How were we able to retire at a relatively early age and still be able to afford to travel full time? Many people have asked us that very question. I’m going to do my best to tell you how I think about that subject and convey some of the techniques that we used to get us where we are. Don’t think that you’ll be able to put your head in the sand just because you contribute to your 401K. Retirement planning means creating a multifaceted roadmap that includes budgeting, savings (pre and post tax), investment strategies and goal planning.
Will the plan be static: No. Will real life get in the way and cause you to make changes: Yes. Will this be a frustrating process: Most likely. What’s most important is to keep one eye on your goals and the rest will work itself out.
Before we can discuss how the pieces all fit together to make an integrated plan we should make sure we fully understand the components of the plan. Let’s start with retirement accounts; that’s an easy concept to get our heads around.
Retirement Accounts
First off, and I’m sure you’ve heard this more than once before, you should always max out your retirement accounts. I don’t care how tight your budget is, if you neglect your retirement accounts you are neglecting your future. You didn’t think you were going to live comfortably only on Social Security did you? In most cases, with the exception of the ROTH IRA, the monies saved are all “pre-tax”. What exactly does this mean?
Let me show you a simple example: let’s assume that you’re in the 25% tax bracket and that your gross income on your federal tax form is about $90,000. That means you’re paying about $22,500 in taxes. Ouch! If you had put the maximum of $18,000 into your 401K your gross income falls to $72,000 and your tax bill would be $18,000. That’s a savings of $4,500; that means that you just received a government subsidy – and you thought that those were only for the poor! In fact that $18,000 only cost you $13,500. Looked at another way: your retirement account just had a 20% sale! But, like the infomercial you’re so tired of, it just keeps getting better and better. Your investments on that money will grow free of interest, dividends and capital gains.
Didn’t think it could get any better than that? You were wrong! If you’re filing jointly each person can contribute up to $18,000 to their 401K: this translates into a new gross income of $54,000 and a new tax bill of just $13,500. That’s a total tax savings of $9,000, or a 40% reduction in your original tax bill. I’ll say that again, you just saved 40% on your taxes!!!
Of course $18,000/$36,000 is a lot of money to sock away each year but who deserves it more than you? Think of it this way: would you rather pay that money to the government or would you rather pay it to yourself? Enough said.
Also, many people work at companies that match a percentage of their 401K contributions up to a certain maximum (typically 3%). This is free money; it’s almost like robbing a bank, but legal. In order to get this free money you’ll have to contribute to your 401K. You won’t be sorry.
So, you’ve sacrificed and maxed our your retirement savings. Think that everything is going to be peaches and cream in your retirement? Probably not. There’s a lot more hard work ahead.
(I am not a professional financial planner. This article is meant only for illustrative purposes. You should check with your own financial advisor before embarking on any retirement plan.)
Thank you for this piece of valuable information. Bryan and each have Roth IRA’s and 401k’s but I didn’t realize that maxing the accounts out would make such an impact on retirement.
I’m so glad you got something out of that article. I should also have mentioned that for earners in higher tax brackets the savings, on a percentage basis, are even higher.
Another good tidbit – if you’re self-employed (get a 1099 instead of a W2) you can open an i401K and sock away as much as $60,000 each year. That will make an even bigger impact on your tax bill.