Retirement

Overview

There are a number of vehicles for saving for retirement that offer tax advantages, both personal and employer sponsored ones. We will go through the details of many of the common ones and the ones we are familiar with (401k/403b, 457, and IRAs).

Saving for Retirement

There is a Chinese Proverb that says, "The best time to plant a tree was 20 years ago. The second best time is now." This is true for saving for retirement.

If you had the ability and knowledge to start saving for retirement awhile ago, you are off to a great start! If not, that is completely ok! The important thing is to start thinking about saving now.

Why is it important to start saving as early as you can?

Because that way you can get your money working for you, rather than you working for your money. It's easiest to think through why this is the case through an example.

Suppose I am 30 years old and I save $1,000 today for retirement. Assuming I invest that $1,000 and receive an average rate of return of 9.1% per year, at age 60 (after 30 years) I would have $13,638.
Suppose instead I wait 10 years until I am 40. To be fair, let's account for inflation (assume 2.5% per year) so that now I have $1,280 (equivalent to $1,000 in today's dollars) to invest in retirement. Again, assuming an average rate of return of 9.1% per year, at age 60 (after 20 years) I would have $7,307.
Finally, suppose instead I wait another 10 years until I am 50. I invest $1,639 and, at age 60 (after 10 years) I would have $3,915.

The takeaway here is not that if you haven't started saving for retirement by the time you are 30, you are screwed. It is, however, that the later you start, the more money you will need to save.

How much to save?

This is a good question. Often when you search for this, you will see percentages like 10-15% of your pre-tax income.

Where does this number come from? Does this "rule of thumb" make sense for you?

The amount of money you will need depends on several quantities, which are usually unknown, but you may have an idea of what they might be:

Age you start saving
Age at retirement
Number of years until death
Performance of money invested (that will fund your retirement)
Amount of supplemental benefits like social security
Expenses (and taxes) in retirement

You can think of these as levers, if you adjust one up or down, you may need to be saving more or could get by with saving less.

Example

The figure below can give you a sense of how each of these factors influence your savings for retirement. Baseline assumes:

an income of $40,000 per year, that keeps pace with a theoretical inflation rate of 2.5% per year.
a savings rate of 12%
started saving at 30 years old
retire at 65
a return rate of 9.1% (70% stock/ 30% bond allocation) per year up to 5 years before retirement and then 6.6% (20% stock/ 80% bond allocation) after.
no supplemental benefit
expenses that are 70% of current income, to stay the same in retirement (accounting for inflation), no taxes

As you might expect, things like starting early with saving, increasing your savings rate, and decreasing expenses in retirement (lifestyle changes and/or supplemental benefits) all help with retirement.

Roth vs traditional

One of the biggest decisions to make about saving for retirement using a tax advantaged account is whether you want to go with a roth or a traditional type account. Note that some employer accounts are only one type and you do not have a choice.

There are nuances (which we will highlight), but the gist is that money going into roth accounts are taxed now and NOT taxed later (when you withdraw) whereas money going into traditional accounts are NOT taxed now and are taxed later.

Simple example: you have $1,000 extra in income that you want to contribute to a retirement plan.

Roth: Your $1,000 is taxed at your marginal tax bracket (suppose you make $44,000 so it is taxed at 22%) which means that you actually only have $780 (since you pay $220 for taxes). So you put $780 into your roth account and supposing a 6% return each year, after 10 years you would have $1,397ish. You can take that out, no taxes. Not bad.
Traditional: Your $1,000 is NOT taxed at your marginal tax bracket which means that you have that full $1,000. So you put $1,000 into your traditional account and supposing a 6% return each year, after 10 years you would have $1,791ish. You can take that out, but you now have to pay taxes. What the taxes are will depend on your income at that point and what the tax structure is. Let’s say that the tax brackets are exactly the same and you are still in a 22% tax bracket. That would leave you with $1,397ish. It is (mathematically) exactly the same as before.

So... which should you choose? Mathematically, it ONLY depends on what taxes you face now and what taxes you will face later. It does NOT matter what the rate of return is.

Do you think your future tax bracket will be lower than it is now? Could it be higher (maybe from lifestyle changes or the government changing the tax structure)? How likely is it that tax rules won’t change so that you suddenly do have to pay taxes when you go to withdraw from a roth? Keep in mind if you go the traditional route that the money you are saving now would have been taxed at your marginal tax bracket and when you go to withdraw money, you will be taxed at your effective rate.

There are some technical details which we will get into in subsequent sections that impact the “roth vs traditional” debate, but a personal consideration is about how you save and spend. Are you someone who, if they get a tax refund, spends it on non-necessities? Or would you save it? The above traditional account scenario is predicated on taking the money you saved from taxes and putting it into the retirement account. If you do not end up putting that “extra” $220 (the money you saved in taxes) into the traditional account and instead spend it, then the traditional is NOT the right choice.

Perhaps you are able to save enough that you could max out your retirement account. Since the example we walked through supposed you could put more into your traditional account, you may be wondering what you should do in that case? For example, suppose you could ONLY contribute $6,000 to your retirement account. So for the roth you could contribute $6,000 (note that you would pay taxes on this, but in this example you are able to contribute that full amount) and for the traditional you could contribute $6,000 (note that you do NOT pay taxes on this). Since you don't pay taxes for contributions to the traditional account, you now have some extra money BUT that extra money will be subject to taxes since you maxed out your traditional account... So it's no longer the same comparison as before. To know which type of account to choose in this situation will depend on several factors, such as your marginal tax rate bracket today and your expected tax bracket at retirement. We'll discuss this further in our section on financial independence!

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