Wednesday, June 30, 2010

How Much To Save To Become A Millionaire

"You have to buy real estate!" Now how many times do you hear that during a real-estate bubble? If you take this advice, it may be wise to ask yourself if you have too much money tied up in your home and not enough in savings. With all the talk of a diminishing social security system, the need to save more for retirement seems inevitable. So, let’s look at some of the options for building that million you need to retire in style.

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Where Are Our Savings?
If you have a great deal invested in your house, remember, listed homes and other property can take anywhere from two weeks to more than a year to sell. Ask any agent who sold homes back in the 1980s, when prime interest rates were averaging over 11%! Still, property seems to be priority. In 2004, the household savings rate averaged a meager 0.8% of disposable income (the rate was 7% over the three previous decades). This 0.8% is the lowest level since the Great Depression (Business Week Online, "Our Hidden Savings", January 2005). Is this because Americans are putting too much of their savings into their homes or are we just bad at saving money?

So exactly how much should you save annually for your retirement? Although there is no correct answer here, most financial planners will tell you that you should be saving around 15-20% of your annual gross income. This figure may sound unattainable for many, but suppose your employer matches contributions of up to 6% of your salary - now you need to save only 9%!

Sizing up the Options
Let's look at how some retirement savings vehicles can help you reach your goals:

, 403(b) and Other Employer-Sponsored Retirement Plans
These are perhaps the best savings vehicle for most of the working population. You need to take advantage of your company plan if one is available. Not only do the earnings in the account grow tax-deferred, but a simple contribution of 6% can help reduce your tax bill if hte contributions are made on a pre-tax basis, as pre-tax contributions are excluded from your gross income for income tax purposes.

Traditional and Roth IRAs
Individual retirement accounts are available to those individuals with qualified compensation. Traditional and Roth IRAs are funded with after-tax dollars. However, if your income level qualifies, you can receive a tax deduction for contributions to your traditional IRA. The major difference between the two IRAs is that earnings in the Traditional IRA grow tax-deferred, while those in the Roth IRA grow tax-free. (For a more detailed comparison, see Roth Or Traditional IRA...Which Is The Better Choice?)

Simplified Employee Pension (SEP)and SIMPLE IRAs
The SIMPLE IRA is a tax-favored retirement plan that certain small employers (including self-employed individuals) can set up for the benefit of themselves and their employees.

SEP IRAs are plans that can be established by the self-employed or those who have a few employees in a small business. The SEP lets you make contributions to an IRA on behalf of yourself and your employees. The SEP and SIMPLE IRAs are popular because they are simple to set up, require little paperwork and allow investment earnings to grow tax-deferred.

Taxable Brokerage Accounts
These allow you to invest additional funds after you have maximized all of your retirement account options. Brokerage (cash) accounts can serve also as good savings vehicles for a particular goal such as a home or yacht. Be aware, you’ll need to pay taxes on the income generated in these accounts in the year that it is paid. (For further reading on how finding a broker, see Brokers and Online Trading.)

Getting Disciplined

So you know about some of the powerful savings tools, but you may be wondering where you get the extra cash to invest. Well, there can be a number of places - it first starts with your budget. Match up your monthly income with your expenses for the month. Can you cut back on your dining out? Do you really need that manicure once a week? Can you save money on your current insurance? Try shopping around for other carriers for better rates. Do you really need permanent life insurance (whole or universal life) when you could be saving hundreds with term insurance? (see Buying Life Insurance: Term versus Permanent)

After you’ve skimmed down the budget, there are three keys to making your million dollars. First, as we already mentioned, you must take advantage of any type of employer match program. If you have a 401(k) plan at work and the employer matches up to 6% of your pay, you should contribute at least 6% of your pretax income to the plan. Second, set your accounts up on automatic investment plan, so each month income goes to forced savings. And lastly, invest in the best savings plans first and weed out the bad.

Reaching $1,000,000 with Ease
To take full advantage of your retirement savings vehicles, try to contribute the maximum limit. In 2009, you can contribute up to $16,500 to a 401(k) plan ($22,000 if you are age 50 or older by the end of the year); you can also contribute $5,000 to a Traditional or Roth IRA of your choice ($6,000 if you are age 50 or older by the end of the year). Keep in mind that the eligibility to contribute to a Roth IRA has some income limitations.

Let's take a look at how an average person, let's call him Joe, can reach this million-dollar goal by the time he retires at age 67 (27 years from now). Joe (single, age 40) has an annual gross income of $50,000, and his employer has a 401(k) plan and matches contributions up to 5% of Joe’s salary. Joe is also committed to saving $4,000 a year in a Roth IRA. We'll assume his investments have a 10% return.

Joe takes full advantage of the employer match and defers 5%, or $2,500, of his salary each year. His employer will then contribute $2,500 each year as per the matching agreement. (Assume Joe’s salary remains the same until retirement) Here's the breakdown of his savings over the 27 years.

401(k) Roth IRA
Annual contributions of $5,000 Annual contributions of $4,000
Compounded at 10% for 27 years Compounded at 10% for 27 years
Equals $605,500 Equals $484,400

Grand Total of $1,089,900. Welcome to the Millionaire Club!

If Joe had started his plan at different ages, here's what his results would look like:

Starting Age Annual Investment Annual Return Value at age 67
25 $9,000 10% $4,838,732
30 $9,000 10% $2,970,355
35 $9,000 10% $1,810,239
40 $9,000 10% $1,089,900
45 $9,000 10% $642,624
50 $9,000 10% $364,902
55 $9,000 10% $192,458

At younger ages, you still have the time to be a little more risky with your investment selections and seek out investments that have the potential to get you that 10% return or more. If you're looking at certificates of deposit and money-market investments think again - you need to consider other investments such as equities to achieve returns that can outpace inflation. (see Guide to Stock Picking Strategies.)

The chart above also demonstrates the value of compounding interest, one of the most valuable tools to accumulate significant wealth - the key is to start while you’re young and stay disciplined. (see Delay in Saving Raises Payments Later On.) Stick to your plan! The ride may be slow and boring at times, but you’ll be pleased with the long-term results.


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