I have heard accounts of single parents earning less than $25,000 a year, living in an expensive place like New York City that still manage to save money for their future. I have also heard accounts of people earning six-figure incomes that live paycheck to paycheck. Your particular current income has no bearing on your ability to achieve Wealth.
If you have 40 years (or know a 25 year old that wants to be a multi- millionaire) I present some interesting scenarios that make this a reality. The following scenarios are generic examples of how individuals can save and invest for retirement. With that in mind, the average median household income (vice individual) is roughly a little more than $50,000 per year. From that, I tried to base the scenarios on median income. Regardless of your own personal income, the principles still apply. Though you may not be able to afford to make the maximum contribution to a retirement account, savings and investing still need to be part of your long-term goals.
401k Scenario #1
A 25 year-old earning $50,000 per year can achieve a retirement income of over $188,000 a year if we consider the following:
- Starting Age – 25
- Retirement age – 65
- Life Expectancy – 90
- Income – $50,000
- 401k Annual Contribution – 10%
- Employer Match – 50% on 6% of salary
- Expected return on Investment – 8%
- Expected return after retirement – 6%
Using the data above, a person will have over $1.9 million in savings to draw a $147,000 annual income for 25 years. We can determine this “salary” by the fact that money in the retirement account will also continue to earn interest. However, the data and results above do not account for the fact that many people will earn some kind of salary increase. The results above were based on earning a straight $50,000 from age 25 to 65 with no salary increase. Let us add a dose of reality to the calculations.
401k Scenario #2 (Same as #1, but more realistic)
Many stock analysts will tell you that an average 10% return is what you can count on, others will tell you it is more like 6%. As the disclaimer says, you cannot base future earnings on past performance. For our calculations, we will keep 8% as our goal, but add a 4% average salary increase thereby making your 10% 401k contribution grow every year. With that, you will have earned $3 million. If you receive no employer match, your earnings will still be over $2.3 million.
401k Scenario #3: “Maximus Contributus”
Let us keep the same data except that our thrifty 25 year old wants to contribute the maximum level allowed by law (as of 2009), $16,500 a year. As that allowable contribution will rise over the next 25 years, the result will be greater than the result displayed here. We will assume an annual 4% increase in pay, but to account for the shift from higher risk in your 20s to low risk in your mid 50s, we will also assume an average rate of return of 7%. The result is $6.6 million at the age of 65. That translates into a yearly retirement income at age 65 of over $516,000. Adjusting for a 3% inflation over 40 years, this would be the equivalent of $152,000. Once again, this calculation does not account for the upward adjustment of the maximum contribution level, nor the ability to add an additional $5500 (for 2009) to your contributions if you are 50 or older.
Still want to contribute more?
As your 401k provides tax-deferred savings, that means you will pay taxes on the earnings as soon as you begin to withdraw funds after the age of 59½. Think about combining that with tax-free income in your retirement. Using a Roth IRA as an additional means of saving for retirement will achieve this.
The current limit for Roth IRA contributions (as of 2009) is $5000. Like the maximum contribution for a 401k account, these limits will rise. Also like the 401k, those 50 and above will be allowed to contribute more. Currently this is an additional $1000. Contributing $5000 per year to a Roth IRA with an average rate of return of 8% not adjusting for increases in the maximum contributions will provide you with $1.4 million dollars in savings. When you begin to withdraw a yearly income from this fund, you will receive over $108,000 per year tax-free. Adjusting for 3% inflation over 40 years brings the real value of this down to about $32,000 in today’s dollars. Add that to your income from 401k savings and social security (if it is still around), and your retirement should be very comfortable.
Do not forget that you can contribute as much as you want to a brokerage account. There are tax implications once you sell a mutual fund or stock and you need to exercise the same caution in selecting stocks, bonds, and funds for your brokerage account as you would a 401k or IRA.
Hey Older Guys and Gals – It is not too late to get in the game
There are many circumstances in life where we may not be fortunate enough to have started serious retirement investing until late in life. Never fear. Beginning to invest at age 50 may bring some unexpected benefits.
Using a reasonable expectation of average income for a 50-year-old person, we can see how “reasonable” to “low risk” investing will create enough savings for a comfortable retirement. Here is a good representation of an average 50 year old who wants to start contributing the maximum allowable amount:
- Starting Age – 50
- Retirement age – 65
- Income – $60,000
- 401k Maximum Annual Contribution – $22,000
- Employer Match – 50% on 6% of salary
- Expected return on Investment – 6%
In 15 years, a 50 year old will have saved $740,000 by investing conservatively. This does not account for probable upward allowable maximum contributions. Add to that a Roth IRA account, and in 15 years using the same criteria and an annual $6000 contribution, that person will have an additional $148,000 in savings. Between both the Roth IRA and the 401k, this will provide almost $900,000 in retirement savings in 15 years.