Dear Carrie: How much should one save as a percentage of their income? Ten? Fifteen? Twenty? -- A Reader
Dear Reader: Thank you for focusing on one of the simplest -- but most important -- questions in financial planning. Many of us are much more interested in discussing esoteric investments, but at the end of the day, the amount of money you save will likely have an even bigger impact on your success.
A comfortable, financially secure retirement is certainly the biggest challenge for most of us. I'll devote most of my answer to that critical issue, but I will review some other common savings goals as well.
Of course, like so many personal finance questions, there's no single correct answer that works for everyone. You can find all kinds of calculators and tools online to help you figure out how much money you'll ultimately need for retirement. But the following guidelines can be helpful.
Also, understand that the experts who did the math for us made some assumptions. For example, they assume that you'll need about 80 percent of your pre-retirement, pre-tax income, and that your retirement will last about 30 years. They are also assuming that you will keep working (and saving) until that time. And they suppose that you have no current savings at all -- that you're starting from scratch.
The bottom line? As you might guess, the younger you are, the less you have to save as a percentage of current income. And the differences are pretty dramatic:
-- If you're getting started in your 20s: Save 10 percent to 15 percent of your pre-tax income.
-- If you're getting started in your 30s: Save 15 percent to 25 percent of your pre-tax income.
-- If you're in your early 40s: You'll need to save 25 percent to 35 percent of your pre-tax income to ensure a comfortable retirement, which is starting to be a meaningful chunk of your income.
-- And if you're 45 or older: Well, now the percentages start to get big quickly. A 46-year-old, for example, will need to save about 40 percent of pre-tax income; someone over 50 who is just starting to save will need to set aside about 60 percent of pre-tax income.
The real beauty of these guidelines (especially if you're still young) is that the percentages won't change as you get older. If you're 25 and can save 15 percent of your income for retirement, you probably won't need to save more than 15 percent as you age. Starting early is a huge advantage, thanks mostly to that investing miracle: compound returns.
Of course, saving 15 percent of your pre-tax income when you're 25 is not easy. Young adults are typically just getting going in their careers -- with salaries to match. They might have student loans to pay off. And some young people simply find it difficult to put money away for a goal like retirement that seems impossibly far into the future. But the numbers don't lie: Retirement is a hugely expensive challenge, and the earlier you start investing for it, the better.
The easiest way to save is to arrange an automatic transfer to your savings or investment account each month; that way, you won't have to consciously make the "save or spend" decision each month. A payroll deduction plan is ideal, especially if it goes into a tax-advantaged plan like a 401(k) or an IRA account. Your 401(k) plan contributions are often matched to some degree by your employer, which makes your effective savings rate even higher.
These guidelines should put you in good shape for retirement, but people have plenty of other savings goals, too:
-- Emergency fund: If you don't have a cash cushion, another goal should be to put away three to six months worth of cash in something very liquid and very safe just in case something unforeseen happens.
-- A child's education: If you have kids, saving for college is an excellent idea -- the earlier the better. Use a 529 plan to shelter investment gains and income from taxes. The amount you need to save will depend on your income and the type of college (public or private) you envision.
-- The down payment on a house: A more near-term goal for many people is buying a home of their own. If you've started saving for retirement and you've built an emergency fund, you'll probably just want to save as much as you can afford (on top of saving for your retirement and other goals) to buy your own home.
To recap: Let your goals determine your savings habits. Most of us have multiple savings "buckets," with retirement being the highest priority.
Finally, remember that "saving" in today's world really means investing. For longer-term goals, you'll likely need to tap the potential of the financial markets (particularly the equity markets) to give your savings the chance to grow into wealth. Best of luck!