In part one we discussed the basics of the Roth IRA and my thoughts on using this vehicle as one of the main investment tools in your arsenal. Today, I would like to describe how I plan on using my Roth during my retirement. Before I discuss this though, let me set up an example of a retirement fund that may be typical for most people that are using a Roth.
In this example I will use what I think should be an average income and savings for today’s families. According to the Department of Numbers the real median family income was $65,910 in 2014. These are the most recent data points that I can find as of today.
I have suggested saving 15% for retirement in past posts. The first step in achieving this is making a minimal investment in the employer supported investment plan (401k, 403b, etc), just enough to achieve the sponsored match. Anything left over from this 15% pool should go toward a Roth IRA until this is maxed out and any remaining funds plugged back into the employer fund until this is maximized as well. Lets look at an example of how this works.
Any number of online investment calculators can be used to determine what the current and future investments may be worth upon retirement. I just happen to like this one. You can plug in your specific data, but for this example we will assume a 35 year old (we’ll call him Jim) that is making the average median family income as mentioned above ($65,910). Remember 15% is the goal while applying the minimum to get the employer match and maximizing your Roth IRA. We will also assume an average nest egg to this point of $50,000 split 50/50 between the 401k and the Roth.
Considering this, 15% would equate to $9,886, roughly per year. Since we have decided to max out the Roth each year, our investments will look like this:
$5,500 yearly contribution
$4,386 yearly contribution + Employer match of 3% ($1,977) = $6,363 yearly contribution.
Before we go any further we must take a few things into account:
1. I understand there is some discrepancy due to the fact that the 401k contribution is pre tax and the Roth is post tax, so the 15% savings, may be off a bit, but for this example we are close enough.
2. I can also appreciate that this example does not include any annual merit raises nor does it account for inflation or taxes, which may be significant in some cases.
Now back to the good stuff. Since we have determined that Jim is 35, lets assume a balance of 32 years to reach full retirement age of 67 (2045). You can add or subtract as many years as applicable to your situation.
Lets also assume an 8% annual return rate, to be conservative. We all know by now the average return for the S & P 500 has been closer to 10%. When the calculations are complete, I would also run the numbers for a 6% return as well as a 10% return, you never know what the future holds. I say plan for 6% and hope for 10%.
What did you come up with? This lucky guy will end up with:
401k 32 year plan: $ 929,180
401k 42 year plan worth: $2,624,700 (Only 32 years of contributions however)
Roth 32 year plan: $1,090,075
I also calculated a 42 year 401k plan of investment total with a 32 year contribution. Why? I’ll explain.
I’m assuming by the time this person retires, the mortgage will be paid off as will most, if not all, of their major purchases (cars, loans, children’s education, etc.) Generally speaking those entering retirement should be financially secure enough to plan on spending their money on daily living and enjoying life (traveling, golf, hobbies, etc.) and not worried about a loan payment that is due, but things happen so plot your data as you anticipate your retirement will go.
Using the Social Security Quick Calculator we see that Jim, will likely receive $5,656 in monthly benefits upon retirement. This is based on future dollar expectation. There have been multiple research studies that show a safe retirement withdrawal rate should be estimated at 4% to improve the odds that someone does not outlive their money. In fact Rob Berger wrote a really nice piece explaining the 4% rule, take a look here.
At the time of Jim’s retirement he will have an investment worth at least 2 million dollars (32 year Roth and 401k combined). An annual distribution of 4% would be in the sum of $80,770 a year, or $6,730 a month.
Finally I am getting to my point, my Roth plan for retirement. Considering the monthly social security income of $5,656 + $6,730 coming from retirement savings, this will give Jim a little over $12,000 a month to live on. Remember these are future dollars, so $12,000 may seem like a lot now, but in 30+ years, this may likely be a modest living. If Jim were to withdraw from his Roth IRA exclusively (no tax liability) and leave his 401k to continue to grow, his Roth should last at least 13.5 years ($1,090,000 / $6,730). What this means is Jim can use his Roth money and allow his taxable income grow untouched for another 10 years, at least.
Remember the 42 year 401k calculation above? This is calculated because the expectation is to live off of the Roth and Social Security for the first 10+ years of retirement. Allowing the 401k to continue to mature, it will grow almost 1.7 million dollars during the time (10 years) the retiree is collecting money from Social Security and the Roth account, without any additional input. This is the true power of compounding.
I don’t know about you, but this makes me want to run out and make another deposit to my Roth account! I have tried to be as conservative as I can with this example, otherwise what is the point, this would be dreaming and not investing.
The really good news regarding this particular plan for the Roth is that it only gets better as I did not account for annual salary increases, nor did I account for catch up investments to the Roth (additional $1,000 a year for this over 50) contributions. I would suspect this retiree will be much better off after these factors are entered into the equation., maybe by as much as 10% – 20% or more.
Hopefully I didn’t confuse everyone with my backward thinking, but now you can fully appreciate the benefit of the Roth IRA as I do.