Q: I was looking up how much money I’ll need for retirement, and I keep seeing that I’ll need 90% of my income, but how do they know what my income is, or what things will cost when I retire in 20 years? — Tana (via email)
A: Tana, they don’t. There’s really no better way of putting it. But in theory, they don’t need to. Let me explain.
That formula assumes that you are living within your means — either you personally, or you as a household. In other words, that you are spending less than you make, which we should all be doing. If you decided to retire today, and you’re currently making $50,000, then you would need to have some plan by which to generate 90% of $50,000, in this case, or $45,000 each year, despite the fact that you are no longer earning a regular paycheck. This could be a passive income source like rental properties or simply expected returns on your investments.
Where most of us get tripped up is that we’re not going to retire today. So without knowing what your income or expenses might be in 20 years, you have no way of knowing how much that passive income source needs to provide to you. What I would do instead is keep looking at that formula on a regular basis. For instance, I know that — based on the 90% assumption and on the amount of passive income I could scrape together right now — I cannot afford to retire. But I will look at it again next year, and the year after that. And eventually (hopefully) that will change.
But yes, Tana, you are correct that this formula does not provide you with a dollar amount toward which you should be saving for 20 years down the road. And even if it did, you still have to consider that if you start withdrawing the earnings on your investment portfolio instead of reinvesting them, then the return from those investments won’t increase from one year to the next. Yet the prices of gasoline, health care, and food all will. If you’re only going to be retired for a year or two, that may not matter much. But realistically, you could fairly easily be retired for well over 20 years. In that time, these inflationary concerns are going to matter. So be sure that your projected retirement income can keep up.
Q: What is the difference between a qualified and a non-qualified investment? — Meesha (via Twitter)
A: Meesha, qualified and non-qualified investments refer to the two categories of retirement plan that were created by ERISA in 1974. And while which investments fall into which category can be unclear online (in fact, on a highly respected retirement savings website, I found blatantly contradictory answers to whether or not an IRA is a qualified investment) the technical definition matters very little. Conventional wisdom states that a qualified investment just means putting your money into a tax-advantaged savings vehicle. Usually that means an IRA or 401(k). Non-qualified retirement savings are less common things like income annuities, split-dollar life insurance, executive bonus plans, and investment assets like stocks, bonds, REIT’s, etc., which are not purchased within a qualified retirement plan. I say that because a qualified IRA allows you to buy stocks within the IRA, in which case the stock investment would be qualified. I know ... it’s confusing.
Normally, people will try to maximize qualified dollars as their first priority. The reasoning behind this is that a tax-advantaged account either allows you to save pre-tax money, like a 401(k), or make tax-free withdrawals after you retire (like a Roth IRA). Those tax savings can be substantial when multiplied over the number of years that you’ll be utilizing them, so maximizing those accounts makes the most financial sense. Only after you have put $6,000 into your IRA and $19,000 into your 401(k) each year would you typically start looking for other (non-qualified) ways of putting money away for retirement. And if both you and your spouse are already putting $25,000 each aside for retirement, I doubt you have much to worry about in your golden years.
I hope that helps, and thanks so much for writing in!
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— Eric Litwiller has spent the last eight years of his professional career helping people achieve their financial goals through the use of budgets, retirement vehicles, and estate planning options. He is a firm believer in the importance of using earthly riches to fulfill a mission of Christian stewardship. Eric is not a licensed financial planner.