The percentage of net worth that should be in retirement accounts is the percentage that will allow you to accumulate as much as possible in those accounts before retirement, as well as be able to pay for your lifestyle throughout retirement. Factors that determine the ideal percentage of net worth to allocate to retirement accounts are age, assets, retirement strategy, tax rates, employer incentives, and net worth level.
In this post, I’ll expand on each of these factors so you can determine the optimal percentage of net worth to keep in your retirement accounts based on your own situation.
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Factors for the Percentage of Net Worth to Keep In Retirement Accounts
The percentage of net worth in your retirement account depends on many factors as noted above. Each of these primary factors is addressed in more detail below. Keep in mind that these factors will change throughout your life.
The good news is the 30 something person won’t need their retirement account for at least a couple of decades, assuming they’re planning on retiring in their 50s or 60s.
It makes good sense for traditional investors of stocks and bonds to stash as much as possible, as early as possible, into retirement accounts, however, for several reasons.
- Retirement accounts have tax advantages.
- The withdrawal restrictions for retirement accounts encourage investors to keep money in the accounts.
- Investments inside the retirement accounts compound and grow over time if the investments are performing well.
Your life stage at any given time will affect the percentage of net worth you’ll want to have in your retirement account.
Someone that is 30 will have different priorities for how they use their earnings than someone who is 60.
A 30 something may be saving for their first home, or have recently made a downpayment for a home, while a 60 year old is heavily focused on making sure their retirement accounts are well funded. The 60 year old has also had decades to fund their retirement account.
Therefore, a 60 year old will usually have a higher percentage of net worth in retirement accounts than a younger person. Shortly before or during early retirement, a large percentage of net worth should be in retirement accounts for investors of traditional assets such as stocks and bonds. This is also assuming that the investor makes enough money to be able to take advantage of the tax benefits that come with retirement accounts.
An exception to a young investor having a lower percentage of net worth in a retirement account than a 60 year old is when a young investor has been working and contributing heavily to their retirement account and has not yet accumulated much, if any, home equity. This was my experience in my 20s as explained later in this post.
Assets Outside Retirement Accounts
Most individuals have stock and bond portfolios. More advanced investors hold alternative assets in addition to stock portfolios.
Many investors have made their wealth from, and continue to hold, alternative assets such as small business or real estate and little to no stocks or bonds. Such an investor may have little to no money in a retirement account but this isn’t wrong; they simply have other, alternative investments.
Therefore, the type of investments you own will heavily influence the percentage of net worth allocated to retirement accounts.
It’s also worth pointing out here that one of the reasons investors are so drawn to retirement accounts is because of the tax benefits they provide. Alternative investments, such as business or real estate, have their own tax benefits. The primary reason investors use retirement accounts is for tax benefits.
Let’s remember that home values are included in net worth calculations. It can make sense, therefore, to deduct home equity from net worth when considering the percentage of net worth that should be in retirement accounts. Doing so allows you to see the percentage of liquid assets that are in your retirement accounts based on the assets that you would actually sell if you needed to do so. While some investors do sell their homes to fund retirement, homes aren’t generally considered assets available for sale like stocks, bonds, and even investment real estate are.
It’s also more likely that someone with a high net worth will have alternative assets in addition to traditional assets such as stocks and bonds. In this case, many high net worth individuals have a lower percentage of net worth in retirement accounts.
The retirement strategy you’re planning to use will affect the percentage of net worth you’ll want in retirement accounts. Let’s consider the two main retirement strategies next.
The traditional retirement strategy is to withdraw 4%, adjusted for inflation, annually from retirement accounts. This account withdrawal provides funds for retirees to live in addition to Social Security or any other income streams.
Investors planning to use a retirement withdrawal strategy will want a high percentage of net worth in retirement accounts so they have a larger pool from which they can withdraw.
An alternative and increasingly popular retirement strategy is to purchase income generating assets before retirement and live off of the income they generate. As addressed previously in this article, such an investor might have a small percentage of net worth in retirement accounts.
Many employers match employee retirement account contributions for varying percentages. I was fortunate enough to have 100% employer matching in my first corporate job as an accountant!
Therefore, when I left that job in my 20s, a high percentage of my net worth was in my retirement accounts, between my 401K and my IRA. (Of course, my net worth was relatively low.)
I share this story to illustrate that when employers contribute to retirement accounts the percentage of net worth in your retirement accounts can rapidly increase because funds inside your retirement account can increase disproportionately in a very good way.
As a financial coach, I must mention that employer contributions to your retirement accounts are free money. They can help you save enough to retire much faster, particularly when the retirement accounts are invested for optimal returns.
Tax considerations should play a big role in deciding how and when to fund retirement accounts as well as what type of retirement accounts you use. This means tax related factors will also affect how much of your net worth ends up in retirement accounts.
Annual Earnings Affect Retirement Account Funding
As previously written, one huge advantage of putting money into retirement accounts is the accompanying tax benefits which can occur at the time of funding a retirement account as well as for investment earnings inside retirement accounts. This will affect the percentage of net worth inside a retirement account.
Regarding earnings, a high earner might want to take advantage of delaying taxation on earnings. This could lead her to funding a retirement account in those high earning years for the maximum amount.
On the other hand, a low earner with a low tax rate might want to go ahead and pay taxes on earnings to avoid paying potentially higher taxes on those earnings later. In this situation, he would likely choose to not put money into a retirement account, or he may choose a Roth IRA funded with after tax money.
These are just examples. Each of these approaches will determine which type of retirement account is used and if and how much, if any money is put into those retirement accounts for any given year.
There are many factors that come into play here, of course, such as what you anticipate your future tax rate will be. What gets really tricky is that earnings change from year to year for many people. It certainly does for us.
Given the many variables here, I suggest speaking with a financial planner or a CPA to help you decide how much to put into your retirement accounts to save as much as possible in taxes. Many financial planners or CPAs can be hired by the hour for tasks like this. In my experience, financial planners tend to be more familiar with retirement strategies than CPAs, however.
Investment Earnings Inside Retirement Accounts
Investment earnings “sheltered” in retirement accounts have tax benefits. It gets even more complex though, depending on the type of investment strategy you use. These factors affect the percentage of net worth you will want to have in retirement accounts as explained next.
For example, if you invest in a way that generates short term capital gains, you’re more likely to want to do that inside of a retirement account since short term capital gains are taxed like earnings, at a high rate. This would lead to a higher percentage of net worth being in retirement accounts since the investment earnings would be sheltered inside the retirement accounts.
On the other hand, if you invest in a way that generates long term capital gains, many investors pay a 15% long term capital gain tax rate. (There are however income limits that can lower the long term capital gain tax rate or increase the long term capital gain tax rate.) This lower tax rate reduces the need to have funds inside a retirement account.
Then there’s also whether you are a passive investor using index funds, and thus having few transactions. Fewer transactions equate to fewer taxable transactions.
Alternatively, you or your financial advisor might be an active investor who buys and sells securities more often, increasing the need for capital gains to be sheltered inside a retirement account.
The retirement funding strategy you choose as well as the investing strategy and the type of retirement account you use (Traditional IRA, Roth, 401K, or other) will affect how much goes into retirement accounts for tax savvy investors.
I could summarize and say that is smart to put the highest amount of your net worth into retirement accounts that will generate the least amount of taxes. At the end of the day, this will result in a higher net worth because you get to keep and invest more money that can be used to retire and fund your desired lifestyle.
Progress Toward Your Financial Goals
The progress you’ve made toward your retirement savings goal will affect the percentage of net worth to keep in your retirement accounts.
It’s well documented that most people don’t have enough money in their retirement accounts. This need for additional retirement funds drives investors to put more savings into their retirement accounts.
Some investors, however, have reached their retirement savings goal. They feel very confident they have enough money in their retirement accounts to sustain their desired lifestyle, for life. Such an investor can let their guard down a bit. This may take the form of finally spending funds on a home remodel, for example, instead of stashing more money into retirement accounts.
The Bottom Line for How Much of Net Worth Should Be in Retirement Accounts
To repeat an important sentence: The percentage of net worth that should be in retirement accounts is the amount that will allow you to accumulate as much as possible in those accounts before retirement, as well as optimally fund your retirement.
Adhering to a set percentage of net worth for funding retirement accounts is like putting the cart before the horse.
As you can see, there isn’t a hard and fast rule about the correct percentage of net worth to put into retirement accounts that applies to everyone because everyone’s situation is different. The percentage of net worth you put in retirement accounts should really stem from an overall financial plan that considers many factors.
Plus, financial situations change making rigid rules less reliable.
Hopefully, the factors addressed above will help you decide how much to put into your retirement accounts based on your own financial goals and situation.