Filed under: Retirement, 401K, IRA, How to Save Money
According to an analysis of the Current Population Survey done by Sentier Research, the median American household income was $52,959 as of April. The key to turning that kind of income into a $1 million nest egg is simple to describe (if harder to practice): You must be willing and able to live on less, and then invest the money you save towards that goal.
How Much of Your Salary Do You Need to Save? For How Long?
The chart below shows what percentage of that median salary you'll have to sock away each month -- starting with nothing in your nest egg -- based on various expected rates of return and number of years you can devote to working toward that $1 million mark.
The color coding serves two purposes. First, it indicates just how much of a sacrifice you'll have to be willing to make -- starting now -- to become a middle class-millionaire. Second, it also helps you choose between the tools to achieve that goal.
Data from author's calculations.
The green values are ones you can reach by investing within an individual retirement account. People under age 50 with wage income can contribute up to $5,500 per year to their IRAs.
The orange value is reachable if you can almost completely fund both an IRA and a 401(k), but at 38.5 percent of a median income, it's quite a stretch.
To reach millionaire status with the red values will require both saving above and beyond retirement focused accounts, and a tremendous sacrifice, especially for someone who hasn't previously been saving.
The Hardest Part of the Journey
If you're looking at that chart and wondering if 6 percent or even 10 percent average annual returns are possible, consider this: Over the long haul, the S&P 500 (^GSPC) has delivered around 10 percent average annual returns with dividends reinvested. Exchange-traded funds like the SPYDER (SPY) are low-cost ways to invest in that index. Of course, there are no guarantees that the trend will continue, but it's not an unreasonable expectation to build into your plan. If you're worried that your portfolio won't reach that level of returns, the wise approach would be to sock away more (planning for those lower returns), then scale back your savings later if you find yourself ahead of target.
In reality, though, the returns aren't likely to be your biggest challenge. The tough part will likely be regularly coming up with that cash to invest.
To reach that $1 million target with those savings levels and those return rates, you'll need to consistently sock away that much of your paycheck every month for all those years. Fortunately, though, it's a journey you don't have to take on your own.
Uncle Sam and Your Boss to the Rescue
The amounts represented in those green, yellow and orange cells all can be saved within qualified retirement accounts. Qualified retirement accounts have several advantages that make it much easier for you to save money for your retirement. Key ones include:
- Tax-deferred growth: Money in your qualified accounts grows without being taxed until you withdraw it in retirement. That helps you compound your dividends and capital gains more efficiently.
- Potential for tax deductions on your contributions: Traditional 401(k)s and other employer-sponsored plans let you contribute directly from your paycheck with pre-tax dollars. Those contributions reduce your tax burden in the year you make them, and put some cash to work for you that otherwise would have gone to Uncle Sam. In some cases, you may also be able to deduct a traditional IRA contribution as well, but the rules are complicated.
- Direct contributions from your boss: Many employers offer matches for employees contributing to their 401(k) or other employer sponsored plans. If your 401(k) offers you a 50 percent match, you only need to contribute two-thirds of the total amount to reach your goal. In other words, if your target is to save 15 percent of your income to reach that $1 million goal, you only need to come up with 10 percent and let the match cover the other 5 percent. Most employers limit the level of their match, but every dollar your company chips in is one fewer you have to save yourself.
The one thing that should be crystal clear from that chart is how important it is to start saving early. It's a lot easier to invest a little bit of each paycheck throughout your career than it is to start later in life and have to come up with huge chunks of your salary to try to reach your retirement goal.
If you want a shot at becoming a millionaire on a middle-class salary, there's no time like the present. Every year you delay brings you that much closer to the red part of that chart.
Motley Fool contributor Chuck Saletta has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. For more advice on saving and investing for the future, see The Motley Fool's new special report "The IRS Is Daring You to Make This Investment Now!" for advice that could help you cut taxes for decades to come.
