Saving, like regular flossing, is good for us.
We know that. The hard part is doing it.
So lets examine an aspect of saving that is seldom discussed: saving, in itself, makes meeting your retirement goals easier. Note that I have not mentioned where you invest the money, the return it earns, or any of the usual worries.
Saving makes meeting your retirement goals easier because every dollar not spent on consumption is a dollar that doesn’t have to be replaced at retirement. Here’s the math:
- If you spent 100 percent of your income and saved nothing, your standard of living would decline in retirement unless you replaced 100 percent of your income.
- If you save 10 percent of your income, you only need to replace 90 percent of your income at retirement.
- If you save 20 percent of your income, you only need to replace 80 percent of your income at retirement.
Basically, every dollar of savings does double duty. First it is put aside for saving. Second, it is no longer spending that must be replaced.
Some readers will think this subject is too obvious to write about. You would be surprised, however, at the number of people who overlook this relationship.
Now let’s work through the numbers.
Step 1: Social Security. If you are an employee, the employment tax takes 7.65 percent off the top. While this isn’t a real savings program, it functions like one. Income not spent on consumption today is the basis for promised income in the future. For the 94[i] percent of all workers who earn less than the Social Security wage base maximum ($87,000 for 2003), Social Security benefits will replace at least 25 percent of pre-retirement earnings.
If the worker is married, his or her non-working spouse will be eligible for a benefit equal to about half of the workers’. Combined, Social Security will replace about 37.5[ii] percent of pre-retirement earnings for a top income worker, more for a worker with less income.
Now the math. After adjusting for the employment tax, the amount of income that needs to be replaced is 92.35 percent. For most people, Social Security benefits will replace at least 37.5 percent of pre-retirement gross earnings. (The Social Security benefits schedule replaces far more income for lower income workers than high-income workers.)
Net result: without a dime of conventional saving, your “retirement income gap” isn’t 100 percent of income. It’s 54.85 percent (92.35 minus 37.50)— probably less.
Step 2: Debt Pay Down. Here’s the ‘upside’ of consumer debt. At age 50 most people still have some debt. For this example we’ll assume no debt other than a home mortgage equal to two years of income. Treated as a 15-year mortgage, the payment would be equal to 9.8[iii] percent of the amount outstanding. That’s 19.6 percent of annual income.
Since the mortgage payments reduce current spending on consumption but don’t have to be continued at retirement, the debt reduces the amount of income to be replaced by 19.6 percent. We know from step 1 that most people only need to replace 54.85 percent of income after Social Security is considered.
So a simple debt repayment program reduces the amount of income that needs to be replaced to 35.25 percent (54.85 minus 19.6). Note that we haven’t put aside a dime of conventional savings— we’ve ‘saved’ by paying off existing debt.
Step 3: Investment Savings. This step is real saving. Every dollar saved today reduces your needed income in the future. Minimal participation in a typical 401(k) plan— enough to capture the employer match— would have you saving 6 percent of gross income. As a result, the amount of income that must be replaced at retirement drops to 29.25 percent (35.25 percent minus 6).
Step 4: The ‘Tax Fudge Factor.’ By reducing the amount of income you need to replace, you also reduce your income tax bill. In this example, the federal income tax bill drops from about 14 percent of pre-retirement gross income to about 6 percent[iv]. This reduces the amount of income to be replaced to 21.25 percent (29.25 minus 8)
For most people the benefit from the tax fudge factor will be larger because my calculations assume worse than the worst— 100 percent of Social Security benefits subject to tax.
Now back to step three for a moment. Remember the six percent you were saving? Well, the longer you save that 6 percent, the higher the odds you’ll come up with the money, even in a period of low returns.
The bottom line: the act of saving is as important as the return on savings.
This has been a fairly steady relationship for well over 10 years.
This assumes earner and spouse are the same age. If the non-earning spouse is younger but takes benefits at the same time as the earner, the second benefit check will be actuarially reduced.
This assumes a 5.5 percent interest rate. The example is not dependent on home mortgages. Basically, whatever your current fixed payments are as a percent of income can be included. What is crucial is that all debt service be eliminated by retirement.
This was calculated based on 2002 tax rates on $87,000 of income and assuming the standard deduction and two personal exemptions, after adjusting for a 6 percent 401k contribution. The actual amount of change could decline if we considered itemized deductions. The federal income tax bill on $87,000 for those conditions would be $12,110. The income tax bill on nearly $52,000 of income that needs to be replaced is about $5,100, a tax reduction of $7,000 or 8 percent If you are wondering why I didn’t take itemized deductions into account, there are three reasons. First, this is an approximation exercise. Second, estimated real estate and mortgage interest deductions are just over $13,000, or about $5,300 over the standard deduction. This doesn’t reduce the tax calculation very much. Third, the standard deduction is indexed to inflation while the interest paid will decline as the mortgage is paid off— the tax benefit is eliminated in far less than 15 years.
This information is distributed for education purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.
Photo: Photo from pixabay.com
(c) Scott Burns, 2022