The man explains it is his number – the amount he “needs to save to retire the way he wants.” He notices his neighbor has a sign of his own…”$ GAZILLION.” “Is that your number,” he asks.

“How do you plan for that?”

“Oh, I blindly throw money at it…hope something good happens.”

Here’s a look at the commercial:

While it is sort of humorous look at retirement planning, I suspect it represents the sort of planning most of us do when it comes to far off goals. I have sat down a time or two to attempt to arrive at my own ”number,” but it is rather difficult to predict what life may be like a few decades from now.

Save as Much as  I Can

Up to this point my retirement strategy has been to “save as much as I can,” which reminds me a little of the gazillion guy. “Saving as much as I can” is not a viable strategy for retirement planning.

Instead, I should come up with a goal amount, a number, based on our current living expenses, project what our retirement income needs may be, and factor some unknowns like inflation, health care costs, etc. Now you see why arriving at a number is so difficult.

Then there is the daunting task of developing a savings strategy for reaching your number. The dog-walker in the video is a little older than me, so for simplicity I will double his number for example purposes.

Let’s pretend my number is $2 million. I’m roughly 25 years from traditional retirement age, so I’d need to save about $3,500 a month at 5% rate of return and 3% inflation, assuming I had no savings right now, to reach this retirement savings goal.

Just $3,500 a month, huh? No problem…just have to set aside a little after I pay the mortgage, the food, the utilities, put gas in the cars, etc, etc. Nothing to it. Yeah right.

You see why this gets overwhelming.

Now let’s assume I’ve been reading Frugal Dad the last four years and socking way a huge amount of savings. I have $100,000 saved towards retirement. With this starter savings amount in place, I only need to put away $2,800 a month to reach my goal.

That’s still a decent chunk of money, but I suppose if I pay off the mortgage early, take on a second job, and/or forgo things like eating and lights I might could scrounge up the money some years down the road.

By now I hope you understand the importance of starting early – particularly if you are reading this and your age begins with a 2!

This is how the exercise usually works for me. Rather than coming up with a goal number, I plug whatever seemingly small amount in I can afford to set aside each month for retirement, extrapolate out 25 years and see what the balance will be. The problem is, using this method I come up woefully short of my “number.” Sigh.

Determining Your Number

Much of the success or failure of this exercise comes from the first step – determining your number. There are plenty of retirement calculators out there that will help you arrive at this number. My suggestion is to use three or four of them and take the average. Most brokerage websites have calculators freely available, as do most major financial sites – Google is your friend here.

One drawback to these online calculators is that they make some pretty broad assumptions. It’s difficult to personalize the assumptions based on your lifestyle, your appetite for risk, your frugality, etc.

I often find the stated income needs in retirement to be much higher than what I really believe I could live on with no debt, no mortgage and a relatively simple lifestyle.

Take the results for what they are – a ballpark figure from which you can make adjustments to arrive at your “number,” or even better, your “Goal Retirement Range,” or GRR, an acronym I use to represent the range I’d be happy retiring on (and an acronym that adequately represents my feelings when trying to perform these retirement planning exercises – GRR!)

Your GRR may look like $600,000 – $800,000. Your neighbor may prefer a GRR of $1.2 – $1.4 million. It all depends on a variety of personal factors.

Just don’t let your GRR look like “oh, somewhere between $1 and $2 gazillion.” How do you plan for that?

Of course, that benefit is not always a given. Tax rates could increase, or your income needs could increase in retirement. Either way, you might find yourself paying more in taxes than you planned on earlier in life.

For me, the tax advantages do not outweigh the other problems/limitations of a 401k. Of course, much of this is very personal, as the company I work for chooses the plan administrator, and the administrator controls the investment options. Your options may or may not be significantly better.

Your employer may also offer a match to your contributions, which would be very hard to pass up as it essentially “free money” towards your retirement.

Having said all that, I chose to not participate in my employer’s 401k for a variety of reasons, but it largely comes down to freedom.

I prefer to invest in things that give me the most freedom – freedom of investment choice, freedom to tap my money if necessary, and freedom to have more control over taxable events now and in the future (sale of stock, withdrawals, etc.).

Roth IRA – An Alternative to the 401k

My wife and I both invest in a Roth IRA. Here, our contributions can always be withdrawn for any reason without penalty, which in effect makes this an extension of our emergency funds – not necessarily a dedicated emergency fund, but additional dollars we could withdraw if it really hits the fan.

The earnings will grow in our Roth IRA accounts and may be withdrawn tax free upon reaching retirement age (59 1/2). If we need money from the Roth before that, we can withdraw contributions without penalty.

Contributing to a Roth IRA also allows us to have more choice with our investments. Rather than being limited to a few mutual fund options with what I believe to be questionable allocations to particular segments, regions, etc, I can invest in something I feel reasonably sure will do well over the next three or four decades. I can speculate with some of my retirement money, or be ultra-conservative, whatever my appetite for risk happens to be at a particular life stage.

Outside of the Roth IRA I prefer to invest in taxable investments, again where I can control taxable events, income, withdrawals, etc. I’ve previously mentioned my strategy to build a portfolio of dividend growth stocks. I would like to eventually own real estate that produces rental income.

I also plan to tap investments before the government-scheduled retirement age of 59 1/2. I don’t know exactly when that will be, but I imagine I will stop working for full-time pay well before 60. I may work part-time, or start my own business, or change careers – who knows. But I’d like to be able to use some of my own money according to my own time table.

Potential Drawbacks to Stopping Your 401k

I am not advocating people stop contributing to their 401k without strong consideration, I’m just sharing my personal strategy. This is how I would allocate funds after getting out of debt:

1. Invest in a 401k up to an employer match. If no match, go to step 2a.
2a. Save a one-year emergency fund in all cash.
2b. Max out Roth IRA contributions.
3. Invest in taxable investments with a low turnover, including single stocks (don’t forget diversity), tax-advantaged mutual funds, hard assets (gold, silver, real estate), certain types of tax-friendly bonds or Treasuries, etc.

One of the benefits of a payroll deduction to a 401k is that the money is siphoned directly out of your paycheck and into your investment accounts. It’s like putting retirement savings on auto-pilot.

Those lacking the discipline to save on their own may benefit from the level of automation a 401k plan provides. I prefer to take a more hands-on approach with our investments, but that doesn’t mean everyone else does (or should).

I’m not one to put out a lot of disclaimers, but I would remind you that you should never do something, or not do something, with your money just because someone on a blog, or TV, or the radio, advocates it. Do your own homework. Talk with a professional. Make your own informed decision.

I’m interested to hear more from readers on this subject. Do you currently invest in a 401k?

I have a far-out idea to share with the next generation of the American middle class.

Right now, I’m speaking specifically to the young people who are finishing up a college degree, perhaps in a promising field, and starting to get interviews for jobs with salaries they could only dream of just a few years earlier. The Adult World lies exciting and vast before you, and the Opportunities are unlimited!

At this point, let’s imagine you just dive in and start playing it by ear. You work hard at the new job, buy a new car, rent an apartment, enjoy restaurants and vacations, and may even save towards the downpayment on your first house.

There is usually a student loan still kicking around, and then a car loan, and maybe even some credit card debt that pokes its head in at some point. Meanwhile your new career advances quickly and within a few years you’ve almost doubled your new graduate salary – perhaps you are now making $60-100k or more.

Eventually, you might pair up and move in with your true love, so that you are now sharing one nice place. Maybe it’s even your very own home. Now you’re about 30, and you are one of the lucky households with an income of well over $100,000 per year! But you’ve still got two student loans, two car loans, assorted other debts, and when you add everything up, you still have a net worth of less than zero.

You are thinking of starting a family, but something doesn’t feel right about your financial security. How did you work so hard for almost ten years and still end up having less than zero dollars? At this point, you turn to the Wise World of Financial Bloggers to see how to clean up your act. And you begin the long slog to get out of debt, just as your expensive first baby is born…

But since this surprisingly realistic example is still just fictional, let’s stop and rewind it back to the beginning. What if the college student or recent graduate could receive the life-changing advice of one of us Thirtysomething financial bloggers, and use it to their advantage? What knowledge could the wise blogger impart?

Here’s what I would say:

“Hey young fella (or lass). It’s me, Mr. Money Mustache. Congratulations on entering the fantastic world of Real Work!

But before you take off running, take a look over here on the side of the grand hallway we’re standing in. There’s a little doorway that most people don’t even notice, called Real Wealth. If you take that particular door, you have the opportunity to become quite rich by the time you’re in your early 30s… right around the time the rest of your friends are just realizing they must have done something wrong because they are still recovering from debt!

In fact, the situation through this door is so good, that you can even quit work entirely in order to spend time with your future children, and for the remaining 70 years of your life, work will be an enjoyable and optional part-time affair of pursuing your true passions in life. Sound good?”

As the New Graduate, you would probably be pretty excited to go through that door. It would put you on the path to True Early Retirement. Instead of spending all your money, I’d advise you to live on about $15 to $25 grand of take-home pay per year, and if you pair up into a couple, the number would become $20-$35k.

The rest – and I mean ALL the rest, regardless of how much you earn, goes into your early retirement fund. Maximum contributions to the 401k, and to Roth IRAs, and then beyond that to more low-churn growth investments that don’t generate taxable gains. Maybe even a rental house or two if you really want to be on the Bullet Train plan.

A plan like this may sound quite tricky if you’re currently stuck in the American Ultraconsumer mindset. But as someone who followed this exact path myself, I can tell you it is absolutely enjoyable, fun, and even still quite luxurious. I still owned houses and reliable cars and a nice bike, and did a reasonable amount of restaurant eating and travel through the whole process.

The only difference between me and my indebted thirtysomething peers is that I was much more careful about considering each purchase to avoid wasteful ones, and I was adamant about never borrowing for anything other than a house. And I married a woman who was willing to live the same fun lifestyle to reach the early retirement goal together.

The ultimate reward for us came with the birth of our baby boy in 2006. We had already retired from our real jobs and could share the joy and pain (OK, mostly pain for the first few months) of parenthood together, with none of the compromised career-juggling lifestyle that defines our country.

We actually do enjoy working, and still do a small and non-mandatory bit each week to bring in extra savings and interact with other adults. But taking the entire pressure of finance out of your life so early on, so that you can enjoy the next SIX DECADES focusing on more worthwhile things, is a worthwhile thing to shoot for as a new graduate.

So which door will you choose, Next Generation of the Middle Class? Will it be more of the same old same old, or do you want to try it the Mr. Money Mustache way?

Mr. Money Mustache is a 36-year-old married man with a 5-year old son living near Boulder, Colorado. He discovered frugality early on in his career as a software engineer and as a result was able to enter an early retirement at about age 30. He started writing the Mr. Money Mustache blog earlier this year after realizing that many people were now earning higher salaries than he and his wife had earned in their careers, yet were still enduring financial hardships every day which were interfering with their goals of raising their children.

There may be no escaping federal income taxes, but state income taxes can sneak up and take a significant bite out your wallet. Your first thought may be to head for a well-known retirement destination with no state income tax such as Florida or Texas, but there are many issues to weigh before making a move, such as:

• State and local sales tax
• Property tax
• Estate and inheritance taxes
• Housing costs
• Insurance premiums
• Relocation and annual travel costs
• Quality of life factors (recreation, security, lifestyle)

A major consideration is the state’s laws governing taxes on different types of retirement income. Different states have different rules governing taxes on Social Security income, government, military or private pensions, and disbursements from retirement accounts such as IRAs and 401(k)s. Review state tax laws that apply to your particular retirement portfolio when considering relocation.

To help in the hunt for ideal places to relocate, here is a list of 10 retiree-friendly states:

1. Alaska. While this polar state might not be everyone’s idea of a retirement paradise, there is a certain undeniable appeal to the fact that the state has no state income tax and no state sales tax. In addition, all residents (after the first year) receive a hefty annual dividend check from the state’s oil coffers. Many older residents are exempted from property taxes on the first $150,000 of assessed value.

2. Alabama. With a mild southern climate, and attractive real estate prices, Alabama is an overlooked retirement spot. Homeowners over 65 are exempt from state property taxes and the state has a lower-than-average state sales tax of 4%. There are no taxes on pensions or Social Security.

3. South Carolina. South Carolina is another state popular with snowbirds fleeing colder climes and seeking lower taxes. There is no Social Security tax and couples can deduct the first $30,000 of retirement income from their state taxes. Up to $10,000 in military benefits can also be deducted. State sales tax is 6% but prescription drugs are exempted. The sales tax falls to 4% at age 85. Property taxes are low and older taxpayers qualify for a homestead exemption that further reduces their tax liability.

4. Mississippi. Property taxes are some of the lowest in the U.S. and there are no pension or Social Security taxes. Distributions from IRAs, 401(k)s and other qualified retirement accounts are also excluded.

5. Nevada. Nevada has no state income tax and food and prescription drugs are exempted from the 6.85% state sales tax.

6. Pennsylvania. Social Security and pension income are exempt in PA. The Keystone state also keeps its paws off retirement accounts such as IRAs and 401(k)s. Be aware that property taxes vary widely from place to place.

7. South Dakota. There is no tax on Social Security benefits or on any other pension income. The state sales tax is a below-average 4%, and prescription drugs are exempt. Homestead exemptions and other tax reductions are available to seniors.

8. Tennessee. While there is no tax on Social Security or other pension income, dividends and interest are subject to tax. The state sales tax, at 7%, is on the high side.

9. Wyoming. Pensions and Social Security income get a free ride in this income-tax-free state. Sales tax is a low 4%, and prescriptions and food are untaxed. These facts, plus low property tax rates give Wyoming residents one of the lowest overall tax burdens in the country, putting this state high on the list of retiree-friendly places to relocate.

10. Delaware. This tiny state has no state sales tax, and state income taxes are on the low side with exemptions for Social Security and other qualified income for taxpayers over 60. A credit toward property tax is also available for homeowners over 65.

Shifting Views on Retirement

When I was a kid, my personal view of retirement was skewed significantly by the fact my grandfather retired from the Marines at 47, my grandmother was mostly a homemaker (particularly in her later years), and my mom was a single mom working 50+ hours a week in corporate America with no retirement in sight.

As I got older, I had friends whose parents were teachers, nurses and factory workers who had dedicated most of their adult lives to a single employer and retired from their chosen occupation. It wasn’t long before I recognized that was becoming the exception.

As our economy shifts away from manufacturing (something I personally find very sad), and into service, I think people will be more likely to change jobs dozens of times in their lifetime. I’m a bit of an exception to the rule myself. I’m in my 30s, but have worked for only two employers in my adult life (with a bunch of part-time gigs at different companies before that).

How Does this Relate to Personal Finances?

With all this job-hopping, the emphasis on personal responsibility for your financial future cannot be emphasized enough. Add in the question of social security’s solvency, the disappearance of the corporate pension, and the possibility of state bankruptcies, and you can easily see we are walking a financial tightrope with no safety net.

Younger generations must be more engaged with their finances than the “set it and forget it” generations before them. It used to be acceptable to plow all your money into 401k mutual funds and company stock. Ever heard of Madoff, Enron, or those target-date retirement funds with overly-aggressive allocations for soon-to-be retirees?

Forty year-olds with five previous employers may be sitting on five different 401k plans with bad administrators cutting into their profits with costly administrative fees. Rolling all those 401ks into an IRA might make sense, but the process can be overwhelming. And there’s always the temptation to cash out when you leave an employer – something that looks appealing, but can easily cost you nearly 40% in taxes and early withdrawal penalties. Ouch!

I’m not against 401k plans, particularly those that offer a matching contribution from employers, but if I had to choose, I’d much rather invest in a Roth IRA. Roth IRAs offer more freedom in terms of investment elections, and they offer the advantage of tax-free growth on earnings (you can even withdraw your Roth IRA contributions any time, penalty-free, in a pinch). And because Roth IRAs may be opened and maintained independent of your employment status with a particular employer, they make a lot of sense for younger generations of workers likely to bounce around the employment world before needing retirement funds.

Do I Even Want to Retire?

Back to the post from J.D; is he really retired if he still works several hours a day? I don’t think so. Has J.D. chartered a course of more personal freedom, rather than being chained to a desk eight hours a day, five days a week? Absolutely.

Perhaps we should change our definition of retirement. Or, maybe we should just expand our definition of self-employed. Were it not for a need to earn additional income, I’d say a full-time writer is mostly financially independent. That is, they no longer need to work for money to cover basic life expenses.

I believe most of us will enter a stage of semi-retirement when we get a little older. We’ll live off a combination of savings and part-time earnings, and be able to afford it by getting out of credit card debt and paying off the mortgage well before exiting full-time employment. Couple that with a frugal existence, and it wouldn’t take all that much to enjoy a lifestyle of more personal freedom.

Imagine getting to travel when most people are working. Imagine spending more time with your kids and grandkids – perhaps even homeschooling them if that is something that interests you. Imagine taking up a new hobby during the day, or volunteering more of your time. It’s all achievable, but not without some sacrifice up front.

I remind my kids, and any other young person I meet, to avoid making the big financial mistakes early on. If you do, you’ll have limitless opportunities to enjoy the next few decades of your life, while your peers will be paying for their mistakes.

In the last series post we discussed ways to reach early retirement through a combination of taxable investments and retirement contributions that may be withdrawn before traditional retirement age. This post picks up where the other left off; we’ve now reached that golden age of 59 1/2 and may begin withdrawing from our traditional retirement plans.

Should we invest in both a Roth IRA and a 401(k)? Should I count on social security income, and if so, should we elect to receive early payments? What alternative investments can we make to fund retirement?

Forget Everything You Thought You Knew About Retirement

Our strategy for retirement is different from the more traditional idea of working somewhere 40 years, retiring, and drawing social security for the next two or three decades (hopefully). Our plans for retirement have been influenced by a shift in some of the long-held financial beliefs.

Things like a guaranteed 8% return in the markets may be soon be a distant memory. Sure, some years will be good and some bad, just as it always has. However, I suspect there will be more volatility and negative financial news than anyone my age remembers. So our plans have been molded by life experiences, the political climate, and even larger economic trends that have developed in our lifetimes. Our investments will be more conservative, and we will always lean to being “cash heavy,” because we value preparedness over the chance of hitting it big.

Maximize Roth IRA Contributions

Each year, my wife and I will contribute the maximum amount to a Roth IRA. I’m a big fan of the Roth IRA, for several reasons. First, the earnings in a Roth IRA grow tax free, and since you are using after-tax dollars, contributions can be withdrawn at any time, for any reason (making the Roth sort of a 2nd pseudo-emergency fund).

The Roth IRA also has no mandatory distribution age, meaning if you hit 59 1/2 and don’t want to tap your Roth IRA balance, you don’t have to. Traditional IRAs require distributions at age 70 1/2, meaning you could be forced to reduce the amount you leave to heirs thanks to mandatory distributions.

With about 27 years until we reach that 59 1/2 years-old threshold, my wife and I could save a large amount in our Roth IRAs, assuming we don’t tap contributions early to fund early retirement (something I mentioned as possibility in the last series post). Assuming a 6% average return on our $10,000 yearly investment, we would have nearly $700,000 in Roth IRA savings in 27 years.

Maximize 401(k) Contributions

In Adam’s recent post asking whether or not he should save for retirement or pay off debt, it seemed the consensus in the comments was Adam should contribute through his employer’s match, but use any remaining funds to reduce his debts. I agree; there is nothing like “free” money in the form of matching contributions.

However, there is a larger question here. After becoming debt free, should one continue to increase 401(k) contributions to the maximum yearly amount (currently $16,500), or should they invest that money elsewhere in a more diversified mix of asset classes (paid-for real estate, business ventures, etc.)? I don’t believe there is a right or wrong answer here. but it seems to me that if all you can afford to do is stretch to max out your 401(k), you may do better to spread that money around a bit. On the flip side, if you can afford to save above and beyond the yearly maximum, then you should first fund all tax-advantaged accounts, such as a 401(k).

What did we decide? After much deliberation, we decided to slash a few budget items and go after the max 401(k) contributions, recognizing we may not be able to do this every year going forward. Fortunately, we are now debt free, and through my blogging pursuits, we have what amounts to a second income. I recognize this does not work for everyone, and it certainly didn’t work for us until just recently. In fact, I haven’t even contributed to a 401(k) in the last few years while we whittled away debts and built emergency savings.

If we could find a way to continue maxing out 401(k) contributions until retirement age, we would have $1.1 million, assuming a 6% return. Add in Roth IRA contributions and growth, and we’re approaching $2 million. Of course, as I mentioned in my last post, this is not likely to happen because I want to move away from full-time employment in the next 12-15 years. If we kept up our goal of maxing 401(k) for just 15 years, we could still build a 401(k) nest egg of just over $400,000, and another $250,000 in Roth IRAs. Not bad at all.

Will We Receive a Return On Our Investment In Social Security?

In a word, no. I don’t believe we will. Put another way; don’t count on it. I personally believe social security as we know it today will not exist in another 15-20 years. It can’t, mathematically, as soon there will be many more people receiving benefits than paying in. That sort of upside down pyramid doesn’t work – just ask anyone associated with a failed Ponzi scheme.

Now, I am not as radically anti-social security as some. I just like the idea of controlling my own investment dollar, because I’m confident I can earn more than the U.S. government can. Enough of that, I’m not out to make a political statement. I am simply trying to reinforce the idea that people in their 20′s and 30′s should not expect to be able to live on social security in retirement.

If we do receive some form of payment from social security, just consider it a bonus, but certainly don’t count on it for financial survival. If the program is still solvent when I reach the age eligible to receive early payments, I’ll likely sign up. After all, nothing is guaranteed – neither my health or the continued viability of the program. Unfortunately, several people close to me paid in their whole lives and never received any benefits, or received very limited benefits through disability before dying young.

Alternative Investments for Retirement

In addition to the traditional types of investments I’ve listed here (and in earlier series posts), we are also interested in things like paid-for real estate. Specifically, we’d like to pay off our own home well before contemplating an early retirement. I have always thought living mortgage-debt free must be the ultimate in financial freedom.

Just imagine no credit card debt, no car payments, and no mortgage payments. Imagine the options available to someone in that position. Imagine the freedom they must feel with the only income requirement to earn enough to cover basic living expenses, and save for future ones. That’s it.

In addition to real estate, I will always have a side hustle or two going, and in the future may elect to invest more money to grow a current hustle, or develop a new one, without introducing too much risk into our lives. I started Frugal Dad over two years ago on less than $50, so it might be tough start something even more frugal!

In the final post in this series, we’ll look at one last topic: giving. Yes, part of our saving strategy is to give a lot away. I’ll share a few ideas I have on the subject, and as usual, try to put some specific numbers to our giving goals going forward.

That’s a question that a lot of people ask while in debt. Dave Ramsey, possibly the most popular debt counselor, recommends that you stop ALL retirement saving while eliminating debt. He argues that it gives you a huge advantage because you have a lot more money for your debt snowball.

I am a little more liberal when it comes to this rule. I think that it should be based on some other factors as well. For example, our current pile of debt is so large that we will be missing out on 5+ years of retirement saving (the amount of time it’s going to take us to pay off this debt). When you add compound interest into the equation, it means that we would be missing out on a lot more money. Let me give you our situation as an example:

I currently work for the Government and am offered a 5% match for money I put into the Thrift Savings Plan (fancy government word for 401k). That means that for every dollar I put into the plan, they match me 100% up to a 5% of my income. That’s a guaranteed 100% return on my money and I can invest it in any of their funds. However, if I didn’t contribute to the plan, I would miss out on that free money. Plus, I would miss out on 5+ years of compound interest.

Now, I am going to put some numbers to the scenario. Let’s say I start putting 5% of my income (plus the match) into the plan starting today (age 25). By the time I reach age 70, I will have almost $2.5 million in the account assuming an 8% return. Now, if I wait 6 years (best case scenario for debt repayment) and start investing the same amount per year, I will only have $1.7 million in the account. Still not bad, but almost $800,000 less than if I would have started at 25. Here is a graph of this example:

So, as you can see, starting to save for retirement 6 years from now instead of today will cost me about $800,000 in retirement savings by age 70. Am I really going to pay that much more in interest by not stopping my contributions? I don’t think so!

So, I guess the question is, when should you stop contributing to retirement in order to clean up your debts? Should you do it if you can get the debts paid off in 2 years or less? 4 years or less? What is the magic number?

All I can say is, I am not missing out on almost $800,000 in retirement growth to save MAYBE a couple thousand in interest charges.

What are your thoughts on the subject? Can you think of any reasons why I should be STOPPING my contributions?

Let’s say you are still working to build a fully-funded emergency fund, but only have one month of expenses. You manage to scrape up a few thousand dollars to save near the end of the year (a bonus, an inheritance, whatever), and would like to open a Roth IRA. If you are like I was, the thought of locking that money away in a retirement account terrified me. What if I have a big emergency two months after I open my Roth, and before my emergency fund is fully funded?

Never fear. If you do have a big emergency soon after contributing to your Roth you can simply withdraw your contributions without penalty. The rules here are different from other tax-deferred retirement savings plans because the money you invest in a Roth has already been taxed. However, the earnings in your Roth IRA have not been taxed, and therefore must be left untouched, unless you meet one of a few exceptions for withdrawing earnings tax and penalty free. Here’s the language from the IRS.gov website, Publication 590, related to making early withdrawals of your contributions from a Roth IRA:

Are Distributions Taxable?

You do not include in your gross income qualified distributions or distributions that are a return of your regular contributions from your Roth IRA(s).

So there you have it; straight from the horses mouth. Withdrawals of regular contributions made to your Roth IRA are not counted towards your gross income. Does knowing you can withdraw Roth IRA contributions early without penalty make you more likely to max out your Roth IRA contribution for the current tax year? It did for us. For the first time in our married lives we maxed out my Roth IRA contribution (currently $5,000), as well as my wife’s spousal IRA (another $5,000).

In the event of an emergency larger than our emergency fund could handle, that $10,000 would be available to us (assuming the market doesn’t tank again). And that is something to consider. I would not suggest using a Roth IRA as your only source of emergency funds, because chances are your investments inside the Roth are exposed to more risk than traditional emergency fund savings.

However, Roth IRA funds could certain supplement your emergency savings, or some other savings goal, such as parking money to be used for a down payment on a first home (by the way, this is one of the qualifying events for which you can withdraw Roth IRA earnings tax free, assuming the account is over five years old).

With compound interest being such a close personal finance ally, the sooner you start investing in retirement funds, the better. Remember, you cannot go back and invest in a Roth IRA for previous tax years. It’s now or never. So go ahead and set aside some money in a Roth, and try your best not to withdraw those contributions. But remember Roth IRA withdrawal rules allow withdrawal of contributions, penalty free, if you absolutely need them.

The first step in retirement planning is to estimate how much money you need to retire. This is actually a fairly straightforward task because there are simple mathematical formulas and easy-to-use online retirement calculators designed to help you. The process is well understood and the tools are easily accessible on the internet.

What is less well known, however, is how these calculators work and the inherent problems involved in using them correctly. In other words, it is easy to create a retirement estimate but surprisingly difficult to do it accurately.

The reason it is difficult to create an accurate estimate for the money you need to retire is because the accuracy is dependent on the assumptions you use. Many people fuss over whether to use elaborate models like Monte Carlo or simple rules-of-thumb like the 4% rule, but that is missing the forest for the trees.

Huge differences in your retirement planning estimates occur when you vary the assumptions used for spending (have you succeeded at paying off your mortgage?), income, inflation, and other required inputs. The unspoken truth about retirement planning is the validity of the assumptions used to determine how much you need to retire will make or break your financial security.

The Inherent Problem With Making Retirement Assumptions

Below are the six common assumptions required by nearly all retirement calculators to determine how much money you need to retire:

1. Annual spending budget
2. Estimated inflation rate
3. Expected lifespan
4. Annual income from sources other than savings
5. Estimated return on investment
6. Expected retirement date

As you read through this list of assumptions you probably realized something – they can’t possibly be answered accurately. Think about it. All but one requires you to predict the future—something no one can do reliably without a crystal ball. In fact, only one question can be answered with confidence because it is the only one you have any control over (number 6 in case you haven’t guessed).

Amazingly, conventional retirement planning requires you to provide assumptions that are impossible to estimate accurately in order to determine how much money you need to retire. It is insanity. If you vary these required assumptions within a reasonable range of probable outcomes you will find the estimate for your retirement savings can vary by two to three times the original amount.

In other words, one set of assumptions might result in $750,000 of retirement savings needed, and an equally plausible set of assumptions might estimate $2,250,000 in required savings. The difference is huge, and yet both set of assumptions are equally likely to be true. The whole process can leave you wondering what is the real retirement number and how can you ever retire in confidence?

Below we will look at each of the assumptions necessary to accurately answer the question, “How much do I need to retire?” so that you can better understand the issues involved.

How To Estimate A Spending Budget For Retirement

Most traditional retirement planning models assume you will need 75% to 85% of your working income in order to maintain your standard of living after you retire. The idea is that you will save on work-related costs like commuting and a professional wardrobe, as well as the expense of raising children. The formulas also generally assume that your home will be paid for and you will enter a lower tax bracket.

The truth is every individual has a unique set of circumstances that affect retirement spending. Today’s retirees lead longer and more active lives driving up the total cost of living in retirement. The expenses of hobbies, leisure activities and travel can easily offset any decrease in work-related expenses.

Your health care expenses are also likely to increase as you age, not to mention the price of long term care if you don’t have insurance to cover that. If you still have a mortgage on your house or a child in college, your expenses during your first few years of retirement may be equal to or greater than before.

The reality is you must plan a personalized retirement budget that reflects your unique plans for retirement. Some will spend more than their current income during retirement, and some will spend less. The research on retirement spending indicates a wide variance in retirement spending patterns with most people reducing spending as they get older. Any way you look at it, the 75-85% rule-of-thumb is a dangerous assumption that is best ignored.

Reasonable Assumptions For Inflation During Retirement

Most retirement calculators assume a modest 3% inflation rate. This is based on recent history (the last 20 years or so) and implies that your spending in nominal dollars will roughly double every 24 years.

The problem is if inflation increases to 6% (not a far-fetched possibility) then your spending will double every 12 years instead. That obviously makes a very big difference in how much you need to save for retirement. Rather than watching your expenses double once or maybe twice during retirement you could see them double 3 or 4 times which would drastically affect what you could afford to spend.

Historically, inflation has fluctuated from negative numbers to double-digits during wartimes and has shown prolonged periods of higher rates than the commonly assumed 3%. Given current conditions with high government debt and deficits combined with entitlement funding problems, many credible economists predict increased inflation over the next 20 years.

So how much will you assume for inflation when calculating how much money you need to retire? A percentage point or two can make a dramatic difference. I suggest using a range of assumptions varying from 3% on the low side up to 6% on the high side depending on how conservative you want to be in your retirement planning.

How To Estimate Life Expectancy

Isn’t it amazing that retirement planning requires you to estimate your life expectancy? Talk about an impossible task.

Sure, you can estimate your lifespan based on family history and your current health and medical conditions, but no one can possibly know how long they will live with any confidence. There is zero actuarial validity to estimating a single lifespan. You are no more likely to live until age 80 than you are to die tomorrow. For any one person life expectancy is random. It is only a valid statistical concept when large numbers are involved – not individuals.

Yet life expectancy has a major impact on figuring how much to save for retirement. The reason is because funding 20 years of retirement is dramatically different from 40 years or more. In the first scenario you can spend principal and the effects of inflation are reasonably manageable, but in the second scenario you not only can’t spend principal but you must also develop a perpetual income stream that grows faster than inflation. In short, different life expectancies imply dramatically different retirement savings requirements.

The conservative solution is to assume the best and plan on a very long life – longer than the actuarial tables estimate. If you come up short the worst that will happen (besides dying early) is you leave a nice legacy behind. If you live a full, long life you will need every penny. Many complain that a long life expectancy pushes retirement savings goals out of reach, but the truth is roughly half those people will outlive the averages and require the greater savings anyway.

Estimating Income From Social Security, Pensions And Annuities?

While Social Security will not likely disappear altogether, the inflation adjusted value of benefits will almost certainly decrease – especially for those retiring behind the Baby Boomers. You can check your annual wage and earnings statement from the Social Security Administration to get an idea of how much you’ll receive when you retire. The younger you are today the greater the risk that the inflation adjusted value of your benefits will be less than currently estimated.

Pensions, particularly private ones, are also proving to be less reliable than they once were. Fewer companies are offering pensions in the first place, but even those with longstanding traditions of fat pension benefits are backing out of those obligations – just ask airline employees.

Sure, there are protections in place to ensure you don’t completely lose out on what was promised to you, but underfunding is a serious problem with the recent market declines. Should your company default on its pension plan you could be left with a reduced payout. If your pension is frozen, you will still be entitled to benefits already earned, but you will stop accruing additional benefits.

In other words, Social Security and pension income may not be as dependable as you thought placing a greater burden on your retirement savings.

What Will Be My Investment Return During Retirement?

Most traditional retirement planning formulas assume long-term historical returns from a traditional stock/bond portfolio of 7% to 10%, decreasing to 4% to 5% after retirement as you shift away from equities and toward fixed income.

The problem with these estimates is they are derived from super-long data periods irrelevant to most retirees. What retirees care about are 15-20 year periods – not 100 year market history – and the surprising reality is how variable the returns can be over 15-20 year time spans. Negative to flat returns are entirely possible but are wholly unexpected when using traditional retirement assumptions – just witness the last 10 years for the U.S. stock averages.

This is incredibly important because even small changes in return on investment can dramatically alter your retirement security. It is not realistic to blindly assume long-term historical returns when your investment time horizon is significantly shorter than the data assumes.

When Can I Retire?

Finally, a question you can answer accurately. You choose your retirement date and you are in full control of when that occurs. If you are somewhat flexible in deciding when to retire, you can significantly reduce the amount of money needed to fund your golden years. Working just a few more years allows you to continue building your portfolio while at the same time putting off drawing down your savings. If retiring is not optional, however, due to medical or other reasons, plugging this known figure into your retirement calculator will send you on your way to determining how much you need to save.

In Summary

The key point to notice from this discussion is retirement planning is not nearly as simple as the financial calculators would lead you to believe. Sure, it is easy to create an estimate when saving for retirement, but creating an accurate estimate is an entirely different matter.

The fact is you need to make six different assumptions when calculating your retirement number; yet, only one of the assumptions can be estimated with any certainty. The rest require you to predict the future which is unknowable and impossible to do. Even the experts can’t do it – and neither can you or your financial planner. If you believe otherwise you are just deceiving yourself.

This is a big problem because the answers you assume to these questions will dramatically affect how much money you need to save so that you can retire with financial security. A small change in just one answer can vastly alter the resulting retirement savings requirement. In fact, I highly recommend you test this using your favorite retirement calculator and prove it to yourself. Don’t take my word for it.

Start varying the three most important and difficult assumptions – return on investment, life expectancy, and inflation – and you will be amazed at the dramatic impact it has on how much money you need to retire. Now, imagine if your estimates are off on all five of the variables—your retirement savings could be wildly off target forcing you to work longer, cut back on your lifestyle, or worse, run out of money before you run out of retirement.

What you will see when you complete this exercise is the traditional approach to estimating how much money you need to retire makes you completely dependent on how well your assumptions reflect your future retirement reality. In other words, you have to be able to forecast 20-40 years into the future. This makes the apparent scientific precision of retirement calculators far less scientific.

After taking advantage of those matching funds by investing through the company match, it most advisers recommend investors turn to the Roth IRA to take advantage of tax free growth opportunities.  After that, you are on your own, and left with a lot of questions.  Do I return to the 401(k) plan and max out my annual contribution there?  Do I invest in company stock?  Do I park anything left over in cash, or single stocks?  Let’s take it one step at a time.

Invest In 401(k) Through Matching Funds

Let’s assume your company offers to match the first 3% of your annual salary if you contribute to the plan.  If you earn $50,000 a year, and agree to participate at a 3% contribution, your annual contribution amount will be $1,500.  Your employer will kick in another $1,500, bringing your total contribution each year to $3,000.  That $1,500 contribution from your employer is almost like free money (nothing is completely free – you will owe taxes on it when you withdraw it down the line).

Max Out Roth IRA Contribution For You and Spouse

If you are living frugal, and haven’t buried yourself in house and car payments, you can probably afford to kick in another few thousand dollars each year to saving for retirement. Assuming you are eligible to contribute to a Roth IRA, it probably makes sense to turn your investment dollars above your employer’s 401(k) match here.

Contributions to a Roth IRA won’t help with your taxes in the year they are made, but earnings grow tax free over the life of the investment.  If your $5,000 contribution this year turns into $40,000 by retirement, you get to keep all $35,000 growth tax free, assuming you withdraw after reaching retirement age, or for a narrow list of specified qualified withdrawals.

Another beauty of Roth IRAs investments is that Roth IRA withdrawal rules allow for the withdrawal of contributions without penalty, at any time.  So theoretically, you could park money in a Roth IRA to grow for three or four years, and then only withdraw contributions, leaving the earnings untouched and continuing to grow.

Max Out 401(k) Contributions or Taxable Investing

At this point you’ve invested in a 401(k) through the company match, and maxed out contributions to a Roth IRA for you and your spouse (if married).  If you still have money to invest for retirement you have a choice:  return to your 401(k) plan and invest up to your annual maximum contribution, or invest in non-retirement, taxable accounts.

The path you ultimately take here depends on your goals for the future, and your overall financial picture. Personally, I would begin to invest in low-cost, low-turnover, taxable investment vehicles such as a broad index fund.  I have plans to “retire” early from full-time employment, and to do so will need access to savings prior to the IRS-defined retirement age (currently 59 1/2). If I planned to work well past the currently defined retirement age, I would probably plow more money back into the 401(k) plan to lower my taxable income and defer those taxes to retirement.

If you do decide to invest in taxable accounts go with a low-cost brokerage such as Vanguard (which I happen to think is one of the best places for a Roth IRA) or Fidelity.  These brokerages are widely recognized as two of brokerages with the lowest expense ratios in the industry.  Inside those brokerages, look for mutual funds with low turnover.

Remember, each time an investment inside a mutual fund is sold or exchanged, or “turns over,” it is a taxable event.  Those taxes will be distributed to mutual fund owners at the end of the year, and can create quite a tax hit, even if your overall mutual fund performance is down.

If I had to pick one fund to invest in it would the Vanguard Total Stock Market Index fund, which owns a little piece of every stock listed.  As you can imagine, there is not a lot of buying and selling happening here, which minimizes your tax hit.  It is also about as diversified as one could get within the domestic equities market (the Total International Stock Index fund is the international investment equivalent).

Additional Resources:

• 2009 401k And IRA Contribution Limits
• Roth IRA Investment Account Basics
• Retirement Saving After 401(k) and IRA
• Find the best stocks to buy in today’s few hot industries