aside, any rule of thumb should be taken with a proverbial grain of salt. Your withdrawal rate, for example, should be personalized to your situation and reviewed periodically to account for environmental factors, such as market returns and inflation.)
Fortunately, there are many ways to accumulate a nest egg for retirement. And today's savers have some rewards that their great-grandparents would have envied. Employer-sponsored retirement plans and Individual Retirement Accounts (IRAs) shelter your investment earnings from current taxes, which makes it much easier to accumulate wealth. With a company retirement plan, your employer may even supplement your savings with matching contributions, in effect giving you a pay raise that will grow and compound over time. The most common workplace plans include 401(k) plans, 403(b)(7) plans, and 457 plans, which are named for sections of the tax code that established them. You can also invest for your retirement by setting up an IRA with an investment provider.
Your retirement savings bucket may be the biggest bucket you need to fill, but it also may be the easiest of the buckets to fill as long as you get an early start. If you start in your early 20s, building a retirement nest egg is more a matter of saving than investing. Time and the compounding of your investments will be bigger factors in your success.
Here's a piece of advice: If you have a 401(k) or other retirement plan at work that lets you have savings automatically withheld from your paycheck, go for it. Contribute as much as the plan permits. If you can't make the maximum contribution, at least contribute enough to receive the full matching amount that your employer contributes, assuming that your employer offers a matching contribution. Then make it your goal to make the maximum contribution as quickly as you can.
Portfolio Pitfall: Be Alert to Low Default Rates
Many employers will automatically enroll you in the company 401(k), which is a good thing, since inertia precludes some individuals from signing up on their own. Automatic enrollments get workers in plans and help them begin saving at the outset of employment. However, many employers will automatically set your contribution rate at 3%, which is a bad thing. Nearly 40% of Vanguard plans have a default rate for contributions at 3%, which I believe is too low. You should set your sights on saving 10%–12%. Add to that the typical 3% match from your employer, and you are putting away a healthy 13%–15% of your take-home pay into a tax-advantaged account. If you join a company that features a 401(k) plan, be sure to check the default rate and increase it if necessary—even if the plan offers an auto-escalation feature that increases your savings rate each year.
Here's a strategy I frequently recommend as a very easy way to build a retirement program, and I'll use one of my colleagues, Jane, to demonstrate. When Jane began working at Vanguard, she contributed to the 401(k) plan at a level to receive the company matching contribution. Then, she gradually increased her savings rate by funneling an amount equivalent to half of each annual salary raise into her 401(k) until she reached the maximum allowable contribution. (Jane believed she could do this because her living costs hadn't increased just because she'd received a raise. Most people should take the same point of view.) By continuing to pump money into her retirement plan at that level, Jane accumulated an impressive sum of money over her 30-year career. It takes discipline not to use all of that salary increase for immediate gratification, but in time you won't miss that “extra” money and will be better served in the long run by earmarking it for retirement.
There are three great advantages to saving through an employer plan. First, your contributions will accumulate on a tax-advantaged basis. Second, the process keeps you saving without any effort of your own. You don't have to make yourself transfer money or write any checks, and you won't be tempted to spend the money before “paying yourself” first. Third, you will be investing a regular amount on a regular basis, a prudent and effective strategy known as dollar-cost averaging. (I'll discuss this strategy several times throughout the book.)
Plenty of ordinary people are saving an unbelievable amount of money through employer-sponsored retirement plans. In the 401(k) plans managed by Vanguard in 2019, there are more than 62,000 individuals who are millionaires. And thousands of other ordinary people are on the way to amassing extraordinary wealth.
Baseline Basics: Accounts for Retirement Investing
There are numerous retirement-oriented accounts to help achieve your investing goals. Similar to college savings programs, there are pros and cons associated with the various options, along with rules that may limit their use and availability. I will cover the two mainstays—IRAs and 401(k) plans—at a high level. However, you may have other options available to you depending on your employment status. For instance, if you work for a non-profit institution, such as a hospital or university, a 403(b)(7) plan may be an option. If you are self-employed, you'll have your pick of a SEP IRA, Simple IRA, or individual 401(k) plan.
Individual Retirement Accounts. IRAs enable you to invest on a tax-advantaged basis for retirement. With a traditional IRA, you may be able to deduct some or all of your contribution from your current income taxes depending on your income. Once you start taking withdrawals, they are taxed as regular income. Note that you'll be required to take distributions as some point in your early 70s. Roth IRA contributions are not tax deductible, but your withdrawals in retirement will be completely tax-free and you will not face required minimum distributions. Your income, however, may limit your ability to contribute to a Roth IRA.You can establish an IRA at a bank, brokerage firm, or mutual fund provider and, therefore, have many investment options from which to choose. You can contribute up to $6,000 a year ($7,000 if over 50 years of age) in 2021 to a traditional IRA, a Roth IRA, or a combination of the two. For most people, though, the Roth IRA is the better bet because of the tax-free withdrawals in retirement.
401(k) plans. If you work for a company, it is likely that a 401(k) will be among the benefits you receive as an employee. Like an IRA, you'll be able to sock away money on a pre-tax basis, which will then grow on a tax-advantaged basis. When you start to withdraw the money in retirement, it will be taxed at your then-current rate. With a Roth 401(k), your contributions are made with after-tax dollars and your account grows tax-advantaged. When it comes time to tap your account in retirement, your withdrawals won't be taxed. You can invest up to $19,500 in a 401(k) plan in 2021. You can kick in another $6,500 if over the age of 50.If you are fortunate, your employer will offer a matching contribution up to a certain level. For instance, you might receive a full match of your contributions up to 4% of your take-home pay. A good 401(k) plan will also offer you a full menu of low-cost funds from which to assemble a portfolio.
Your Debt Plan
So far, I've been discussing how to manage the assets on your personal balance sheet. Now let's think about liabilities—the debts you owe in the form of credit card bills, car payments, mortgage payments, and so on. Part of a sound financial plan includes developing a philosophy on debt. My philosophy can be summed up with a simple proverb: “Loans and debts make worry and frets.”
I've long had a strong aversion to debt. My wife and I started our life together with sizable loans from graduate school and no tangible assets other than a 10-year-old Volkswagen Rabbit. I loathed writing those loan payment checks every month throughout the early 1980s, especially because of the relatively high interest rates that existed at the time. As a result of that experience, my wife and I resolved to avoid debt whenever possible. Not everyone feels as strongly about debt as I do, but even if you don't, you should give serious consideration to several debt issues.
With debt, I recommend borrowing only for long-lived assets. An education serves you throughout your life, so college loans are okay, or “good debt.” A house will last a long time, so mortgage loans are necessary and sensible. You will also be building equity in your home. That said, be cautious about home-equity
