Save your way to a dream retirement

Putting away as much as you possibly can is the best way to ensure your security in your golden years.

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By Walter Updegrave, Money Magazine senior editor

Walter Updegrave is a senior editor with Money Magazine and is the author of "How to Retire Rich in a Totally Changed World: Why You're Not in Kansas Anymore" (Three Rivers Press 2005).

NEW YORK (Money) -- Question: I'm 25 and currently contribute 8% of my salary to my 401(k) since that percentage assures I get the full employer match. But since stocks are so cheap right now, I'm considering bumping up my contribution for a few months. I won't miss the extra amount coming out of my paycheck, so do you think I should go through with this plan? --Mike, Houston, Texas

Answer: I think upping your 401(k) contribution is a wonderful idea, regardless of whether stocks are actually cheap.

My question, though, is why boost it for just a few months? If you won't miss the money, why not make the higher contribution permanent?

If the current financial crisis has taught us anything, it's that most of us are simply not saving enough. During the boom years of the '80s and '90s, Americans somehow acquired the mindset that we could borrow and spend our way to prosperity.

It's become painfully clear, however, that such an approach is irresponsible and dangerous. If we want true long-term financial security and a comfortable retirement, we've got to save more diligently than we have over the past two decades.

But the financial crisis and the market meltdown in particular have provided us with another important lesson as well -- namely, that we need a decent cushion in our retirement accounts so that our retirement dreams aren't totally dashed if the market delivers subpar returns or takes a hit just before or during retirement.

And the fact is that saving more during your career is the surest way of creating that cushion.

Here's a quick example. Let's assume someone your age, 25, earns $40,000 a year, receives 3% annual pay raises and contributes 10% of salary (including any employer match) to his 401(k). If that person gets a 9% return on his 401(k) investments each year, he'd end up with about $2 million at age 65.

Assuming a conservative 4% initial withdrawal adjusted annually for inflation, that should be enough to give him a high assurance of receiving about $80,000 a year of real, or inflation-adjusted, income throughout retirement on top of what he might receive from Social Security, pensions and other sources.

But what if his 401(k) investments don't earn 9% a year? Well, if his 401(k) returns 7% instead of 9%, his balance at retirement would drop to roughly $1.2 million. Assuming the same 4% inflation-adjusted withdrawal, that would be enough to generate about $48,000 a year in real retirement income -- about 40% less. As you can imagine, a reduction of that size would require quite an adjustment in one's retirement lifestyle.

Assuming you're pursuing a reasonable investment strategy, there's little you can do to appreciably increase your 401(k)'s return. Unless you want to ratchet up risk and increase the danger of your investments flaming out, you pretty much have to work with the returns the financial markets deliver.

Build your cushion

But you can offset the effect of lower-than-expected returns by saving more. So, for example, if our 25-year-old contributes 12% of pay instead of 10% throughout his career, he'd end up with about $1.5 million instead of $1.2 million, or an extra $300,000, even assuming the lower 7% annual returns. And if he boosts his contribution to 15% of salary, he would have $1.8 million rather than $1.2 million, or an extra $600,000. That's enough to make a considerable difference in your retirement standard of living.

Increasing your contribution rate can also help in other ways. There may be times when you find yourself out of work and thus unable to save in a 401(k) or other retirement savings plan. By putting more into your 401(k) account when you have the chance, you mitigate the effect of those years when you're not able to contribute.

Similarly, saving more can help bolster your account value should your employer decide to cut or suspend matching contributions, as many are doing now.

And let's not forget the value of having a safety cushion of savings late in your career or even after you've retired. Many people in or near retirement are now re-evaluating their retirement plans because of the big bite the market meltdown has taken out of their 401(k) balances.

Those extra bucks might allow you to go ahead with your retirement plans, even if you have to scale things back a bit. Or you might not have to delay retirement as long as you otherwise would. If you're already retired, the extra savings could mean the difference between big cuts in withdrawals from your account and more manageable ones.

In short, boosting your savings acts as an insurance policy of sorts. It protects you in the event things don't go as planned.

But this is one of those cases where seeing the effect that saving more might have on your particular situation is a lot more convincing that just hearing about it.

So I recommend that you -- and anyone else interested in improving his or her retirement prospects -- go to an online calculator like our Retirement Planner and run the numbers with a variety of different savings rates. If you're closer to retirement and want to see specifically how saving more (as well as other strategies) might affect the amount of retirement income your savings might generate -- and the odds of that income lasting the rest of your life -- check out T. Rowe Price's Retirement Income Calculator.

One final note: I know there are a lot of Roth fans out there and I'm sure that many of them are saying, Hey, if you're already getting the full employer match in your 401(k), why not contribute the extra savings to a Roth IRA?

I believe that having money in both tax-deferred accounts (401(k)s and traditional IRAs) as well as tax-free accounts (Roth IRAs and Roth 401(k)s) is a good way to diversify your tax exposure in retirement. So I'm fine with the strategy of sticking enough in your 401(k) to get the maximum match and then contributing to a Roth IRA, assuming you qualify for one.

But be careful. Without a 401(k)'s automatic payroll deduction, money that's intended for savings sometimes ends up being spent instead. So if you decide to go the 401(k)-plus-Roth IRA route, make sure the extra bucks actually find their way into the Roth.

Because at the end of the day, more important than where you save this extra money is that it actually gets saved. To top of page

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