Retirement savings, especially for a 401(k) or SEP IRA, can certainly feel like a black box at times. Saving into retirement accounts is essential for the future, but many times it leaves people wondering how much they need to save. After having hundreds of these conversations with people, most don’t know whether they need to maintain their level of savings. Sometimes, helping people focus on their financial priorities can show where retirement stands, and when they can shift to focus on other goals as well.
Key Takeaways
- Tracking your savings rate, by dividing your annual savings by your income, is a helpful metric to understand your financial picture.
- If the estimated asset level you need for retirement exceeds your projected needs, then you may not need to keep saving as much.
- Ultimately, how much and where you save comes down to your financial goals.
Retirement Savings
When you are in your 30s and 40s, saving into a 401(k) or similar retirement account can feel as though money is lost. Knowing part of your paycheck “cannot be touched” for decades to come is close to pretending it was never there in the first place. To some degree, it is a healthy discipline, but how do you know when you are contributing too much?
One of my favorite metrics to track is a client’s savings rate. In the simplest terms, the savings rate is simply the annual savings divided by annual income. This could be broken up into a retirement savings rate specifically, if you want to exclude 529s, brokerage accounts, HSAs, or other contributions. But generally, the total savings rate is helpful to know as well.
The percentage of one’s income that is going towards retirement savings can indicate a few things. First, a higher savings rate generally means more disposable cash flow. There are certainly people who make a lot and cannot save, but those with higher incomes tend to save more than those with lower incomes. People with a lower savings rate generally cannot easily raise their savings, since they need more of their income to cover living expenses.
When to Decrease Your Savings
Decreasing your savings, at least retirement savings, may be more of a question about goals than statistics. A business owner who never plans to retire or a military veteran with a massive pension may truly have no need for 6- or 7-figure retirement accounts. Understanding how much is roughly required for your retirement plan can help you determine if you can decrease your savings.
When we meet with clients, we calculate and estimate the amount of assets they need to have at retirement to live on their desired annual income. After taking in all the other sources of income, their retirement goals, and living expenses, we can estimate a single “financial independence” or “nest egg” number for retirement. Then, we show how much they will have at that age, given how much they are saving today.
Assuming you maintain the same savings rate until retirement, if the estimated asset level exceeds the projected needs, then you may not need to keep saving as much. There is room to move some savings from your 401(k) to other goals, such as a 529 for your kids’ college, or a brokerage account for a new home.
When to Increase Your Savings
Alternatively, if the estimated asset level is below your projected needs, then that is a perfect case to increase your retirement contributions or overall savings rate. This doesn’t have to be negative, however. It could be the case for you that the difference between retiring at 65 and 60 is an extra few thousand in savings each year.
There are generally two ways to increase your savings. Either one, make more income, or two, reduce your expenses. It is the age-old personal and business finance principle. If the goal is to increase your savings rate (for anything, not just retirement), start here.
There is a more advanced case for increasing your savings, however, and it is more of a tax argument than anything. Even if you do not need to save another dime, saving into qualified plans like a 401(k), 403b, ESPP, ESOP, 457, etc., can provide a tax deduction to lower your taxes. HSAs and 529s (in some states) can have similar benefits. Even though you may not need the savings, it could be worth maxing these accounts to save more on taxes.
Savings Can Change
Savings are meant to help prepare you for the future. There is no reason that you must save indefinitely for the sake of saving. All cash flow and money should be directed towards a specific purpose. If your retirement savings are ahead of schedule, don’t be afraid to cut them back and focus on a new savings goal. If you are behind schedule, work towards increasing savings over time to get to where you want to go.
TC Falkner 