En Route to Easy Street

Editor's note: This article appears in Kiplinger's special issue Success With Your Money.

At the rate they're going, Jennifer and Brian Reilly will be leading a life of travel and leisure long before their peers can even think about retiring. "We don't want to work forever," says Jennifer, 30. "We want to retire as soon as possible and as comfortably as possible."

Toward that end, Jennifer and Brian, 35, contribute 12% of their salaries to their retirement plans at work -- more than enough to capture all of their employers' matching contributions. But they don't stop there. They also contribute the maximum $4,000 a year to their Roth IRAs through monthly automatic deposits. That will give them tax-free income in retirement. (Roth IRAs offer a way to diversify employer-based retirement plans, from which withdrawals are taxed at your top rate.)

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The Reillys own a comfortable three-bedroom home in the Takoma Park suburb of Washington, D.C., and have a combined income of nearly six figures. What sets them apart is their ability to live well below their means and free of debt.

For example, they take full advantage of free museums, concerts and recreational facilities in the nation's capital and buy used furniture and baby equipment on eBay. They own one car, a paid-for 1997 Subaru, and share a nanny with another family during the three days that Jennifer works as a nutritionist at the nonprofit Cancer Project. Brian, a marketing manager for an architectural firm, takes the subway to work and pays his transportation expenses with pretax money deducted from his paycheck.

In addition to allocating 22% of their gross income to retirement savings, the Reillys contribute regularly to a college fund for their infant daughter, Keller. They add $100 a month to an old-fashioned rainy-day fund in an ever-so-modern online bank account at HSBC that was recently paying 5.05%.

Brian calculates that if he keeps saving at his current rate -- and if his investments earn an average of 10% a year -- his 401(k) alone will be worth $1.2 million by the time he's 60. And that doesn't include the future value of Jennifer's 403(b) plan or either of their Roth IRAs.

The 15% target

As retirement super-savers, the Reillys are well ahead of other people their age. Nearly 40% of workers ages 26 to 41 don't even participate in their company 401(k) plans, according to a recent study by Hewitt Associates. At a time when traditional pension plans are disappearing, it's more important than ever to take advantage of workplace-based retirement savings plans, particularly if your employer matches your contributions.

HOW MUCH IS ENOUGH?

Start with the rule of 25

A conservative rule of thumb suggests that if you withdraw only 4% -- or one twenty-fifth -- of your retirement nest egg during the first year and adjust subsequent annual withdrawals to compensate for inflation, you'll never outlive your money. Another approach is to estimate how much you'll need to withdraw from savings during your first year of retirement and multiply that amount by 25 to determine your target number. For a bare-bones budget, you would need only half as much, or 12.5 times your initial withdrawal. Your personal number is probably somewhere in between.

Age: 45

Current gross income: $75,000

Projected gross income before retirement*: $99,521

85% retirement spending need: $84,593

Estimated Social Security pension income†: $44,593

Potential income gap to be funded by assets: $40,000

Multiply income gap by 25 to arrive at the number: $1 million

*Assuming current salary increases 1.5% each year until age 65. †Social Security income of $19,380 based on Social Security Administration data plus a hypothetical pension income of $25,213.

Source: Fidelity Investments. Copyright 2005 FMR Corp. All rights reserved.

Christine Fahlund, a senior financial planner at T. Rowe Price, recommends that workers try to save 15% of their gross salary (including employer matching contributions) in order to replace 50% or more of their income in retirement. The later you start, the more you'll have to save.

Most retirees will also receive Social Security benefits, which could replace an additional 20% to 30% of preretirement income. That would boost total income in retirement close to the 75% to 85% replacement figure generally recommended to maintain your lifestyle. For the average wage earner, Social Security replaces about 42% of preretirement income; that figure is lower for higher-income workers.

Like many in their generation, Brian and Jennifer aren't counting on Social Security -- another reason they're saving so diligently on their own. Financial planners generally recommend that you restrict your withdrawals to 4% of your total savings during your first year in retirement and gradually increase withdrawals to keep up with inflation. At that rate, you're virtually guaranteed not to run out of money. So if you need to tap $40,000 in savings in your first year of retirement, you will need a $1-million nest egg (4% of $1 million is $40,000; see the box to the right, plus retirement calculators at kiplinger.com/links/success).

Pain-free saving

When you're just starting to save, the amount you contribute to your retirement account has a larger impact on your balance than does investment performance. A recent study by Putnam Investments found that bumping up contributions by just 2% would have doubled retirement wealth after 15 years compared with relying solely on investment performance.

As your balance increases over time, however, investment performance becomes increasingly important. But many people don't want to manage their own retirement plans. As a result, do-it-yourself 401(k) plans are giving way to do-it-for-me options, collectively called automatic 401(k) plans.

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A new law encourages employers to enroll workers automatically as soon as they're eligible to participate (you can always opt out if you choose) and to increase their salary deferral automatically each year until it reaches 6% of pay. "Automated features change the equation so that inertia works in favor of employees," says Lori Lucas, of Hewitt Associates. "It's okay if the employee does nothing, because the 401(k) plan is on autopilot."

About 40% of employers offer life-cycle or target-retirement funds, which provide balanced portfolios of mutual funds keyed to particular retirement dates. The mix of assets in such a fund grows progressively more conservative as you get closer to retirement. Target funds are also available for individual investors. Jennifer Reilly, for example, invests her Roth IRA in Fidelity's Freedom 2030 fund. (Learn more about target funds.)

Another do-it-for-me innovation is the managed account. You fill out a questionnaire about your age, retirement goals and risk tolerance, and professional advisers select and manage retirement investments for you. After consulting with an independent financial adviser affiliated with his company's 401(k) plan, Brian Reilly selected a portfolio of five mutual funds that invest in domestic and international stocks. (For model portfolios suitable for long-term retirement saving, see How to Pick Great Mutual Funds.)

Don't cash out

One of the biggest threats to future retirement security is 401(k) leakage, which happens when workers switch jobs and cash out their accumulated retirement savings. Considering that a 25-year-old man is likely to work for eight different employers by the time he's 65, according to the Congressional Budget Office, the opportunity for such leakage is enormous. A 2005 study of 200,000 workers by Hewitt Associates found that nearly half of them elected to take the cash when they left their jobs.

Rolling over your retirement savings to an IRA or your new employer's retirement plan is a much better idea. Not only do you avoid immediate taxes and early-withdrawal penalties, you also preserve valuable tax-deferred growth.

Let's say you have $50,000 in your 401(k) when you switch jobs. If you take the money and run, Uncle Sam will relieve you of $12,500 in taxes if you're in the 25% bracket and slap on a $5,000 penalty if you're under 55. If you invest the remaining $32,500 in a taxable account and earn 7% for 20 years, you'll end up with more than $130,000.

But if you roll the full $50,000 into an IRA and let it grow tax-deferred at an annual rate of 7%, you'll close out the two decades with about $200,000. Even though you'll owe taxes when you withdraw the IRA money, you'll still end up far ahead.