Often when I hang out with friends in their 20's, they don't think about retirement because they are either putting money into their 401K plan through work or a Roth IRA.
This got me thinking about how much a person needs to retire, and if they only put money into their Roth IRA, how would that work out for them?
What is a Roth IRA?
A Roth IRA is a US retirement plan that is generally not taxed, as long as certain conditions are met. The main difference between a Roth and a regular IRA is that a Roth doesn't grant a tax break for placing money into the account but rather the tax break is granted on the money withdrawn from the plan during retirement.
How much to save?
A good rule of thumb is that if you're taking the traditional path and planning to retire in your 60's, you should save around 15% of your income for retirement. The earlier you start doing this, the easier it's going to be for you in the future.
So let's take a hypothetical 25 year old, who makes $40,000 a year, and as such, is able to save the maximum of $5,500 into a Roth IRA every year, as it only represents a little under 14% of her annual income. She'll continue putting in $5,500 every year into her Roth, until she is 50, when she will start contributing $6,500, which is the maximum contribution for people over the age of 50. Now, let's assume a 7% annual return.
When she retires at 65, she'll have around $1.3 million in her Roth IRA, which is completely tax-free when she withdraws it from her account to live on. That's an amazing sum to have amassed just through a Roth IRA!
And to highlight the importance of starting early, if she had started at 30 instead of 25, she'd have just over $900,000 in her Roth IRA, nearly $400,000 less because she waited just 5 years!
So she retired at 65 with $1.3 million. Now what?
For most people, $1,300,000 is a lot of money - I mean, just look at all those zeroes! But, when you start thinking about that representing all of your financial wealth, and needing to make it last for 25+ years of retirement, it can get a little scary. After all, people are already living longer than they used to, who knows what the average life expectancy could be in another 30 or 40 years!
I've known people in their 20's that get a six-figure windfall from a relative passing away, and within a few years, it's all gone. I didn't even look hard, and two of the top stories on reddit's r/personalfinance are of people who have gone through savings in just a few years. So careful planning is needed to make sure that this money will last through her retirement, and if possible, leave something behind for her children or an important charity for her.
This means that the responsible thing to do is to have a sustainable withdrawal strategy, where she only withdraws what the portfolio can replace. Using the average market return of around 7% a year (remember, that's how much we assumed her account would grow every year), her account should grow on average by 7% a year. However, inflation averages 3% a year, and because we need to preserve her purchasing power through retirement, we have to remove inflation from the 7% market return. This leaves her with a sustainable withdrawal rate of 4% a year.
This leaves us with an income of $52,000 a year, adjusted for inflation. She may also be eligible for Social Security benefits at the end of this too, which will also help her through retirement.
As a baseline, $52,000 a year is a great income from just a maxed Roth IRA, and if she were also able to continue saving through an additional investment account as her pay increased over time, this income number would be even higher.
The main lesson is that it's better to be consistent with your savings and to start early. You can see how waiting just a few years really impacts the account value and the resulting income number. For example, if she had retired at 60 instead of 65 or if she had just started 5 years later, her Roth would be worth around $900,000, which would instead result in $36,000 a year in income!
Further, if both of those circumstances had happened - she had started investing at 30 and retired at 60, she would have cut off 10 years of investing time, and as a result, she would only have around $600,000 in her Roth IRA by the time she retired. This would leave her with just $24,000 a year in income - less than half of the original amount!
So, if you get started early and save prudently, your Roth IRA will be enough to afford a modest retirement, but if you start saving late or become accustomed to a higher standard of living before you retire, you'll need to think about saving more money through additional investment accounts.
As the Chinese proverb goes, "the best time to plant a tree was 20 years ago, the second best time is now."