Planning for retirement can feel confusing and overwhelming. How is it possible to make financial plans for a time that is so far into the future? What will the future even look like, let alone cost?
Saving for the long run is so important, but is notoriously difficult to do. You may feel like you’re on track, saving and investing, but it’s hard to know for sure. Are you saving enough? Investing enough?
You’ve got a 401k and feel like overall, you’re making good decisions. Maybe you are even maxing the amount that you add to your 401k each year. But there’s still a lingering feeling of doubt.
That’s because you know that people are living deep into old age, enjoying longer retirements, and in general, not saving enough for these retirements. You want to be sure that you are not one of these people.
Here, we will walk through the mechanics of 401k investing (such as the 401k retirement age and a hypothetical 401k retirement withdrawal rate) and the proper use of a 401k account.
Then, we’ll dig into details for anyone who has ever wondered, “is 401k enough for retirement?” and “how much money in a 401k is enough to retire?” and give solutions for people who want to do and save more.
How Does a 401k Work?
A 401k is a retirement account that a person can access through their workplace, often offered as a workplace benefit that may provide an employer match. Though historically you could only access one through your job, nowadays a self-employed person can open up what is called a Solo 401k account.
A 401k is a qualified plan that offers several options to contribute money. The most common way that people contribute to their 401k is by making pre-tax contributions.
This means that you do not pay income taxes on the income that you contribute into the 401k, but you will pay them later, when you draw the money out to use in retirement. The idea is that you might be earning more as a working person than you will be spending as a retired person, and therefore in a lower tax bracket as a retired person.
Why is this important? When you are making retirement spending plans, you need to remember that you’ll have to account for income taxes coming out of any amount you plan to spend from tax-deferred plans such as a 401k. For example, if you are planning to take $80,000 from your 401k each year, plan to pay income taxes on this amount.
In addition to the tax savings when you contribute to a 401k, the money invested within a 401k is allowed to grow free from capital gains taxes. Capital gains taxes are levied on the growth of investments that are not in qualified plans, but your growth in a 401k avoids these taxes.
Each year, a person can contribute up to the allowable limits as designated by the IRS. The 401k contribution amount is reviewed each year. Sometimes, it is adjusted upwards for inflation. In 2018, the annual 401k contribution maximum was $18,500, but was increased to $19,000 in 2019 .
The catch with a 401k is that you typically can’t access the money without penalty until you are 59½ years, the 401k retirement age. At age 70½ a person is required to take a 401k retirement withdrawal in an amount calculated by the IRS, and that amount is called the Required Minimum Distribution.
How Much Do I Need to Save in Retirement?
Before we can talk about whether saving in a 401k alone is enough to retire from, one must assess, roughly, how much money is needed to live off of in retirement. As could be expected, this calculation is hard to do because it’s a moving target. Still, there is a general method you can use as a starting place.
To begin, determine your replacement rate . Your replacement rate is how much money you’ll need to live from, each year, in retirement. It’s called a replacement rate because it is the amount of money you will need to replace your working income. For example, you may want to live off $50,000 or $100,000 in retirement; it all depends on your wants and needs (and then add $5,000 per person which is roughly what the average retiree spends on healthcare expenses each year).
If you plan on receiving a pension or social security in retirement, then you should subtract that amount to get your overall replacement rate. To put social security in perspective, the average social security benefits replaces roughly 40% of pre-retirement earnings, but the more money you make the less of an impact social security will have.
Next, multiply the replacement rate by 25. This is how much money you should aim for in retirement. Why 25? Because it is the reverse of taking 4% from the total retirement amount. According to personal finance experts, 4% is the amount that you can withdraw from a retirement portfolio without running out of money over a 30+ year period of time. Your aim is to get to a place where you are living off the portfolio’s investment returns.
Here’s an example using a calculator and a pen. Let’s say you have $2 million saved for retirement. Using the 4% rule, you could take $80,000 from your account each year.
Next, let’s do that calculation in reverse. If you start from knowing that you want to spend $80,000 each year, then multiply that number by 25 to get $2 million.
It should be noted that the 4% rule is a great place to start but far from perfect in determining exactly how much money you need for retirement. For example, the 4% rule was based on historical returns.
This means that 4% withdrawals would not have resulted in running out of money assuming history repeated itself. Therefore, it’s always advantageous to work with a financial planner to determine your unique needs and how your plan would perform under various market circumstances.
Is Saving In A 401k Enough?
Is 401k enough for retirement? As you can see, it’s hard to say whether saving in 401k will be enough for every person in retirement, across the board. Every person is going to need a different amount in retirement, and so the number feels like a moving target.
There are three common reasons why people should consider supplementing their 401k savings with other types of accounts.
First, as discussed above there are contribution limits on 401k plans, so if you need or want to save more than the contribution limit you will need to save somewhere else. This is especially common for high income earners, workers who started saving later in life, or those trying to achieve financial independence at a younger age. Therefore, it might make sense to leverage a Traditional IRA, Roth IRA, or after-tax account to save beyond the 401k limits.
Second, many people contribute to their 401k plan by making pre-tax contributions. As discussed above, this means a tax break now but will lead to paying taxes when you take the money out.
The fact is that no one knows where tax rates will be in ten years let alone 30 years from now when you are retired. Therefore, it might make sense to leverage a individual retirement account so you have a pool of money that you can withdraw from in retirement that you would not pay taxes on.
Third, the idea of achieving financial independence at younger ages is gaining traction among younger employees. As discussed above, qualified plans have restrictions on when you can withdraw money without paying a penalty. Therefore, it might make sense to leverage an after-tax account so you have a pool of money that you can withdraw from, without having to worry about penalties if you access prior to 59.5.
So the simple answer is that saving in a 401k may be enough, but there are some very good reasons to leverage other vehicles.
What More Can I Do?
No one says that you can only save for the long-term in your 401k account. These accounts simply happen to have some tax advantages over saving and investing in a typical brokerage account.
As discussed above, there are some very common reasons to leverage a Traditional IRA, Roth IRA, of after-tax account. To get started, you should think through your goals and figure out which one of those account types make the most sense.
Next, you’ll need to decide how to invest the money. When you are saving for retirement, the typical fees that are charged by most finance companies really add up. That is why investing without fees with SoFi Invest® can be so valuable to younger investors.
You can open a Traditional IRA, Roth IRA, or after-tax account with SoFi Invest to supplement your 401k savings.
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