Retirement Savings 101: All about retirement accounts (and why to start saving now!)

Are you new to retirement savings and want a simple guide to the whys and hows? Today's post covers two topics: why it's a smart move to start saving for retirement now; and the basics about how different types of retirement accounts work.

(The follow-up post will be about how to apply this knowledge: the pros and cons of using different types of retirement accounts; suggestions about the investments that go into your retirement accounts, including Socially Responsible Investing/SRI options; and some guidelines for thinking about how much to save.)

Why start saving for retirement now?

Well, aside from the fact that it's generally wise to start saving early for a big goal rather than have to play catch-up later, there are two big reasons that it's especially smart to save for retirement today:

• Compounding returns: It's basic math, but the results of investing early are more dramatic than you'd guess. Compounding returns are the benefit you get from re-investing the returns you get each year. For example, if you invest $1000 and earn 9% a year on it, you'll have $1090 after one year, $1188 after two years ($1090 x 109%), $1295 after three years, etc. Not impressed yet? Think about exponential growth-- it takes 8 years for your money to double at an 9% yearly return. So if you have $20,000 invested at age 25 growing at 8%, it will double five times by the time you turn 65, and become $640,000. If you don't have the $20,000 invested until you're 33 so it only has time to double four times by age 65, you only have half as much-- $320,000. Make sense now? This is such a big deal that (with those 9% annual returns) you actually end up much better off saving $4,000 a year for ten years from age 25 to 35 and stopping than saving $4,000 a year for thirty years from age 35 to 65-- by a margin of $806,303 to $545,230.
• Employer contributions: If you have any kind of retirement option at work that involves employer contributions, like many 401(k)s or 403(b)s do, it's probably a very good deal. I'll talk more about the details in a minute, but the important thing to remember is that your employer is offering you extra money in exchange for you saving some of your own money.

How does retirement savings work? What kinds of retirement accounts are there?

[First, a point of clarification: terms like IRA, 401(k), and 403(b) refer to different types of retirement accounts. You still have to pick investments (like stocks, bonds, mutual funds, CDs, etc) to go inside of the accounts, but we'll talk about that in the next post.]

The main difference between regular savings and retirement savings is that retirement savings accounts are tax-advantaged. With regular savings or investing, you put your after-tax money into a savings/investment account and then pay taxes on the earnings (in most cases.) But with retirement savings, you save on some of the taxes. There are two basic types of tax savings, and that's one way to divide retirement accounts into two categories:

• In a traditional IRA or 401(k) [more on IRA vs 401(k) in a minute], you use before-tax money. In other words, if you put $1000 into the account, your taxable income is lowered by $1000, which means you pay less in taxes (for example, $250 less if you're in the 25% tax bracket, which would mean that you add $1000 in the account but only have $750 less in your pocket than you otherwise would.) It's like getting a discount on saving $X amount for retirement. However, once you retire, you do have to pay taxes on what you withdraw.
• In a Roth IRA or Roth 401(k), you use after tax money-- putting $1000 into retirement savings means you have $1000 less in your pocket than you otherwise would. But then you never have to pay taxes on the earnings. If that $1000 turns into $32000, you can take all that money out after you retire without paying taxes on any of it.

There's another important way to divide types of retirement savings accounts into two categories: work-related and non-work-related.

• Work-related: 401(k)/Roth 401(k), 403(b), etc. These are taken out of your paycheck at work, and are set as a percentage of your income. [You may also/instead have a pension-- a "defined benefit" retirement plan-- at work, especially if you have a unionized job and/or work in the public sector, but that's a topic for another post. We're talking about "defined contribution" retirement plans here.]
• 401(k) vs 403(b)? They're basically the same except that the 403(b) is for employees of non-profits. There's also the Thrift Savings Plan for federal employees which is very similar.
  
• 401(k) vs Roth 401(k)? Just plain "401(k)" or "403(b)" means it's a traditional account that uses pre-tax money (see above); Roth 401(k)s and 403(b)s are new as of 2006, and use after-tax money. (In other words, if you get $1000 a paycheck and put 6% into a regular 401(k) you get taxed on $940 a paycheck; if you put 6% into a Roth 401(k) you get taxed on $1000 a paycheck.) As described above, the benefit for the Roth 401(k) is that you won't be taxed on the earnings later.
• Employer match or no match? Many but not all employers offer a match to your 401(k)/403(b) savings. If so, they will probably match some percent of your contributions-- perhaps 25% or 100%-- up to a certain limit-- perhaps 4% or 6% of your paycheck. (For example, if they match 50% of your contributions up to 6% of your paycheck, and your paycheck is $1000, then if you put aside 2%/$20 they'll add $10, if you put aside 6%/$60 they'll add $30, and if you put aside 10%/$100 they'll still put in no more than $30.)
  
• Vesting rules? You should keep an eye out for vesting rules which might say that you have to stay at your employer for a certain length of time in order to keep the employer's contributions when you leave. (You always get to keep your own contributions!) Sometimes there is partial vesting-- you may get to keep 20% of the employer match after 1 year, 40% after 2 years, etc.
  
• Rollovers? When you leave your employer, there are a couple choices of what to do with your money. You can leave it in its original 401(k) plan, if your employer allows it (they have to let you to keep it there if you have more than $5,000 in it, but if you have less, they can make you move it.) If you have to or want to move it, there are a few options: take the money in cash (generally a bad idea, since not only does it decrease your retirement savings but you also have to pay a 10% penalty on top of the taxes), roll the money over to a 401(k) account at your new employer, or roll the money over to an IRA. What's an IRA? Read on...
  

• Non-work-related: IRA/Roth IRA. IRAs and Roth IRAs are non-work-related; IRA stands for "Individual Retirement Arrangement."
  
• How and where? There are several places you can open an IRA, including banks, mutual fund companies, and brokerages. Your choice will limit what investment goes in the account, so it generally makes more sense to first pick the investment you want and then open an IRA with whoever offers that investment. This means you may end up with multiple IRAs to hold different investments, which is perfectly allowable, although there are some drawbacks like the hassle and possibly higher administrative fees. (More on how to decide on investments coming soon in the follow-up post!)
• Contribution limits? You can put in up to $5000 a year combined across all your IRA/Roth IRA accounts in 2008 ($6000 if you're over 50 years old); this will go up in future years to adjust for inflation. However, if you earned less than $5000, you can only put in as much as you earned (there's an exception if you're married where you can contribute based on your spouse's earnings.)
  
• Income requirements (as of 2008)?
  
• Traditional IRAs (if you have a work-based retirement option available): If you're single, it starts to phase out at $53,000 AGI and you're totally ineligible to contribute tax-free once you hit $63,000. If you're married filing jointly, it phases out between $85,000 and $105,000.
• Traditional IRAs (if you don't have a work-based retirement option available): No income limit, unless you're married filing jointly and your spouse has a work-based retirement option while you don't, in which case it starts phasing out at $159,000 and you're totally ineligible at $169,000.
  
• Roth IRAs: Starts to phase out at $101,000 AGI for single tax filers/$159,000 for married filing jointly; you're totally ineligible at $116,000 for single filers/$169,000 for married filing jointly.
  

Now what?

In part two: so how do you apply this knowledge? We'll talk about the pros and cons of using these different types of accounts, ideas about how to pick investments within your account (including some of my favorite socially responsible options), and some thoughts about how much to save.

Any questions about what we've covered so far? Any additional information-- or clearer ways to explain things!-- that you want to include in the comments?

Disclaimer: I am not a financial professional. While I consider myself well-informed and try my hardest to be accurate, it's possible that something in here could be wrong. Please try to verify things yourself before making important financial decisions!

Looking at I Bonds for protection against inflation

For the last few years, with my savings in high-yield savings or money market accounts, I haven't worried too much about interest rates and inflation. "All I want is to keep my savings safe and beat inflation," I kept telling myself, "so I'm doing fine." But with my bank account's APY dropping (from 5.00% to 4.15% to 3.30% in the last six months) and inflation climbing, I am starting to feel rather nervous.

Part of why this money is important to me is because it will give me the freedom to make the best choices for a happy and fulfilling life in the short term (not just decades from now at retirement age.) When I leave my current job (probably in the next couple years), I want my options to be wide open: I want to be able to take some time to travel-- to be able to take whichever job I think I'll like best, regardless of salary-- to consider working part-time and/or trying to work as a writer. The cushion of savings I've built up (about $50,000 at this point) is vital to giving me those opportunities, but I'm starting to worry about inflation, which could shrink the amount of time I'd be able to live on my savings if the interest I earn doesn't keep up. This would probably only happen to a relatively small degree, so it's likely that I'm feeling more anxious than I ought to be, but of course there's always a chance that there'd be more dramatic inflation.

So I've been looking at I Savings Bonds. They're sold by the federal government, and this is how they work:

• Interest rates:
• When you buy an I Bond, one portion of the interest rate is fixed for as long as you hold that bond. Right now the fixed rate is 1.20% (anyone buying I Bonds between November 1, 2007 and April 30, 2008 gets that fixed rate), but they announce a new fixed rate every six months for new buyers.
  
• The other portion of I Bond interest changes every six months for everyone, based on the Consumer Price Index. So it's basically designed to neutralize the effects of inflation for you.
  
• When you put the two portions together, theoretically you get a guaranteed, fixed return over inflation. (The only problem would be if the published CPI-U doesn't reflect the actual inflation you experience.)
• The current rate is 4.28%, but that will change in May.
  
• More about I Bond rates from TreasuryDirect.gov
  
• Term:
• You have to hold I Bonds at least 12 months.
• If you sell your I Bonds before you've had them for 5 years, you forfeit 3 months' worth of interest as a penalty.
• You can hold the bonds for up to 30 years.
  
• Taxes:
• The interest you earn is exempt from state and local taxes.
  
• You don't have to pay taxes on your interest until the year you redeem the bonds.
• If you cash out the bonds to spend them on qualified education expenses, you don't have to pay taxes on the interest at all.
  
• More on I Bonds and taxes from TreasuryDirect.gov
  
• Miscellaneous:
• If you buy your bonds before the last day of a month, you get the full month's worth of interest. (It also counts as a "month" for the 12-month holding requirement.)
  
• You can only buy $10,000 in I Bonds a year ($5,000 max online and $5,000 max in person), although this was lowered only a few months ago and apparently some people are still having luck buying up to $30,000 online.

With those factors combined, I think buying some I Bonds is a good financial choice for me right now. (I'll probably wait another couple weeks and see if people are guessing the fixed rate will go up or down on May 1, before I decide whether to buy in late April or late May.) They'll give me the peace of mind of knowing that, barring some serious governmental collapse, the money I put into I Bonds today should be worth as much or more to me when I access it in the future.

The biggest drawback for me isn't financial, it's having to withdraw a big chunk of my money from my community development bank, knowing that less of my money will be invested in doing good for communities and the environment. Because of that, I wouldn't pick I Bonds if we were talking about a small, fixed difference in interest rates-- but major inflation could create a big difference, and so it's worth it to me to protect some of my money against that.

What do you think about my plan? Do you own I Bonds, or are you planning to buy some? What do you think about them? Do you try to protect against inflation in other ways? Do you have any predictions or expectations about inflation?

Look out for abusive overdraft charges at your bank!

How does your bank deal with overdraft charges?  Partly out of fear of this very thing, I keep way too much in my checking account, so I haven't had to deal with the issue.  But if I was smarter, I'd have a lower balance, and that might include the risk of an occasional overdraft.  And if I was less lucky and less fortunate, I might have no choice about cutting things close in my checking account.

 

So I was really disturbed to read this recent report from the Center for Responsible Lending  ( via Michelle Singletary's WaPo column).  Based on a study of 18 months of data including more than 3 million banking transactions, they estimate that Americans are paying $17.5 billion a year in abusive fees on overdraft loans-- for balances totaling only $15.8 billion and loan terms that average less than five days!

 

Basically, many banks and credit unions automatically enroll customers in what CRL calls "abusive overdraft loans" and the banks typically refer to as "bounce protection " or "courtesy overdraft coverage."  The programs are exempt from the Truth-in-Lending Act, and they're usually hidden in the fine print.  When customers overdraw their accounts, the bank automatically loans them the money to cover the charge-- but on the average loan of $27, the fees total an additional $34.  And since the bank recoups the total from the next deposit into the account, the term is very short, typically 5 days or less.  In contrast, even the priciest alternative-- covering the charges with a credit card or line of credit at 20% or 25% APR-- is markedly cheaper.  ($27 at a 25% APR is less than $7 a year, less than 50 cents a month.  According to CRL, the transfer fees for drawing on a line of credit are usually $5-$10.)

 

This is a growing problem, not only because the fees are more common (only 2.5% of banks and credit unions charged them in 1999 , but now most customers are enrolled in such a program), but because many banks have stopped declining debit-card charges when there are insufficient funds in the account.  Banks claim they're doing it as a service because customers would rather pay the fees than face the "embarrassment, inconvenience, merchant fees and other adverse consequences of having a check bounce or a transaction denied,"  but CRL did a survey that found that 53% of customers would prefer their card be declined and only 22% wanted the bank to cover it (the other 25% had no preference or didn't know).  Many banks also allow customers to overdraw their account at the ATM without any notification they're over the limit, even though 79% of users would cancel the transaction if warned rather than pay the fee.

 

The report also highlights some other unethical practices designed to increase the number of overdraft fees, like processing debits faster than deposits, and processing debits in whatever order maximizes the number of fees (ie, instead of processing small charges first and then the final big charge that leads to the overdraft, they can process the big charge first so that all of the small charges lead to additional fees).

 

So what can you do?  Read the fine print!  What will your bank do if you overdraw your account?  What are the fees?  Can you link your checking account to your savings account (preferred), or to a line of credit or credit card if necessary, to cover the balance rather than taking these bank "loans" with their higher fees?  Can you opt out of the overdraft protection and ask your bank to decline debit card and ATM transactions if you don't have the balance to cover them?  And what is your bank's policy on the order of processing debits?  If the answers are not what you'd like, perhaps you should consider other banks.  Of course it's important to monitor your balance closely and keep yourself safely in the black, but it's also wise to be informed and prepared for the worst, and this is more important the more often you find yourself skirting the edge.

 

CRL is also pushing for public policy solutions to address some of these issues.  They're backing a bill called HR 946 that would require banks to disclose their overdraft programs and get express written consent, warn customers when their ATM withdrawals will overdraw their accounts, and prohibit banks from manipulating the order of debits and the timing of deposits in order to increase fees. 

 

What do you think?  Do you know what your bank will do if you overdraw your account?  Do you think the laws need to be changed? (I do!)

Making your money fit your priorities: budgeting advice for new (and not-so-new!) grads

A friend of mine just graduated from college, and asked some advice about budgeting.  I thought about it for a minute, and told him that there are no hard and fast rules... budgeting is about understanding your priorities and finding ways to make them work.  After reflection, I still think that soul-searching about your values is the most important part of budgeting-- money is and should be just a tool to help us shape our lives the way we want-- but it is also important that it be informed priority-setting, with a full understanding of what your constraints are and what options you have available. 

 

This guide is addressed to those new to the workforce, but I think most of the principles are good ones for anyone...

 

Understand your constraints:

• Figure out your take-home pay. Remember that your gross pay and your net pay will look very different-- run your information through a calculator like this one to see what you'll actually be taking home.  You can do this even if you don't have a job yet-- in fact, it's a great way to understand what different salaries will mean for you. 
• Figure out your fixed expenses.  Think as thoroughly as you can about your basic, unavoidable spending.  What is the cheapest rent you could reasonably get?  How much will basic utilities cost?  How much will you spend on groceries?  Will you have health insurance payments?  Car payments and/or auto insurance?  Student loan and/or credit card minimum payments?  Is there clothing you really have to buy for work?  Are there other expenses you consider truly non-negotiable, like trips home to visit family?  Even if they're not monthly recurring expenses, you'll have to pay for them somehow, so divide the cost up and plan to save a portion each month. Now, how much do those basic costs add up to and how does that compare to your take-home pay?

Understand your options and their consequences:

• Read up about the smart moves you have available and make sure you know why they're smart.  No one will force you to take advantage of all of them, but it is wise to at least know what you're deciding on.  Make sure you really understand the benefits of compounding interest, the advantages of starting young .  Read up on the benefits of opening a Roth IRA at your age, especially if you're in a low tax bracket.  Learn about the 401(k) or 403(b) from your employer if you're offered one, and if there's a 100%, 50%, or even 20% match, keep in mind that it's the kind of return on investment you won't find anywhere else.  Find out if you're eligible for the  Saver's Tax Credit, and think hard about the benefits of saving for retirement and getting 10-50% back in your pocket.  If you have credit card debt,  take a serious look at how much you're throwing away in interest which you could keep if you accelerated your payments, and understand that paying only the minimum will keep you in debt for decades.  You don't have to make every smart move in the book, but you should at least make informed choices.
• Have a plan for emergencies.  If your plan is asking for help from your parents (or other relatives), that's okay, if you're sure they are willing and able to back you up, and you're comfortable with asking them to.  If they're not or you're not, you need to save up an emergency fund.  Convential wisdom suggests you shoot for three to six months worth of expenses... figure out a monthly savings amount that works for you, but remember that until your emergency fund is bulked up you risk falling back on Plan B-- and if Plan B is credit-card spending, think long and hard what that means in terms of the interest payments you'd be handing over to the credit card company.

Understand your priorities:

• Do some soul-searching about what matters to you.  What optional spending is most important to you?  Do you want an apartment in a better location, with more space, and/or without roommates?  Do you want to pay for cable and/or Netflix?  Do you want to spend on books or music?  Better food?  Clothes, shoes, accessories? Do you want to eat out, go to bars, movies, concerts, go on vacations?  Which can you find smart, creative ways to do more cheaply, and which are so important that you won't cut corners?  Do you want to make donations to charity and/or causes?  If you don't have a job yet, this is the time to think about how different job possibilities with different salaries (and benefits!) fit into your priority list-- what spending/saving are you willing to give up for a great job?  Then take a look at your available funds, and your list of priorities, and make a plan for what you can spend on each.  That's really all a budget is. 
• Think about what sacrifices today are worth it for benefits tomorrow, and vice versa.   You can put money into retirement savings today and get way more bang for your buck than if you try to catch up later.  You can save up an emergency fund and help cushion the stress of an emergency later.  You can pay the minimums on your credit card or add credit card debt in order to have a better cashflow today but give yourself a huge interest burden for years to come-- or you can pay down (or avoid) debt now and have the freedom of no payments later.  It's silly to be completely focused on the future to the exclusion of the present-- none of us know what tomorrow will bring-- but you need to find where the balance lies for you.  (I struggled with this in Save for tomorrow or live for today?)
• Be honest with yourself about your weaknesses.  If you find that your priorities don't match what you're spending in certain areas, you'll need to make a plan to cut back in order to achieve your goals.  Don't make a budget that rests on expecting dramatic changes, but do set goals and commit to making progress, and when you slip, remind yourself that you're doing this because you decided you wanted something else more.  And if you realize you don't actually want the other thing more, change your budget!  I love this quote from Gandhi:

"As long as you derive inner help and comfort from anything, you should keep it. If you were to give it up in a mood of self-sacrifice or out of a stern sense of duty, you would continue to want it back, and that unsatisfied want would make trouble for you. Only give up a thing when you want some other condition so much that the thing no longer has any attraction for you, or when it seems to interfere with that which is more greatly desired."

 

When's it time to "grow up" and upgrade your stuff? (& does it have to break the bank?)

"Keep living like a college student after you graduate" is one of the best bits of frugal advice for twenty-somethings, and one I've taken very much to heart. But recently I've begun to wonder: how long is that supposed to last? Once you reach a certain age, how do you figure out what's frugal and smart-- and what's putting off "growing up," to your own detriment?

Very soon it'll be three years since I finished college, but you would never know it from visiting my apartment. The furniture is nothing much to look at: not high-quality, rather mismatched, all used and well-worn (in some cases visibly so). The decor isn't elegant, and leans more towards posters than art. The apartment itself is small-- a decision I'm happy with and don't plan to change, but one that certainly doesn't help the other factors.

Most of my friends are a) laid-back and b) younger than I am, so I've never been embarrassed to invite them into my place. But lately, after hearing the "This looks just like a college student apartment!" remark one too many times, I'm rethinking a little.

See, I don't mind the status quo for my own sake. I know some people really enjoy living in a well-put together, elegant home, but that's not a top priority of mine. But as I get older, as I make new friends, as I become interested in maybe hosting acquaintances, colleagues, etc. at my apartment, I don't really want my place to shout out "Penny's just a sloppy, mismatched kid! Please don't respect her as a mature adult!"

So I am really interested in hearing from those of you who are around my age, and those who are older and wiser, about how you handled this stage. How important do you think it is to upgrade the way your apartment looks? Is there a certain age at which people start really wrinkling up their noses at an adult sporting a college-student style? Or is this just another situation where being a good frugalite means not buying into the pressure to be defined by your material possessions? Did you ever find yourself feeling the way I do, and how did you approach it?

I'm sure plenty of you will say "You can be smart about having a sophisticated-looking apartment on a budget!" Well, your suggestions are greatly appreciated! Do you have tips for putting together an elegant style on the cheap? Are there certain approaches that have the most bang for the buck? And damn, most furniture is expensive, and hunting down bargains is not conducive to having pieces that match! Is there any way around that?

Sorry, no answers today, just questions!

[Update: Check out this followup post with highlights of the wonderful comments and suggestions I got!]

How NOT TO repair your credit (and the ethics of blog ads)

This month, I rejected a LinkWorth ad for the first time. Actually, I rejected two, and for the same reason: they were for "credit repair" services. These services are at worst a scam to get access to your personal information, and at best a waste of time and money for vulnerable people. Anything they can do, people can do on their own to improve their credit. But if I run their links, that'll help them show up higher on the internet searches of people struggling with bad credit, instead of the resources people need to understand how to improve their credit. So instead of sending people in the wrong direction, I'll put in my piece to help connect people to the right information.

I'm not an expert on credit reports, credit scores, and/or credit repair, but here are some quick points:

• Everyone has the right to dispute the accuracy of any entry on their credit report-- and if the creditor can't prove it's accurate, it has to be removed. You only have to send it to one credit bureau, and if it's unable to be verified, it'll come off all three. Credit repair services offer to write the letters, or charge you for templates, but really the letter doesn't have to be anything special and you can find examples all over the internet just by Googling "sample dispute letters," etc.
• If a collection agency is trying to collect on your debts, you have the right to ask them for "validation"-- proof that the debt is yours. This time you'll want to look for "sample validation letters."
• If you have unpaid accounts, you should feel free to try to negotiate them with the creditor/collection agency. You can offer to pay less than the full amount, and/or you can haggle over how they report it on your credit report (at the very least, they should call it "paid in full" even if you agreed to pay less than the total due... but you can also try to get them to take it off your report entirely after you pay). Make sure you get things in writing!

You can really learn a ton about credit repair online; just be careful you're reading reputable sources. Message boards are also great-- lots of people's advice and stratgies and perspective, including many who really know their stuff and will make sure that misinformation doesn't stand. One I've used in the past is CreditBoards.com. And if you really feel like you're in over your head, look for a trustworthy non-profit credit counseling service, whose job is to help you out, not rip you off.

What do you think? Either on the topic of credit repair specifically, and/or on whether you turn down some ads and why (or don't run any at all)? And do you have any good resources or tips to share on the topic of credit repair?

Retirement Planning in Your 20s (& Beyond), Part 4: Riding Compound Interest to the Finish Line

So you've estimated the big number you need for retirement and it's freaking you out. Well, if you're in your 20s, you're in luck. We can take advantage of the wonders of compounding interest, so our goals aren't as insurmountable as they seem. (Well, obviously, everyone gets to take advantage of compound interest, but the younger you are, the more it pays off.)

Just think about it. In Part 3, I mentioned the Rule of 72-- take 72, divide it by your interest rate/predicted returns/etc, and you get the number of years it takes your money to double. So, if we assume 8% returns, your money will double every 9 years (72 / 8 = 9). If you have $1,000 today, you'll have $2,000 in 9 years, $4,000 in 18 years, $8,000 in 27 years, $16,000 in 36 years, and $32,000 in 45 years. See the benefits of starting early? Your savings can be half as much as the person 9 years older than you or one-quarter as much as the person 18 years older than you, and if returns are consistent you'll have the same amount at the same retirement age. This is why it pays off so much more to save when you're young than when you're older-- think about that when you're making your savings decisions in your 20s!

I'm basing my calculations on a retirement age of 68, in the year 2050, which is 44 years away. For curiosity's sake, how much would I need in savings today to end up with the $1.6 million I've projected I need? Well, my money ought to double nearly 5 times, so by my math, I'd need a little more than $50,000.

$50,000. Doesn't that sound a lot more manageable than $1.6 million?

Of course, I don't have $50,000 now, and I won't have it anytime soon. I have about $14,000. So how about another easy number-- 36 years out from retirement, enough time for my savings to double four times with 8% returns. For me, that's 2014, eight years from now, at age 32. If I end up with $100,000 by then, and my other assumptions hold up, I could theoretically leave my money to compound, never save another dollar for retirement, and still reach my goals. I'd have $100,000 in 2014, $200,000 in 2023, $400,000 in 2032, $800,000 in 2041, and $1,600,000 in 2050. (Isn't that exciting to watch?!)

(Important disclaimer: don't forget about taxes! The $100K I need by age 32 is the after-tax equivalent. The amount in Roth IRAs is fair game, but anything tax deferred is going to shrink when it's withdrawn. So if you have a certain amount in a tax-deferred account like a 401(k) or a traditional IRA, you'll need to account for taxes. For example, I'll reduce my tax-deferred savings by, say, 33%. The state of taxes decades in the future is yet another of those hard-to-predict things, but I think 33% is a pretty fair estimate. So, for example, I should think of the $4,500 in my 401(k) as equivalent to $3,000; if you add the $9,500 in my Roth IRA, that makes $12,500. The $14,000 number that I use in my net worth calculations-- the sum of the account balances-- isn't the right one to use for this discussion.)

I think I am going to try hard to reach that $100,000 goal by age 32. It's ambitious, like all good goals are, but also realistically acheivable. Then everything I save for retirement after that time would be pure gravy (well, also insurance against all of the ways my assumptions could be wrong, but that's a given). I like that thought a lot.

You can come up with a similar goal. Just fiddle around with the Rule of 72 until you come up with a goal you think works for you. You could assume 8% returns like me, but set a goal of 1/8 of your retirement "number" to be reached 27 years ahead of retirement (instead of my 1/16, to be reached 36 years ahead of time). You could assume 9% returns, and set your short-term goal at 1/16 of your retirement goal, 32 years before your retirement date (doubling four times, once every 8 years). You could assume 7% returns (so your money doubles every 10.29 years) and look to reach 1/8 of your retirement goal 31 years before retirement. See how flexible it is?

So, there we are. I've estimated my annual retirement expenses in Part 1, thought through Social Security in Part 2, calculated my needed savings in Part 3, and now I've come up with a plan to reach that total with time to spare. I have a goal-- to save $100,000 for retirement by 2014-- and the confidence that if I do so I have a reasonable chance of reaching my retirement goals without significant additional savings after that point. I'm sure I will continue to save past 2014, but this goal also opens things up for me to imagine more flexible ways of working and living in my 30s, 40s, and 50s which focus on the present without worrying so much about the future. I've enjoyed this process, and I hope you have too.

How about you? Do you have a short-term goal for your retirement savings? Do your calculations assume you'll contribute a set dollar amount (or percent of income) up until the day you retire, or do you hope to reach what you need early so the rest is just gravy? Or do you just plan to retire as soon as you've hit the number that'll carry you through?

Retirement Planning in Your 20s (& Beyond), Part 3: Figuring Out the Nest Egg Needed

So once you estimate what retirement income you'll need, how do you figure out the nest egg that'll produce it? A tricky question for anyone, especially for those of us who are decades and decades away. But I'll give it a try anyway; be warned that this post contains a lot of details, numbers, and statistics!

For starters, who knows how much inflation will occur over the next decades? None of us, obviously. Inflation has varied widely over different periods in history. Some years it's been over 10%; some years it's been negative (deflation). Over the last 80 years as a whole, inflation has averaged about 3.1%, but in recent years it's been higher. Most retirement planning advice I've seen suggests assuming inflation rates anywhere between 2% and 6%, with 3% or 4% (or something in-between) being most common. So given how arbitrary this number is going to be anyway, I'm going to go with 3.5% as my inflation rate.

Great, what does that mean? Well, it means I can figure out what dollar amount I'll need when I start retirement (for me, I'm going to say it's 2050, when I'm 68). I've yet to find a good simple calculator to do this process (tell me if you know one!), but I do know a handy shortcut called the Rule of 72. Basically, if you divide the number 72 by your interest (or inflation) rate, the result is how many years it takes to double at that rate. For example, if you have $100 at 6% interest, in 12 years (72/6) you'll have $200.

So the question is, how many years does it take inflation to double the amount of money you need? I divide 72 by 3.5 to get a little less than 21 years (you can do the same if you want a different inflation assumption). So by 2047 inflation will have caused my income needs to quadruple (double twice), from $16,500 to $66,000. Three more years at 3.5% would bring it up to $73,000. So I need $73,000 in 2050 dollars to retire on. (Another tool you can use is this table-- scroll down.)

And how do you get $73,000 a year (or whatever your amount is)? Well, it depends on whether you want to leave your nest egg intact and live only on the interest (the safest approach, and one that preserves your savings for your heirs), or are planning to use up the savings over time. For me, it's certainly not a priority to leave money behind for my kids-- especially if accumulating the wealth to do so affects my ability to make the family happy when I'm alive-- and as we've established, I'm trying to be realistic but not overcautious here.

So, most advice I've seen suggests that withdrawing somewhere between 4% and 5% of your portfolio in the first year of retirement, and adjusting for inflation thereafter, will likely keep your nest egg alive for 30 years. 3% is the ultra-conservative choice; some people do 6% or 7% or more, but that seems too risky. So I'll pick a 4.5% withdrawal rate. (The table in this article says that's 95% safe over a 30-year retirement.) If I withdraw 4.5% in 2050 to get my $73,000, that would make my number $73,000 / .045, or (drumroll please...) $1,622,222.

Wow. I need almost two million dollars. Granted, that's in 2050 dollars, which is the equivalent of less than $500,000 today, but that's still a sizable hunk of change.

The good news? I'm 24, and I have decades to take advantage of compounding interest, so it's easier than it looks, and if you're near my age you're probably in the same boat. What do I need to do to get my $1,622,222? How can you reach your retirement goal? Check in next time and see!

Retirement Planning in Your 20s (And Beyond), Part 2: Consider Social Security

Welcome back as I continue to try figuring out what I'll need for my (long-distant) retirement. Part One was on estimating retirement expenses. Today's topic: should I consider Social Security in my planning, and if so, how?

I'm guessing most people are making plans assuming you'll get nothing from Social Security. That's certainly the safest route. But on the other hand, I'm in my 20s. As I try to come up with this estimate of needs, I'd like to try to be as realistic as possible. If I turn out to be unnecessarily optimistic, I've got decades to course-correct. (And besides, I'm not planning to change anything about my savings at the moment-- so this estimate is just informational.)

Of course, at first I thought that "$0 (or very little) from Social Security" was the most realistic estimate. But reading up on it, it looks like Social Security isn't predicted to go broke until I'm 60 or 70-- and broke only means that the trust fund will be depleted and inflows would have to cover outflows, which means benefits would fall to about 75% of their promised levels. 75% isn't great, but it's way, way more than 0%. (And that's if no action's taken to improve the system so benefits don't need to be cut.)

The Social Security calculator projects my benefits would be the equivalent of $17,000 a year in today's dollars (after adjusting the earnings projections to make them more conservative). 3/4 of that is $12,750. Heck, even if benefits get cut in half, it'd be $8,500. That's certainly not enough alone for me to live on-- but it's not peanuts.

As I discussed in Part 1, I'm estimating my annual retirement living expenses at $25,000 (in 2006 dollars). So a reasonable estimate (although obviously not fool-proof) is that Social Security would cover between 1/3 and 1/2 of those expenses. Not too shabby.

I'll use the 50%-of-promised-benefits estimate to be on the safe side, which suggests I'll need $16,500 a year (in today's dollars) from my investments. Check in next time as I try to estimate how to produce that.

In the meantime: how do you handle Social Security in your planning, and why? I'm personally trying to come up with a reasonable, realistic estimate here, not the most ultra-safe one. But I guess you can't go wrong assuming you'll get nothing and being pleasantly surprised when/if you do (unless it leads you to make sacrifices in the present which on balance you'd rather not make). So, folks, do you count out Social Security entirely? If so, is it because you believe you'll get nothing from it, or do you figure you might/probably will get benefits but it's just safer to focus on your own retirement savings?

Retirement Planning in Your 20s (& Beyond), Part 1: Estimating Annual Retirement Expenses

It seems like most advice for young people planning for retirement consists of "save as much as you can now, and figure out how much you'll actually need later." Your 20s is a great time to save and take advantage of the wonders of compounding interest-- and there are so many variables involved in predicting future retirement needs-- so this is quite good advice, if it satisfies you.

The problem is, it doesn't satisfy me! I really like having goals, targets, an idea of where I'm going and how well I'm doing. So as challenging as it seems, and even though it's probably an unnecessary step at my age, I still want to come up with "my number," even if it's one that gets revised many times in future years.

That's what this brief series of posts will be about: me stumbling towards an estimate of how much I need to accumulate for my retirement, and hopefully finding it a little simpler than those crazy calculators that always ask questions I don't know the answer to. Feel free to play along at home, but please note that I am not an expert, and in fact would absolutely love any suggestions or information from you to help me along in this process. (Also, these steps should work just as well for people in their 30s and beyond; it's just that it seems like you've all done this already!)

For starters, I want to try to estimate how much income I'll need in retirement. (All numbers will be in 2006 dollars for now, and we'll adjust for inflation later.) I see so many people talking about wanting six-figure retirement incomes: $100,000, $200,000, sometimes even more. When you run the numbers, the amount you need to save to produce those amounts seems astronomical and overwhelming. (Although doable for some people, I'm sure.)

But those don't feel right to me. One common suggestion to calculate your retirement expenses is 80% of current expenses. 80% of my current expenses (not counting student loan payments) would come out to about $12,000 a year. Which sounds really, really low. Maybe my current style of living is way off from what I'd want in retirement; even though I bet I'll continue to be frugal, there are probably some inconveniences I'll no longer be willing or able to put up with to save a buck or two.

Then I found this data from a study of older Americans. It finds that the average expenses of a married person over 65 was $14,762 in 2001. Maybe I'm not so far off! And even for couples in the top 20% of income, average expenses (per person) was $25,567, spending about 1/4 of that on entertainment and gifts. (There's all sort of interesting data in the report to help you think about what you might end up spending; all the tables in the appendix are a great place to start.)

Based on these numbers, I think I'm going to go ahead and use $25,000 as my yearly expenses/income-needed number (in 2006 dollars; I promise I'll adjust for inflation later!). If it's (almost) enough for the average person in the top 20% of income, it ought to be more than enough to cover a frugal-minded little old lady like me. And it's more like 160% of my current expenses, rather than 80%. I feel like my expenses might actually end up lower in reality, but I might as well play it on the safe side in these estimates.

For those of you who've done this step, would you be willing to share what you came up with as your annual retirement income, in dollars or as a percent of current income? Or maybe just talk about the process you used to come up with it? I don't think I've ever seen anyone talk about a number in the ballpark of my $25K; is yours anywhere near it, or do you think I'm crazy? And for those of you reading who've never tried this-- play along at home! What do you come up with?

Save for tomorrow or live for today?

Obviously the answer lies somewhere in the middle-- but where? We take pride in making responsible choices for the future instead of thinking only of today, but do you ever feel like you're going too far? Not appreciating the present enough?

I hear that suggestion a lot regarding how much money frugalites and penny-pinchers spend: that we're not enjoying life enough because we're not willing to spend much money. The thing is, I don't think that spending more money would make me noticeably more happy! I mean, certainly there are some things that I could spend more on and enjoy-- probably more expensive vacations, maybe going out to eat more and/or at fancier places-- but in general I'm very comfortable with the way things are. I find ways to enjoy myself that are free, cheap, or just good values for the money... and if there's something that comes up that's expensive but would be really wonderful, I weigh it carefully but am pretty good about letting myself go for it if it's worth it.

However, it's the flip side that concerns me. The amount you save is a combination of how much you make and how much you spend, so it follows that to save the most for tomorrow you need to make as much money as you can today. A lot of personal finance bloggers like to stress the importance of increasing your income as much as possible.

For me personally, while I'm not earning as much as I could if income was my only priority, at $47,000/year I'm above average for my age group and well above average for liberal arts majors. And I'm still doing a job I like and one I feel is good for society. The thing is, I've never really envisioned myself following a standard "career path." My top priority is helping to make positive change in society, and I've fully intended to experiment with a variety of non-profit organizations and jobs and evaluate which feels most right to me. While I like it well enough, I know that my current job isn't "the one." Yet most of the other options will likely pay substantially less, in some cases perhaps as little as half as much. So the question is, how long should I stay at a good-paying job that I'm fairly but not completely happy with? I definitely want to try other work, but don't I have plenty of time for that later on?

There are many arguments for doing higher-paying work first-- getting money into savings and taking advantage of compounding interest, paying off debt-- and putting off more satisfying but lower-paying work for later, maybe even until retirement or an early retirement. (For just one example, it's the classic recommendation for socially-minded lawyers: put in a few years at a big firm, rake in the dough, pay off your loans and save up, and then later you can give it up and go do your public interest law.) But the approach worries me in a lot of ways. What if I get too used to the benefits of making my current income? How do I decide when I'm financially "ready" to switch to a lower-paying job? And what if when that "ready" comes, it coincides with the time in my life when I'm looking to buy a home, get married, have children, etc, and suddenly the financial hit seems a lot less doable?

So maybe it's better to try different and more challenging options now, when I'm young and more flexible and I know I can pull it off. Besides, who knows what unforeseen things could happen in my life that might constrain my future decisions? I'm sure I'll regret it if I don't try working at other kinds of organizations; I would hate to look back and realize that I missed out on great opportunities only because I was too concerned about the size of my retirement account. There's a lot to be said for seizing the moment.

I have a personal goal to let concerns about money affect my choices as little as humanly possible. The hard part is finding the best way to do this. Working to save as much money as I can is one way to help free me from money concerns later in life, but it means putting money squarely in the center of my decision-making process today. If I try not to worry about money and income in the present, that will make things harder in the future. It's so hard to figure out where the right balance is.

Do you struggle with tradeoffs between earning money and being happy and fulfilled? While I doubt many people have precisely the same concerns as me, I feel like this dilemma is probably applicable using a lot of different measures of happiness and satisfaction: pleasant vs. unpleasant work environments, a more personally satisfying career vs. a higher-paying career, a job that has shorter hours and/or is more flexible vs. a job that eats into your personal life but pays well, even working vs. staying home with kids. How do you make these kinds of decisions in your life?

Gandhi on Budgeting

"As long as you derive inner help and comfort from anything, you should keep it. If you were to give it up in a mood of self-sacrifice or out of a stern sense of duty, you would continue to want it back, and that unsatisfied want would make trouble for you. Only give up a thing when you want some other condition so much that the thing no longer has any attraction for you, or when it seems to interfere with that which is more greatly desired."-- Mahatma Gandhi

I read this quote the other day, and it blew me away. In just a few simple but powerful sentences, Gandhi lays out a clear path to budgeting and consuming in a way that is fulfilling and satisfying.

• Don't force yourself to give up things just because you should, because it'll hurt more than it'll help. This is so true. When you deny yourself something and tell yourself it's because it's bad or wasteful of you to spend money on it, you feel deprived and unhappy, with the persistent feeling in the back of your mind that if you could only go ahead and buy whatever-it-is, you'd feel better. It's the perfect recipe for splurging on things you'll regret. It's just not a sustainable pattern. If you want to cut back, the real way to do it is to...
  
• Identify your priorities and goals, and use them to make decisions about what's worth spending on. Whether you want to retire early, get out of debt, buy a house, stay home with kids, take a more fulfilling but lower-paying job, travel the world, give more money away... whatever it is you really want, you can consciously match it up against the items in your budget, and figure out which is more important to you. That's how real changes occur-- when you get to the point where "the thing no longer has any attraction to you" because "you want some other condition so much." (Or if getting rid of "any attraction" is a little too much to ask, you just have to become conscious of how spending on X would "interfere with that which is more greatly desired.") But no matter how much you want to reach your goals for the future, you shouldn't give up everything in the present. You just need to find a balance and...
  
• Figure out what things genuinely bring you "inner help and comfort." I think the key to this is that you have to really think through what's truly important to you, because it's so easy to go on auto-pilot. There are a lot of things that we buy and do because they bring us a pleasure that's fleeting and superficial on a certain level, and we assume that they're making us happy-- but a closer examination reveals otherwise. (And when I say "we," that definitely includes me.) But if we do the soul-searching, we can keep the things that are most important to our happiness and fulfillment today while doing a better job of reaching our goals for the future.
  

That Gandhi fellow sure was wise, wasn't he?

Work, Retirement, and Financial Independence

At Make Love Not Debt, He recently wondered why so many personal finance bloggers are looking to "retire early." I just finished a really thought-provoking book called "Your Money or Your Life," which is prompting me to rethink this concept.

I have always had a very negative association with the whole concept of retiring early and living off your investments. It conjures up images of a privileged "leisure class," living in decadence off the sweat of working people, using their free time to golf or shop or stay at fancy hotels around the world. And I imagine that they have enough money to do so because they put money above all else, not caring about who or what they hurt on their way to the top. That doesn't fit my values at all!

But "Your Money or Your Life" has totally turned this on its head for me. I just finished reading it this week and am still processing it, and I'm not sure I agree with everything it suggests, but it talks a lot about achieving financial independence (actually, FI, which includes financial intelligence, financial integrity, and financial independence). The case it makes is that once you are FI, you will be able to spend your time and live your life purely according to your values. And a big part of their message is living simply and frugally (both in the present so you can save money, and in the future so you can afford to be FI)-- I can't argue with that!

YMOYL is full of examples of FI people doing incredible things to make the world a better place. Many of them have values similar to mine, and honestly, it sounds incredibly appealing. Yes, I have a great job which I enjoy and which promotes my values, and I'm in no hurry to leave it. But there are so many other meaningful things I would love to do in my life that would inevitably pay me little or nothing at all. It would fit my values perfectly to have the freedom to do those things anyway without having to worry about where the next meal's coming from. In my fondest dreams of the ideal society, everyone can do work which they love and find fulfilling without having to worry about getting paid for it; FI is a path towards that for the individual which leaves the rest of society intact, for better or for worse.

I'm still trying to figure out what effect YMOYL will have on my decisions (and I bet I'll be writing more about it as a result!). But if nothing else, it's helped get rid of my automatic negative reaction to anyone who's trying for early retirement/financial independence. I don't know their motives or their values, and it's unfair of me to assume that they're bad ones. Who knows what wonderful things they might do once they are freed from paid work?