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As you plan for retirement, your investment allocation is not the only thing that changes as the years pass by.
In fact, the very task of retirement planning evolves over the decades.
Just remember, the sooner you start saving and investing for your future the more flexibility and security you're giving your future self.
Retirement Planning Through the Years
These 3 stages of retirement planning discuss a typical retirement beginning in one's mid-60s as you near eligibility for Social Security and Medicare benefits, with tips for determining an early exit plan from work life.
Phase One – Age 20 to 35 years old:
At this point, retirement is so far in the future that it seems like an almost laughable concept. It may seem ridiculous to you to plan for an event that could be three or more decades in the future.
And you would not be entirely wrong.
It’s probably not worth the mental energy at this phase to try and project what your life in retirement (and its attendant expenses) will look like.
Right now, the basic rules of thumb are good enough for your retirement plan:
- Save about 15% of your gross income…
- …in a low-cost, diversified portfolio…
- …that’s appropriate for your risk tolerance and your risk capacity.
Yes, you can complexify this a bit if you want (debating the merits of Roth versus pre-tax retirement accounts, for example). But honestly, that’s just window dressing for most people at this stage of life.
This rule of thumb originated with seminal 2014 academic research that demonstrated that 15% is the amount necessary to save over the length of a career to replace 70% of working income for a typical middle-income household.
Many assumptions are baked into this figure, but at this retirement planning phase, these assumptions truly and sincerely do not matter very much.
You simply do not have enough information available to you today to know if your retirement experience will be more or less expensive than the average retiree.
If 15% is just too daunting given your current income, start where you can. At a minimum, capture the full employer match if there is one.
Up your contribution by 1% every six months or annually until you reach 15%. (Set a reminder on your phone to do this!) Automate your retirement account contribution and move on with your life.
Your crucial retirement planning task in Phase One is establishing the habit of long-term investing.
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Phase Two – Age 35 to 50:
For sure, continue what you started in Phase One, assuming you have been saving as described above.
If you’ve not been consistently investing, get started right now. If you’re on the upper end of this Phase Two age spectrum, 15% may not be enough to get the job done if you need to make up for lost time.
A simple online retirement calculator is all that’s required to determine if you need to save more aggressively. This easy-to-use and visually attractive calculator from Nerd Wallet is one of my favorites.
Another approach to gauge your progress – derived from the same research cited above – is the multiples of income approach. By this metric, you should have saved at least 1x your current annual income by age 30, 3x by age 40, and 6x by age 50.
Again, some inherent assumptions may not apply to your personal situation. However, this metric may be all you need at this stage to know if you should bring more attention to this area of your financial life.
The more interesting part of your retirement planning in this phase comes from the fact that by now, you’ve accumulated enough working and life experience such that you may be starting to form broad, over-arching ideas about your retirement.
Most importantly, will you want to retire earlier than the traditional mid-60s age?
If so, this is when you need to think of your retirement savings as two buckets:
- tax-advantaged savings that you will not access until age 59 ½ (when you can tap into your retirement accounts without penalty), and
- non-qualified savings you can tap into earlier
If you have a specific early retirement age in mind, calculate the gap: multiply the number of years you’ll spend in early retirement by your desired annual income. (Don’t forget to calculate an adjustment for inflation.)
A very simplistic savings calculator, such as this one, is good enough for today’s purpose: a rough-and-ready estimate of your “early exit” nest egg and how much you need to devote each month to achieve this specific goal.
However, it’s more likely you have only a vague idea that a significant lifestyle and/or employment change sometime before the age of 59 ½ would be welcome. Past that, your ideas are very much unformed.
In that case, consider directing a percentage of your retirement savings to a non-retirement investment account, giving you the flexibility to take this option in the future if you decide to do so.
Don’t overthink this; just do it. The worst case scenario is that you decide not to tap into this account pre-59 ½ years old, and you’ve paid for this flexibility with lost tax benefits.
Your key retirement planning task in Phase Two is planning for flexibility.
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Phase Three – Age 50 to 65:
This is the cusp of retirement, and your vision of what retirement means is starting to focus.
That said, don’t feel bad if you haven’t figured it out yet; if you’ve been saving all along, you have the flexibility to do whatever you decide, when you decide.
Of course, task number one is to re-check that the amount you have saved (and will continue to accumulate) is enough to meet your needs.
At this age, you should have a better grasp of what those needs, and the associated costs, really are.
The same retirement calculator from Phase Two can serve you well here.
The difference is that you should now be able to bring much more realistic and accurate inputs to the computation:
- Social Security. Download your Estimated Benefits Statement to determine how much income you can expect from this source.
- Health care expenses. According to recent research, an individual can expect to spend up to $165,000 in out-of-pocket medical expenses throughout a typical 20-year retirement. Of course, you need not have that entire sum at the ready on Day One.
- Long term care. This is the planning phase during which you must decide how to meet the possible cost of long term care. Whether you choose to purchase long term care insurance or self-insure, a deliberate choice must be made.
- If not, you may find yourself in a dire circumstance with few good options. This decision must be part of your financial retirement calculation.
And because spending in retirement is way more complex than saving for retirement, during this phase, you will begin to start considering how to position your investment assets for distribution:
- Taxable versus non-taxable income. If all your retirement investment is in a traditional, tax-deferred account, this could have unwelcome consequences when the time comes to start spending down your savings.
- This pre-retirement phase is the time to carefully consider the tax effects of your retirement income stream and, if necessary, re-align the tax treatment of your past and/or future contributions.
- Sequence of returns. When you’re accumulating savings, you can be rather indifferent to yearly fluctuations in market performance. But when withdrawing from your savings, poor returns in the early years can impact your nest egg’s lifespan.
- You may need to reallocate your investment portfolio for distribution during this phase.
This is easily the most complex phase of retirement planning. Bringing in a professional to help you consider all your options can be an excellent move if it feels overwhelming.
Your essential retirement planning task in Phase Three is conducting research to enable informed decision-making.
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Article written by Lisa Whitley, AFC®, CRPC®.
Lisa enjoys having money conversations every day with people from all backgrounds. After a long career in international development, she brings a cross-cultural dynamic to her current work to help individuals and families achieve financial wellness.