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How to budget for retirement: The full breakdown

At a glance:

  • Small changes can add up to big savings

  • How retirement plans help you save on taxes

  • Paying yourself first can make a big impact

  • Building a budget for retirement

  • Summary of budgeting for retirement

  • Practical ideas you can start with today

If you want to save a big nest egg for your later years, you need to budget for it.

That means taking money out of your paychecks to fund your retirement.

Small changes can add up to big savings

Building wealth is a daunting task for many because they see it as looking up a tall mountain and thinking it's too high to climb.

But the truth is, even putting aside small amounts can add up to something big. Small, periodic expenses on discretionary items like coffee, candy, and fast food (and the sales taxes on them) can add up to a lot.

If those expenses were saved and put into an account that earns interest, dividends, or capital gains, the results over time could be substantial.

Learn more about the risks of investing. Investing involves risks, including fluctuation in value and possible loss of principal. Generally, greater volatility means greater risk.

No investment provides guaranteed returns. You should consider your risk tolerance, investment horizon, liquidity, and other personal factors before purchasing any investment product.

What it means

This need not mean that you must deprive yourself of the little things in life.

Rather, it is just an example; it means to look closely at your spending by tracking it for a while, see where you are leaking money needlessly, and make changes to your spending.

Many an investor has built wealth by doing just that — all without suffering much deprivation in the process. It's about full awareness of where your money is going.

The next step is diverting these small amounts into savings or investments where they can grow in value or earn interest, capital gains, or dividends. With compounding, the earnings can add up even faster.

In fact, for many people the lost earnings are the biggest casualty of not saving and investing more.

Think of it as a starting point

Saving small amounts here and there is not what investing is about.

Rather, saving small amounts here and there is one starting point for gaining the discipline to control your spending.

A good way to find out where you can make changes is to track your expenses for a month. Record every single penny spent. Check any online bank accounts to see if withdrawals are being made that you are unaware of.

Most people are surprised to find expenses they can cut out — without depriving themselves of the little things in life.

The drive to save is much stronger when you first establish a goal that you want to work for — retirement, a house, a small business, a hobby item, etc.

How much can you save by making small changes to your spending?

So-called "latte factor calculators" that you can find online let you plug in the numbers.

For example, spending $3 every other day over the course of 10 years could instead become over $7,200 if put into an account earning 6% interest (compounded annually).

In this photo taken Monday, Nov. 4, 2019, barista Porter Hahn makes an iced coffee drink for a customer in a coffee shop in Seattle. (AP Photo/Elaine Thompson)
In this photo taken Monday, Nov. 4, 2019, barista Porter Hahn makes an iced coffee drink for a customer in a coffee shop in Seattle. (AP Photo/Elaine Thompson)

This figure includes over $1,700 worth of interest alone. Is what you are spending money on periodically worth losing all this potential interest?

Of course, interest rates change, prices change, spending habits change, and time periods change. You probably cannot predict with certainty the amount that you will save, but you can see that small changes do indeed add up. That's the point.

And you can still splurge on your favorite things (more so once you have built up a good savings), but you may need to scale it back or cut out other expenses.

Going cold turkey could backfire and prompt you to binge-spend at inopportune moments.

How retirement plans help you save on taxes

Besides helping you build income for your retirement, retirement plans may offer the added benefit of reducing the effects of taxes.

Many retirement plans have potential to build tax-deferred value, and some allow you to reduce your taxes on current income as well, by offering tax deductible contributions.

What is tax deferral?

"Tax-deferred" means that any earnings that build up in your plan are not taxed currently, as in other kinds of investments. Your earnings are free from taxation while they are in the plan.

Once you draw them out, either at retirement or before, your earnings from these plans may be subject to taxes.

Even though you may have to pay taxes on your retirement plan earnings when you take them out, you may still pay less than if you had that income taxed as it was being earned.

This is because you may have lower income in retirement, which may place you in a lower tax bracket.

You can contribute on a pre-tax basis

In addition to savings from tax deferral, some employer-sponsored plans allow you to contribute your income pre-tax, so you don't have to pay taxes on the money you contribute today (at least, not until you take the money out).

With some non-employer-sponsored plans, your contributions can be taken as deductions from your income for tax purposes.

There is a price to be paid for all this tax freedom, however. With most plans, any money you take out prior to retirement (age 59½ for IRA plans, age 55 with separation of service for most employer plans) can be subject to a 10% federal tax penalty in addition to being taxed.

There are also limitations to how much you can contribute to some plans, based on your income or employment status.

Paying yourself first can make a big impact

If you're like many people, you want to save money for yourself, but when it comes time to set aside money from your paycheck, you find that there's nothing left over.

You've paid the rent, the bills, and the leisure. And that makes it impossible to save.

So why not pay yourself first rather than last?

What does it mean to pay yourself first?

Paying yourself first means setting aside money for savings before you pay any of your bills or other expenses. In other words, the first "bill" you pay each month should be to yourself.

This forces some discipline onto your spending. You may find that you have to rethink your money priorities. You may have to do without some things, or at least change how you do them.

Paying yourself is about making regular and consistent contributions toward some kind of goal, such as retirement. Although some might see it as a kind of deprivation, it is more about freeing yourself so you can afford other opportunities in life. To pay yourself first is to make yourself more important than your bills.

And it's not about being selfish — as your wealth grows, you will find yourself in a better position to help others.

An example

Just how much can you build by paying yourself first? It varies. Here's an example: saving $20 a month and depositing it monthly for five years at 2% will yield about $1,262.

Taking out $20 a month as a 28-year-old and putting it into an account earning 5% per year will grow to over $24,000 by age 65. Can you afford to forego $20 a month for this? The point here is that putting away even small amounts should add up over time.

The earlier you start, the more it will likely grow. Every little bit helps.

And you can increase your contributions as you grow older and more disciplined, and you can choose investments that have the potential to grow more than 5%.

And remember: Investing involves risks, including fluctuation in value and possible loss of principal.

No investment provides guaranteed returns. You should consider your risk tolerance, investment horizon, liquidity, and other personal factors before purchasing any investment product.

How it relates to retirement

Paying yourself first is important to retirement planning because you will need to save regularly over the course of many years. You want to make it a habit.

If your employer offers a retirement plan, you can enroll in it and contribute regularly; if it matches your contributions, that's like getting free money.

How to do it

The most painless way to pay yourself first is to set up an automatic savings program.

You'll never know it's gone, and you'll adjust accordingly. Consider having regularly scheduled withdrawals made from an existing account (e.g., the checking account where your paycheck is deposited) and transferred into a retirement account.

Generally, any financial services institution that offers savings or investment accounts will offer an automatic savings plan. Most retirement accounts will have the option to link to your savings or checking account to withdraw funds regularly.

If you find that you can't make ends meet by paying yourself first, look for expenses you can cut or find ways to raise the needed money. An honest and thorough look at your spending should provide some clues.

Building a budget for retirement

Like budgeting for a car, a home, or some other expense, you may need to budget for retirement.

That's why it helps to treat your contributions to your retirement accounts as expenses that must be paid. Including them in your budget gives them a priority and prompts you to treat them with importance.

About budgeting

The key to a successful financial plan is managing one's cash flow. Did you ever meet someone who complained, "There is too much month left at the end of the money"?

This can happen more often than one thinks. In fact, it is quite a normal occurrence, even for those in good financial shape.

Why it's easy to fall into debt

Here is why. Most persons have a steady stream of income each month, but their expenses may vary so much that some months have more expenses than inflows from income.

This is usually not a problem, because on those months when the income exceeds expenses, the excess income goes into savings that can be used later when expenses exceed monthly income.

It only becomes a problem when monthly expenses exceed monthly income so often that there are not sufficient savings to provide for the difference. When that happens, one is forced to borrow money to balance the inflows and outflows.

This leads to increased expenses, because the cost of borrowing money itself (interest) increases monthly expenses.

The key to a successful financial plan is managing one's cash flow. (Graphic: Hannah Smart/Cashay)
The key to a successful financial plan is managing one's cash flow. (Graphic: Hannah Smart/Cashay)

To stay out of debt, you must economize

To avoid this, one must economize. Economizing is merely determining how much one can spend on each expense item so that the expenses do not exceed income over time.

Since "income" is the limiting component, one economizes by incurring expenses based upon the amount of income one expects to receive over time. If you had an expectation of $50,000 of income over the next 12 months, you couldn't very well plan to spend $75,000. That just doesn't make sense.

On the other hand, if you had an expectation of $50,000 of income per year for the next three years, and you wanted to spend $75,000 this year and only $37,500 per year (including interest on the borrowed $25,000) for the following two years, that would make sense, because the inflows from income would balance the outflows.

If, instead, you spent only $37,500 per year for two years, you could spend $75,000 in the third year without incurring any interest charges — in fact, you would probably have earned interest on the unspent income for the first two years.

One must economize. (Photo: Getty Images)
One must economize. (Photo: Getty Images)

Plan your expenses to match your inflows from income

Economizing means planning your expenses to match your inflows from income over time. The key to successful economizing is in setting goals and putting them in order. One can usually predict future income fairly accurately. It's the expenses that pose a problem.

Some expenses are just not discretionary. But judge carefully. True, one must have a place to live, but how much one spends depends upon one's goals and priorities. One must buy clothing, but how much one spends depends upon one's goals and priorities.

You can make a successful cash-flow management plan by projecting your expenses based upon your short-term, intermediate-term, and long-term income expectations, as well as on your goals and priorities.

Summary of budgeting for retirement

A sound budget is key to successfully saving for retirement.

Becoming aware of your expenses, keeping them in line with your income, and paying yourself first will help you build that nest egg for your later years. Once you have started budgeting, you are on your way to achieving your retirement potential.

If you use an automatic savings plan, you can save yourself a lot of time and effort. This will help you "pay yourself first" and help address worries about not saving enough for retirement.

Practical ideas you can start with today

  • Track all my expenses for a month to see where I can cut costs.

  • Calculate how much I will need to save for retirement.

  • Pay myself first by withholding a chosen amount from each paycheck and putting it into savings. Start with an emergency fund.

  • Set up an automatic savings plan(s) at my financial institution.

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

Read more information and tips in our Retirement planning section

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