Wealth Watch: Rules for a Rich Retirement

Photograph by Cheryl Maeder/Gallery Stock Close

Photograph by Cheryl Maeder/Gallery Stock

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Photograph by Cheryl Maeder/Gallery Stock

"Why'd you have to go and make things so complicated?"

Pop star Avril Lavigne had a point when she sang those words in her 2002 hit, and not just about romance. From paying taxes and buying homes to pricing health care, needless complexity makes us miserable. Unfortunately, that means guidance from financial advisers and newsletters can sound wishy-washy, since the devil can be in the (boring, lengthy) details. What's the strategy to take? "It depends," we say -- often sowing more confusion than clarity.

No wonder that, when quizzed, so many Americans score themselves as financially illiterate.

The last decade has called into question long-standing assumptions about the performance of markets. Remember when homebuyers were told that home prices would always go up?

Against this backdrop, maybe what we need are a few clear, simple guidelines. While generalizing can be dangerous, there are a few good rules of thumb:

1. If possible, save about 15 percent of your income for retirement.

The Center for Retirement Research ran the numbers: If you start saving 15 percent of your income at age 25, you should be able to retire at age 65. That assumes a somewhat conservative 4 percent annual rate of return on your investments, and it assumes retirees will want to replace 80 percent of their pre-retirement income. It also assumes Social Security continues to exist.

If you retire early or start saving later, you'll need to save more -- in some cases dramatically more. If you don't start saving until age 45, you'd need to set aside 65 percent of your salary to retire by age 62 -- hardly a realistic expectation. Then again, if you retire at 70 (and somehow manage to be employed until then -- but that's another story), you'd need to put away a less alarming, though still substantial, 18 percent of your salary.

Remember: A goal of 15 percent is much easier if your employer matches some of your 401(k) contributions.

2. Except in rare cases, a Roth 401(k) or individual retirement account (IRA) is a wiser long-term choice than a traditional one.

Traditional retirement savings plans allow you to sock away money before you're taxed on it. You only pay taxes when you withdraw the money in retirement, when all your withdrawals are taxed as income. With a Roth 401(k) or Roth IRA, you put money away that you've already paid taxes on. All subsequent gains aren't taxed.

For most Americans, the choice is a no-brainer, says Stuart Ritter, a financial planner at T. Rowe Price. "The Roth gives you more spendable income in retirement," he says. Roth contributions make sense for everyone except those over the age of 50 who expect their tax bracket to fall significantly in retirement, he adds. Even those older savers may benefit from "tax diversification" by making sure they can draw on tax-free Roth money in retirement when needed.

The tax law passed in early January makes it easier for Americans to convert traditional 401(k) assets into Roth accounts. So is it right for you? Whether it makes sense or not rests in large part on your cash flow and what your spending and saving priorities are (college tuition, anyone?). Converting a regular 401(k) into a Roth usually requires paying a big tax bill, Ritter notes.

In other words -- it depends.

This essay originally appeared in Bloomberg.com's weekly personal finance newsletter, Wealth Watch. Sign up here.

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