If everyone got a dollar every time they wondered, “How much do I need to retire?” we’d all be a lot closer to retiring.
Joking aside, there’s no one answer to the perplexing question of how much you really need to retire. It’s really a personal calculation based on numerous factors, including your income, your age, how much you’ve already saved and when you can tap retirement and Social Security benefits.
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That said, it is possible with the help of a few guidelines to get a sense of what size nest egg you’ll need to retire comfortably and, we hope, achieve financial security.
Related: A guide to self-directed IRAs (SDIRA)
How Much Do I Need to Retire, Really?
The amount of money you need to save for retirement depends largely on your goals, health and lifestyle. However, one convenient rule of thumb suggests that an individual will likely spend 80% of their current income each year in retirement. So, if you earn $100,000, you’ll need about $80,000 per year when you retire.
This figure is flexible and can be adjusted based on the amount of Social Security you can claim and how much your retirement lifestyle might cost. You might need more income if you’re planning to retire and start a small business or less if you’re planning to downsize, work part-time or take on a roommate. You may want to take into account your likely health or medical expenses and whether your retirement nest egg is meant to cover two people or one.
It’s worth spending some time, and perhaps having some candid conversations with your spouse and family members, about your retirement plan. The amount you think you need may be different than the amount you actually will need. It’s important to explore the options since there are different ways to slice this pie.
The 4% Rule
How much do you need to retire? To understand the amount of total savings you might need if you’re aiming to replace 80% of your income each year, you can use the 4% rule. This rule of thumb recommends you withdraw no more than 4% of your total retirement savings to cover your annual expenses. The theory behind this rule is that by withdrawing a small percentage of your nest egg each year, you can leave the bulk of your portfolio intact and hopefully grow it steadily over time.
So if you consider your desired annual income of $80,000 and subtract, say, $20,000 in annual Social Security benefits (more on Social Security below), you would need about $60,000 to come from savings or other income.
Then, divide this target income amount by 4% to get the approximate total you’ll need to save. For example, for a target annual income of $60,000, divide $60,000 by 4% (60,000/0.04), you get about $1.2 million.
Target Retirement Savings By Age
Because lifestyle, standard of living and individual costs can vary so widely, there’s no exact recommendation for how much different age groups should have already saved for retirement. However, once again, there are some useful guidelines.
Are You on Track?
The rules of thumb above can help you benchmark whether you’re on track for retirement. However, it’s also important to factor in your personal financial situation as well as your retirement goals to get a handle on your individual needs. Depending on your personal circumstances, you may need to save more or less.
Give yourself an honest assessment of your financial present by doing an inventory of your current expenses, income, taxes and savings. Which expenses do you expect to carry over into retirement? Which won’t?
For example, perhaps you have a mortgage that you’ll pay off before you retire, so you won’t need to factor that into your retirement income needs. Do you have enough income to meet your savings goals? How much have you already saved in your retirement, brokerage and savings accounts? You can subtract the amount you’ve already saved from your total goal.
Understanding the Role of Social Security
Social Security benefits can provide a vital supplement to your retirement income. However, it’s critical to understand that the amount of your benefit will vary depending on your age. The earliest you can start receiving Social Security benefits is age 62; however, your benefits will be reduced by as much as 30% if you take them that early — and they will not increase as you age.
If you wait until your full retirement age (FRA), you can begin receiving full benefits. Your full retirement age is based on the year you were born. For example, if you were born in 1960 or later, your full retirement age is 67. You can find a detailed chart of retirement ages at the Social Security Administration’s website.
But here is the real Social Security bonus: If you can put off claiming your Social Security benefits until age 70, perhaps by working longer or working part-time, the size of your benefits will increase considerably.
Choosing From the Different Types of Retirement Plans
There are a number of tax-advantaged retirement accounts that can help you meet your retirement savings goals:
1. 401(k) Plans
A 401(k) plan is an employer-sponsored retirement plan. Contributions are made with pre-tax dollars, which lowers your taxable income for an immediate tax break. In 2021, individuals can contribute up to $19,500 each year, with an additional $6,500 for those age 50 and up. Funds are typically taken directly from your paycheck to make savings automatic.
Employers will often offer matching contributions, and employees should typically save enough to meet the matching requirements. After all, it’s essentially free money and can boost your retirement savings.
Investments inside 401(k) accounts grow tax-deferred, and withdrawals in retirement are taxed at your normal income tax rate.
Account holders who leave their job or are laid off at age 55 or older can make withdrawals from their 401(k) without paying an early withdrawal penalty. Otherwise, individuals must wait until age 59-and-a-half. Your 401(k) plan is subject to required minimum distributions (RMDs) once you turn 72.
2. Traditional and Roth IRAs
In addition to saving in a 401(k), you can also consider a traditional or Roth IRA. To help decide which one works for you, let’s look at the differences between the two:
- Traditional IRA. With a traditional IRA, contributions are made with pre-tax funds and grow tax-deferred inside the account. Withdrawals for a traditional IRA are taxed at ordinary income tax rates. Withdrawals can be made at age 59-and-a-half without penalty. Early withdrawals, though, are subject to both income tax and a 10% penalty. Traditional IRAs are also subject to RMDs.
- Roth IRA. Roth IRAs, on the other hand, are funded with after-tax contributions, so there is no immediate tax break. However, money inside the account grows tax-free, and withdrawals are also tax-free in retirement. Because you’ve already paid taxes on the principal (the amount of all your contributions), those funds can be withdrawn penalty-free at any time — but if you withdraw earnings as well, you could incur a penalty.
While the idea of tax-free retirement income is pretty appealing, Roth accounts come with several rules and restrictions, most notably income limits. Before opening a Roth, be sure you understand the terms.
Contribution limits for both traditional and Roth IRAs are $6,000, or $7,000 for those age 50 and up.
The Takeaway
Asking yourself, “How much do I need to retire?”, is such a common question, yet it doesn’t have a one-size-fits-all answer. Determining the amount you’ll need to cover your expenses in retirement requires weighing various personal and financial factors, including how much you’ve saved and estimating how much you’re likely to need in the years to come.
Fortunately, there are some basic rules of thumb that can help you reach a potential target amount. While these figures aren’t set in stone, they can provide a reasonable ballpark to help you start planning, saving, and investing.
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8 retirement plan options for the self-employed
You can avoid costly retirement mistakes by picking the right retirement plan for yourself and your business.
As a self-employed freelance writer, I spent hours researching and learning about different self-employed retirement plans. When you’re self-employed or run a small business, these retirement savings plans are not an automatic benefit like an employer-sponsored 401(k) or pension plan that many employees receive as part of their job.
Thankfully, there are a number of self-employed retirement plan options, but each comes with its own benefits and limitations. Ultimately, I settled on a solo 401(k) for my business, but that doesn’t mean it’s the best fit for everyone.
Here’s everything you need to know about self-employed retirement plans and how to choose the right plan for you. We’ll talk through the plans one by one, and then give you some tips on how to open the retirement account of your choosing, so you can start putting aside some of your self-employment income to create a successful retirement scenario for yourself.
Related: 7 brilliant moves to thrive in an uncertain economy
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An individual retirement account — IRA for short — is a type of retirement plan that anyone can use, including self-employed individuals. You can contribute to an IRA in addition to other self-employed retirement plans, and depending on your income and the type of account you choose, you may be able to take advantage of tax savings.
With a traditional IRA, you may be able to deduct your contributions when you file your tax return every year. Any earnings you receive will be taxed on a tax-deferred basis when you withdraw them in retirement. That means you’ll pay taxes on them according to your tax rate at the time of withdrawal.
In contrast, a Roth IRA doesn’t allow you to deduct contributions from your taxable income. You pay taxes on those contributions in the year you make them, and then when you take the money out in retirement, you receive it tax-free.
However, there are some limitations that can reduce the value of an IRA, depending on your situation:
- In 2020, IRA contribution limits are set at a maximum of $6,000 or your taxable compensation for the year, whichever is less. If you’re age 50 or older, that limit goes up to $7,000.
- Contributions made in excess of the annual limit will be taxed at 6% for each year they remain in the IRA.
- Depending on your modified adjusted gross income on your tax return, you may not be able to contribute to a Roth IRA, or you may be subject to a lower contribution limit.
- Your MAGI may also impact your ability to deduct contributions you make to a traditional IRA. IRA deduction limits can vary based on whether you also have an employer-sponsored retirement plan.
- If you take withdrawals from an IRA before you reach age 59 1/2, you may have to pay taxes on the amount plus a 10% penalty for early withdrawals. There are, however, exceptions to this rule.
Because of the nature of IRAs, they can be a great way to supplement savings you’ve put into a self-employed retirement plan. However, because of their low annual contribution limit, they’re not the best option as a primary retirement plan.
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Also called a one-participant 401(k), a solo-k, a uni-k, or a one-participant k, a solo 401(k) is designed specifically for small business owners who have no employees (other than a spouse, if applicable).
In general, a solo 401(k) functions similarly to an employer-sponsored 401(k). You’ll make contributions with pre-tax dollars, and these contributions will grow tax-deferred until you take withdrawals in retirement.
There are, however, a few differences besides the single-participant nature. For starters, as the business owner, you can make contributions as yourself and also as the employer:
- In 2020, you can make employee contributions of up to $19,500 as an individual; if you’re age 50 or older, you can add another $6,000 in catch-up contributions.
- As the business owner, you can make employer contributions of up to 25% of your compensation annually, up to a maximum of $57,000 in 2020.
Those employer contributions can also be counted as a business expense, further reducing your tax liability each year. Depending on which plan provider you go through, solo 401(k)s are relatively inexpensive. For instance, I paid a few hundred dollars to set up mine plus an ongoing monthly fee of $25.
Unlike with an IRA, you may be able to set up a loan option with your solo 401(k), though interest charges will be involved. In addition, doing something like taking a 401(k) loan to pay off debt and borrowing from your own retirement should be considered only as a last resort.
All that said, here are some potential drawbacks of a solo 401(k) to consider:
- As with IRAs, if you take withdrawals from a solo 401(k) account before you reach age 59 1/2, you’ll be assessed taxes plus a 10% penalty. Although there may be options to allow loans or hardship withdrawals, there are fewer exceptions to the 10% early withdrawal penalty than you’d get with an IRA.
- You’re not eligible to open this plan if you employ anyone besides yourself and your spouse, though 1099 workers don’t count.
- You may not be eligible if you’re also covered under an employer-sponsored retirement plan — for example, you work as an employee at a company and also run a side business in your spare time.
Because of how a solo 401(k) is set up, you might consider it if you’re an independent contractor or sole proprietor with no salaried employees — though, you can still qualify even if you employ your spouse.
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A Simplified Employee Pension IRA is a type of IRA that you can establish to benefit you, your employees, or both. The primary difference between a SEP IRA and a traditional or Roth IRA is that only an employer can contribute to a SEP IRA.
The maximum contribution amount for each employee, including yourself, is the lesser of 25% of compensation or $57,000 in 2020. A SEP IRA functions similarly to a traditional IRA for tax purposes, which means your earnings will grow tax-deferred. Also, your contributions as the employer are tax-deductible.
If you want to make separate contributions to a traditional or Roth IRA, you can. In some cases, however, you may be permitted to make your personal IRA contributions to your SEP IRA.
Here are some potential issues you might run into with a SEP IRA:
- A SEP IRA allows only employer contributions, unlike a solo 401(k), which allows you to contribute to your self-employed retirement plan as an individual and an employer.
- If you have employees, you must contribute the same percentage of salary for each person who’s participating in the plan. That includes employees who are no longer employed on the last day of the year.
- If you take a withdrawal before age 59 1/2, you’ll need to pay income tax and a 10% penalty on the distribution. There are, however, some exceptions to the 10% penalty requirement, which are the same as traditional and Roth IRA exceptions.
- You can’t borrow from a SEP IRA as you can a solo 401(k).
A SEP IRA is for business owners who want the simplicity and lost cost of an IRA, but with a much higher contribution maximum. There’s also less paperwork involved than with a solo 401(k).
Andrii Dodonov / istockphoto
A Savings Incentive Match Plan for Employees IRA allows both employers and employees to contribute to a traditional IRA. In 2020, you can contribute $13,500 as an individual or $16,500 if you’re age 50 or older. The same limit applies to any employees. As the employer, you can also choose to make a nonelective contribution of 2% of compensation or a matching contribution of up to 3% of compensation.
Because the SIMPLE IRA is designed as a traditional IRA, your contributions are tax deductible in the year you make them, and your earnings will grow tax-deferred. You can also contribute to a traditional or Roth IRA on your own.
Here are some important things to know about the SIMPLE IRA:
- Although the structure of a SIMPLE IRA is similar to a solo 401(k), in that you can contribute as the employer and individual, its contribution limits are lower.
- You can’t borrow from a SIMPLE IRA as you can a solo 401(k).
- You may need to work with a special custodian to open a SIMPLE IRA account.
- Withdrawals made before age 59 1/2 will be subject to income tax and a 10% penalty, though there are the same exceptions to the penalty as other IRA plans.
Consider a SIMPLE IRA if you want the chance to contribute as the business owner and an individual, but don’t expect to need the higher plan contribution limits of a solo 401(k). This self-employed retirement plan is also better if you have employees and don’t qualify for a solo 401(k).
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A Health Savings Account isn’t technically a retirement plan, but you can use one to set money aside to use in retirement. You can use this account in addition to one of the other self-employed retirement plans and a traditional or Roth IRA. In fact, I contribute to both a solo 401(k) and an HSA every year.
HSAs are available to taxpayers, including business owners, who have a high-deductible health plan. You can set aside money in the account to use for out-of-pocket medical expenses on a tax-free basis. In other words, your HSA contributions are tax-deductible, and you won’t pay any taxes when you make withdrawals for eligible medical expenses. If you take withdrawals for ineligible reasons, the amount will be subject to income taxes plus a 20% penalty.
That said, if you hold onto your HSA funds until you’re 65 or older, withdrawals for non-medical reasons will still be subject to income tax but not the additional 20% penalty. As a result, an HSA can function similarly to a tax-deferred retirement account. Of course, you can also use HSA funds to pay for health care costs in retirement and avoid all tax-related costs.
In 2020, you can contribute up to $3,550 to an HSA if you’re the only one on your health insurance plan, or up to $7,100 if you have a family plan. Depending on your HSA provider, you may be able to invest these funds.
If you’re considering an HSA, here are some things to keep in mind:
- Because it’s not a traditional retirement plan, it’s not a good idea to rely solely on an HSA to save for your future.
- You won’t qualify for an HSA if you don’t have a high-deductible health plan.
- HSA contribution limits are lower than most other self-employed retirement plans.
If you qualify, consider an HSA as a way to supplement your other retirement contributions. Keep in mind, though, that any ongoing medical expenses may make it challenging to use the funds to save for retirement.
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Depending on your personal financial situation, you may also consider other types of small business retirement plans. Here are a few less-common options that self-employed people might consider.
Take some time to consider all of your options to determine which retirement plan is right for you. Also, consider consulting with a tax professional and/or financial advisor to get an idea of which plans would benefit you most when it comes to your tax planning.
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A tax-deferred pension account, a Keogh plan allows you to set up a defined-benefit or defined-contribution plan. Keogh plans are relatively complicated and require more upkeep and costs than other types of self-employed retirement plans.
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With a Keogh plan or a separate defined-benefit plan, you’ll make contributions based on a set amount you aim to receive annually in retirement. There may be contribution limits, though, depending on how you plan to structure the plan.
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With this type of retirement plan, employees get a share in the profits of the business. There are no contributions from the employee with this type of plan, and contributions by the business will depend on quarterly or annual earnings.
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In most cases, you can get any of these self-employed retirement plans from a major brokerage firm. In some cases, some brokers may not offer certain types of plans, so decide which plan you want to go with before you start shopping around.
As you compare brokers and their self-employed retirement plans, review several features, including:
- Cost (setup and ongoing fees)
- Ease of use and access
- Administrative help
- Investment options (mutual funds, ETFs, etc.)
- Resources and advice
There’s no single best investment broker for everyone, so it’s important to take your time and consider how to choose a brokerage that’s best for you and your business.
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Self-employment comes with a lot of perks. But without an employer-sponsored retirement plan, you’re responsible for making sure you have everything in place to save for your future. Saving for retirement sooner rather than later is important because it gives you more options when you’re ready to slow down or stop working entirely.
Think about your financial goals, ability to save and tax situation to help you determine which retirement plan is the best option for you. Also, think about the costs, upkeep, and potential pitfalls associated with each plan. The retirement planning process can take some time, but getting the right account set up could make it easier to avoid costly retirement mistakes in the long run.
Learn more:
- 8 brilliant moves if you make more than $5,000/month
- Recession checklist: 7 things you need to survive an economic downturn
This article originally appeared on FinanceBuzz.com and was syndicated by MediaFeed.org.
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