deposits into theirher employer-sponsored 401(k), this is basically free money for you. And because you can have your employer withhold funds to deposit directly into your retirement account, not only will you not be tempted to spend money you were never paid, the money deposited will be pre-tax, meaning that a larger amount of money will get invested right away, versus investing yourself and having to wait six months to a full year to get that money back through a tax refund.

7. Understand how to manage your retirement investments

Ideally, you should adopt a ‘set it and forget it’ approach to most retirement investments. When you invest for retirement and other long-term goals, the basic assumption that you’re making is that your money will grow over many, many years in the market.

The stock market returned 10.02% a year on average between 1926 and 2015, versus just 5.58% for bonds, according to research firm Morningstar. Given stocks’ superior returns over the long haul, most financial advisers recommend that investors whose retirement is more than 20 years away hold at least 3/4 of their portfolios in stocks and stock funds.Of course, having a 75-90% stock portfolio won’t be right for you as you age. Our risk tolerance, defined by our willingness and ability to take risk, changes over our lifetime. Target date funds are a good option for those who are not quite sure how to rebalance their portfolio over time. Generally, as you get closer to your retirement date, you’ll tend to dial back your risky assets like stocks and increase the allocation of your portfolio to bonds and cash. If you’re looking into trusts and estate planning to begin generational wealth building, it’s best to involve a financial professional at that point.

8. Learn how to roll with the punches

Life is what happens to you while you’re busy making other plans

John Lennon

The savings goal you set for yourself when you were 20 will not apply to your life even when you’re 25. As you grow and evolve, so should your savings and investment goals. There will be periods of time when you simply won’t be able to save as much as you anticipated. If you choose to go for higher education or start a business, your short term savings might go down to $0 or even lower. But that does not mean you’ve failed to meet your goals or are further behind than your peers. In the same vein, life events like marriage, kids, buying a house, health complications, etc. all have a financial impact. Your financial goals should be compatible with your life, not the other way around.

Other than for reasons of health or layoffs, when and how you choose to retire is a very personal decision. What this guide aims to do is to provide you with the knowledge you need to make the best choices for yourself and your family. After all, you wouldn’t want to be forced into an early retirement nor keep working beyond an age you see fit to retire. By saving early and often, you give yourself the luxury of options.

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