Step 5 – Max Out Your Retirement Accounts
Saving for retirement needs to be your top financial priority, even over funding the college education of your children. You can borrow money to pay for college, but you can’t borrow money to retire.
Hide Money From the IRS…Legally
The government gives tax advantages to your retirement accounts in order to encourage you to save for retirement. In other words, they allow you to legally hide money from the IRS, which is why you need to maximally contribute to your retirement accounts.
Your tax advantaged retirement accounts include the Thrift Savings Plan, Individual Retirement Accounts (IRAs), and any other 401(k) or 403(b) accounts you might have access to. The tax benefits of these plans offer a massive benefit that allows your investment to grow larger over time. You don’t want to miss out.
For example, if you make a $5,000 annual contribution for 45 years and assume an 8% annual investment return in a regular, taxable investment account, you’ll have approximately $750,000. This sounds good until you realize that if you make this same investment in a tax-deferred plan, you’ll have approximately $2 million. (Source: The Elements of Investing: Easy Lessons for Every Investor) Which would you rather have?
It is critical to start saving as early as possible because the only way to get rich in the military is to get rich slowly. And to do that you need to take advantage of compound interest.
Albert Einstein said, “Compound interest is the eighth wonder of the world. He who understands it, earns it…he who doesn’t pays it.” Did he really say that? I don’t really know, but it’s on the internet, so it must be true.
Compound interest is earning an investment return not just on your initial investment or principle, but also on your previous return. Here’s an explanation of compound interest from Vanguard’s website:
“When earnings on invested money generate their own earnings. For example, if you invested $5,000 and earned 6% a year, in the first year you’d earn $300 ($5,000 x 0.06), in the second year you’d earn $318 ($5,300 x 0.06), in the third year you’d earn $337.08 ($5,618 x 0.06), and so on. Over longer periods of time, compounding becomes very powerful. In this example, you’d earn over $1,600 in the 30th year.”
Because of this, time spent in the market is much more important than trying to time the market by buying and selling at the right times. The long-term return of the stock market is approximately 9.5% per year. Adjusting for 3% inflation, $1 invested grows to: (Source: The Little Book of Common Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns)
- $1.88 in 10 years
- $3.52 in 20 years
- $6.61 in 30 years
- $12.42 in 40 years
- $23.31 in 50 years
While your income level and investment returns play important parts in how much you accumulate for retirement, the most important factor is how much and how early you save. Over time, the effect of compound interest repeats itself and works miracles, giving you much more money than you’d think you’d have.
Make Sure You Get the Match
Another benefit of maximally contributing to your retirement accounts is that you can get free money. Yes…FREE MONEY!
If your employer matches your retirement contributions, like the DoD will do in the new Blended Retirement System, you need to contribute enough money to get the match, even before paying off high-interest debt. Under the new Blended Retirement System, if you contribute 5% of your pay the government will match it and give you an additional 5%. This is an immediate 100% guaranteed investment return, and you won’t find that anywhere else.
Recommended Savings Rate
A common recommendation from financial planners is to save 10-15% of your pre-tax/gross income for retirement, but part of the reason I’ve been so successful saving for retirement is because I read a book about being an automatic millionaire. In that book, it stated that in order to be rich you needed to save 20-30% of your pre-tax/gross income. As soon as I read that, I said, “Hey, I want to be rich. I better save 30%.”
I started at 20% in my twenties, gradually increased whenever I could (like after my annual military pay raises), and have been at 30% for over 10 years now. Saving 20-30% if you can will ensure you save enough and have options for an earlier retirement or the freedom to cut back on your workload at some point and work part-time.
Total up your household’s gross (pre-tax) income for the year. Include all sources of income, literally all the money you make from anywhere, including any tax-free allowances that you might not consider income. Multiply that number by 20% or 30% or whatever percentage you settle on. That is how much you need to save annually for retirement. If you can’t get to 20-30%, get as high as you can. Anything is better than nothing.
As an example, let’s pretend your household makes $50,000 annually before taxes. Multiply that by 20% and you’ll see that you need to save $10,000/year for retirement.
Every time you get a raise, bonus, or income tax refund, use it to increase the amount/percentage you are investing for retirement. Don’t use it to buy more stuff.
Use This Money to Fill as Much of Your Tax-Advantaged Retirement Accounts as You Can
You likely have a few different retirement accounts available, so here is the order in which you should invest in them. Start with the first action and move down the list:
- Contribute to any employer-provided retirement account (like the TSP) up to the maximum that your employer will match (like the first 5% in the new Blended Retirement System). As discussed before, this is free money you can’t afford to leave on the table.
- Maximally fund any tax-advantaged retirement accounts you have, like the TSP or any other 401(k) or 403(b) accounts you have.
- Fund an Individual Retirement Account (IRA) for both you and your spouse/partner, if applicable.
- Put any remaining retirement funds into a taxable mutual fund or brokerage account.
You may have other options such as funding a Health Savings Account as a “stealth IRA” or starting a SEP-IRA or individual 401(k) if you or your spouse/partner are self-employed. Some believe in using life insurance as an investment for retirement, but I don’t recommend this. In general, after you’ve maxed out the contributions to all of your tax-advantaged accounts, you’ll have to put the rest in a regular, taxable investment account.
For some of the options above (including the TSP) you’ll have to decide whether to pursue a Roth option (pay taxes now) or use the traditional tax-deferred approach (pay taxes later). That decision will depend on your individual financial situation and current and anticipated future tax brackets. There are many on-line calculators to help you decide this (here is one), and here is a good website that compares the two options.
If you find it difficult to save, set up an automatic investment plan so that the money is automatically removed from your pay and you never get a chance to spend it, like the payroll deductions DFAS does for your TSP contributions.
Leave It Alone and Keep Investing
Once money is put aside for retirement, never touch it until you retire. Remember, you can borrow money for a house or to pay for college, but you can’t borrow money for retirement.
Remember that the stock market will go down, and when it does you need to resist the temptation to sell investments or stop investing. KEEP INVESTING!!! The best time to buy something is when it is cheap and on sale. The same is true for the stock market. When the market recovers, which it will, you will reap the rewards. Focus on the long-term and just keep investing.
How Much Do You Need to Retire?
How much money will you need to save to retire? Most retirement planners state that you’ll need approximately 70% of your pre-retirement income to maintain your current standard of living once you retire. This number, though, is heavily dependent on what you consider to be a good retirement and what type of a lifestyle you intend to lead. For example, since I save 30% of my gross income for retirement, I’m already living on only 70%, so I highly doubt I’ll need that much when I retire. If you are frugal and pay off your mortgage, you may find that you need as low as 25% of your pre-retirement income to retire comfortably. You won’t be staying in the Ritz Carlton, but there’s nothing wrong with the Hampton Inn or Navy Lodge.
There is a lot of uncertainty in life, but the 4% rule is a nice rule of thumb to use when coming up with a dollar figure of how much money you’ll need to accumulate before you can retire. The 4% rule says that you can take 4% from your retirement savings annually, adjust for inflation each year, and never run out of money. The devil is in the details, but use the 4% rule and assume that you can get approximately $4,000 per year of retirement income from every $100,000 you have saved. So, if you need $20,000/year in retirement income in addition to your military pension and Social Security, you’ll need to save $500,000 for retirement.
What’s the Bottom Line?
The 5th step to financial security is to maximally invest in your tax-advantaged retirement accounts while saving 20-30% of your pre-tax income. No, it is not easy, but it is how you get rich slowly over time.
What do you invest in? Well, that’s the 6th step to financial security.