Good Morning Everyone!  Welcome to the second post in our new investment series Retirement Planning for Young 20 Something Investors. Planning for retirement is a great investment strategy, but it only works efficiently if we have a retirement plan.

A good retirement plan takes into consideration our current age, the number of years that we need to invest, as well as our target retirement age.  Investing for the long term is a great retirement strategy because it takes advantage of The Compound Effect.  This is the concept of earning interest on top of previously earned interest.  However, none of this information matters if we don’t know how much income we will need to live comfortably during our retirement years.

How Much Do I Need to Retire?

How much we need to retire usually depends on our lifestyle before retirement.  Financial Planners usually consider 60% to 80% of a person’s pre retirement income to be the amount of income they will need to live comfortably during retirement.  Of course this always depends on a person’s ability to save before retirement as well as their future retirement needs.

The days of people retiring mortgage free and without personal consumer debt are over.  The truth of the matter is that people upgrade their homes, buy a second home, and move several times throughout their lives.  All of these events can prolong the life of a mortgage.  The concept of buying a house at 30 years old and amortizing it over 25 years so that it is paid off when we retire at 55 is definitely in the past.

I would say that 70% to 75% of a person’s pre retirement income is ideally what they will need to live comfortably during retirement.  80% could be very high and depends on someone’s financial obligations, and 60% is very low and depends on someone’s ability to save.  Once we determine how much money we will need to live comfortably during our retirement, the next step is to determine where our retirement income will from.

Our primary source of income during retirement will come from Social Security in the US, and the Canada (or Quebec) Pension Plan in Canada.  These government funded retirement pension plans are our primary source of income because they are mandatory.  Our second source of retirement income should be our employer pension plan, if we are fortunate enough to have one.  If these two pension plans do not provide enough income during retirement we will then have to fund our retirement income from our own personal savings.  This includes both our registered retirement savings plans as well as our non registered investment accounts.

If we can determine our target retirement age, the number of years until retirement, and where the retirement income is coming from, we will know how much we need to saving for our retirement years.

Life Expectancy Calculator

Our retirement years are the number of years from the date we retire from our job to the date that we “retire for the final time” aka pass away.  As a general rule of thumb Financial Planners use 90 years old as the average life expectancy.  However, my Great Grandmother lived until she was 104 and my Grandfather passed away at 78…so who really knows?

I like to think that Saving for Retirement is Like Eating Chocolate.  It is a personal preference and depends on our personal (financial) taste.  If our family has a history of fatal disease, or we have been diagnosed with a life threatening disease, of course our life expectancy age can be reduced as needed.  The reason that Financial Planners use 90 as an average life expectancy age is because it’s better to be conservative and have money left over upon death, rather than being too aggressive and spend all of our retirement savings too early.

Retirement Calculators

Many financial institutions offer retirement planning tools such as various retirement calculators that can help us determine the amount that we need to save now to have a comfortable retirement in our future.  Check out these retirement calculators:

Merrill Edge offers a retirement calculator called our Personal Retirement Number.

Chase offers the Chase Retirement Calculator to help us determine if our current retirement assets will be enough to meet our unique retirement goals.

RBC Royal Bank offers an RSP-Matic Calculator that shows how contributing on a biweekly or monthly basis can really add up for our retirement.  They also offer an RRSP Future Value Calculator that tells us how much today’s savings will be worth in the future.

Photo by Quinet

Good Monday Morning Green Panda Tree House Readers! I hope you all had a nice weekend.  Today we are starting a new Investing Series on Green Panda called Retirement Planning for Young 20 Something Investors.  We are going to start our week off on the right financial foot by discussing our financial futures.  Retirement Planning 101 tells us that investing for our retirement is for the long term.  One of the benefits of investing for the long term is the compound interest effect.

What is the Compound Effect?

In a nutshell the Compound Effect is the benefit of earning interest on interest.  Whether we are earning our rate of return as interest, dividends, or capital gains as long as we allow them to be reinvested in the investment account, we will benefit from the compound effect.

If we invest $1000, and we earn $50 of interest on our investment the first year, and we let the $50 of interest reinvest with our original investment of $1000 we will earn interest on $1050 in the second year.  This is the benefit of the Compound Effect; we will continue to earn interest on our compounded (reinvested) interest every year.  The Compound Effect allows are money to grow faster over the long term.

How does the Compound Effect Grow Our Money?

Let’s use the same example as above, let’s say that we invest $1000 at an interest rate of 5% for 25 years.  If we have our interest paid out to us every year we will receive the exact same amount of $50 interest each year, because our 5% interest will always be calculated on our original investment of $1000.  This will give us a total amount of $1250 in interest for the 25 years. Without the compound effect our original investment of $1000 will be worth $2250 in 25 years.

If we allow the 5% interest to reinvest every year and we take advantage of the benefit of the Compound Effect our original investment of $1000 will be worth $3386 in 25 years.  Allowing our interest, dividends, or capital gains to reinvest over the years is definitely beneficial for our investment growth.  The Compound Effect is definitely a beneficial investment strategy that all young investors should take advantage of.

Does the Compound Effect Affect My Taxes?

The Compound Effect does not affect our annual personal income tax return.  Whether we choose to have our investment returns (interest, dividends, or capital gains) paid out to us, or whether we choose to reinvest our returns and allow them compound, we will still receive a tax slip at the end of the year.  Whether or not we allow our investment returns to compound we will always have to pay tax on any investment gains at the end of the year.

Most investments such as Guaranteed Investment Certificates (GICs) as well as Mutual Fund Investment Accounts always suggest that we allow our investment returns to compound.  If we want our investment gains paid out on a monthly, quarterly, or annual basis we will have to specify our investment instructions to our financial institution.  The default for interest, dividend investing, and capital gains is usually to allow them to reinvest and take advantage of the compound effect.