“A dream doesn’t become reality through magic; it takes sweat, determination, and hard work.” – Colin Powell
Broken rule of thumb: You should save at least 10% of your take-home income for retirement.
This rule sounds like the most reasonable and broadly applicable rule when you take it at face value. 10% sounds like a lot and should be meaningful to anyone. I think it’s one of the worst rules because it sounds like a plan that can be followed. If followed, it falls short almost every time.
We save for retirement for a couple of reasons. First, the obvious, we don’t want to work forever. Second, retirement plans have distinct tax advantages that can make a dramatic impact on our finances. The math works extremely well for the standard Dave Ramsay customer who makes 50-100k, wants to be debt free, taxes aren’t their worst enemy and likes to keep things simple.
One big crack in the foundation, this rule assumes take-home income which would drop your savings by anywhere from 15-50%. Let’s ignore this glaring fault and rewrite the rule as if it called for 10% of your total income. Guess what? It still breaks.
Using gross of $100k income. The math can’t be simpler:
- $10,000 in savings per year into retirement savings.
- $10,000 grows by 8% year one, add another $10,000 that grows by 8% year 2 and so on.
- In 40 years you add $400,000, compound interest turns it into $2,500,000.
- Use the 4% rule of thumb and whammo, you have $100,000 retirement income.
Houston, we have a problem. Actually, we have two problems. Inflation and taxes. First, let’s tackle inflation. Inflation long term should be around 3%. So every year $1 buys $0.03 less. In 40 years, it stacks up. $100,000 at that time will only have the buying power of $30,000 today.
How about taxes? That 100,000 today is in the 22% tax bracket. Let’s pretend you don’t live in California and only pay 5% State taxes. Cut the income by 27%, Now $100k only gives you about $22,000 in today spending dollars.
Our two saving graces: Income replacement ratio and social security. The first takes into consideration how much of your current income is needed in retirement to have the same standard of living. Calculating social security, let’s pretend you and your spouse each make $50k for your 100k income. That means together according to SSA.gov you will have an additional $41,688 in today’s dollars. Add that to your $22k, annual income is now $63,688.
Let’s break down income replacement ratio: If you save 10%, pay 7.5% payroll taxes, 10% of your income pays your mortgage (you pay off by retirement) and taxes goes down let’s say by 7.5%. Together, you can live the same with 65% of your current income. $63,688 kind of works. As long as you never have an emergency along the way…
What you need to know about this rule. The less you make today, the better it works. The more you make… Well, the opposite happens. Here’s why. Say you make $250k per year and your spouse doesn’t work. Let’s break it down:
- Save $25k/year, grows to roughly $6.5 million. Provides $250k income in 40 years, $80k today.
- Social security provides $36k today’s dollars for you, $18k spousal benefit. $54k more income.
- Income replacement at 65% so you need $162k in today’s dollars. Unfortunately, saving 10% only gets you to $134k. That’s a 20% shortfall! Ouch.
The more you make, the less this rule works. High income or not, it gets even worse for two big reasons:
Did you start saving at 25 years old? Do you know many 25-year olds who do? How about 30-year olds? Most of us don’t face the need to save and benefits of compounding investments until we’re in our 30’s. Unless the plan is to work until you’re 75 or 80… 10% of savings is a terrible rule of thumb.
The second makes the first problem a bigger issue. According to Gallup, the average American retires at 62 years old. This is because they physically can’t work anymore. Many take social security because they didn’t save adequately for retirement and upon being forced out of the workforce end up taking a 35% haircut on their social security benefits for life costing them hundreds of thousands in social security benefits.
We don’t want this to be your problem too. How much should you save? You’ll need to work with a financial planner to understand you personally. We typically find most of our clients need to save somewhere between 12% and 35% depending on if they have a 40-year runway or want to achieve a work optional lifestyle in 20 years.
If you want to learn how we can guide you through our savings process, call Ryan Forster at 913.681.9155 or email ryan@engageadvisors.com.
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