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This trend is quietly derailing your retirement

The Motley Fool logo The Motley Fool 2/21/2020 Catherine Brock

If you feel like you can't get ahead in life, you're not alone. According to data from the Bureau of Labor Statistics, making more money generally translates to spending more money. That's called lifestyle creep, and it's public enemy No. 1 with respect to retirement savings.

Lifestyle creep, also known as lifestyle inflation, is the natural tendency to increase your living expenses in lockstep with your income. You get a big promotion, and you respond by upgrading your home or car. Those decisions, made to improve your quality of life, are not automatically bad financial moves. Especially early in your career, you'll appreciate outgrowing a cramped studio apartment and the ramen noodle dinners that go with it.

The problem arises when we don't draw the line on upward mobility. When your tastes keep growing indefinitely, a six-figure income feels as tight as a minimum-wage paycheck. There's seemingly no money to save, or worse, you end up in debt. And reversing that situation can be painful, particularly when debt is in play.

Here are three steps you can take now to head off lifestyle creep and start building wealth for retirement.

1. Set a budget

Being mindful of spending may not come naturally, but you can develop the habit -- and setting a budget is the right starting point. If you've never budgeted before, try an app like Mint, Good Budget, or Clarity Money. These pull your banking transactions into one place, where you can group them into categories. From there, you can easily review your spending by category and set limits for each one.

Ideally, you'd set spending limits that allow you to direct 15% of your income into a retirement account. If 15% feels impossible, get as close as you can. Where it makes sense, trim back your non-essential spending to free up cash.

Then, commit to living within that budget. Admittedly, this is the hardest part. But having the discipline to rein in spending is also a skill that's essential for wealth building.

2. Bank your raises habitually

Once you're living solidly within your income, you can lean on your raises to increase your savings contributions. If, for example, your current budget allocates only 10% of your income to savings, you can easily increase that contribution rate to 15% within a year or two by banking your raises. And the best part? You don't have to cut coupons or cancel your cable.

You do have to decide where to put the money, though. If you're saving 15% of your income annually, you'll probably hit the 401(k) contribution cap at some point. In 2020, that cap is $19,500 ($26,000 if you're 50 or older).

Your retirement account options after the 401(k) include the Roth IRA, traditional IRA, HSA, and a taxable brokerage account. The Roth IRA is appealing because it's flexible -- you can withdraw your contributions at any time without penalty. But if you're maxing out your 401(k) contribution, your income is likely too high for Roth contributions. Eligibility for these starts phasing out at $124,000 in income for single filers and $196,000 in income for married filers.

Thankfully, there are no income caps on traditional IRA contributions. In 2020, you can contribute up to $6,000 ($7,000 if you're 50 or older). If you're also participating in a 401(k), you probably won't get a tax deduction for those IRA contributions, but your earnings will still grow tax-free.

For those with qualifying high-deductible health plan coverage, an HSA or Health Savings Account offers a triple tax benefit. Your contributions are pre-tax, earnings grow tax-free, and withdrawals for qualified medical expenses are also tax-free. Once you reach the age of 65, you can withdraw funds for any purpose without penalty -- you just have to pay income tax on withdrawals that aren't used for healthcare. In 2020, those who qualify can contribute up to $3,550 in an individual HSA and up to $7,100 in a family HSA.

A taxable brokerage account can hold any funds available after your 401(k), IRA, and HSA contributions. You won't get any tax benefits here, but there are no restrictions on withdrawals either. Invest in a diversified portfolio of tax-efficient mutual funds and stocks to keep your annual tax bill low.

3. Plan out your lifestyle upgrades

Once you've held your lifestyle in check and banked your raises for three or four years, you're in a great position to make strategic lifestyle upgrades without disrupting your retirement plan. Maybe you need a bigger car to shuttle your kids around, or maybe you need a bigger house with room for a home office. These are reasonable goals, and you can fulfill them safely with some planning.

First, check in on your savings rate as a percentage of income. If it's more than 15%, you're in a nice position to make a lifestyle upgrade. Ideally, you'd hold your retirement saving contribution at 15% and use the excess to fund your new car or home. If you're saving less than 15%, you have three options. You could:

  • Wait and let your income grow for a few more years
  • Increase your income now with a side hustle or second job
  • Cut back other areas of spending to create space in your budget

The point is, your 15% retirement contribution is off limits. You can splurge thoughtfully, but only after you save that 15%.

Save first, then spend

Combat lifestyle creep with a budget, good savings habits, and disciplined lifestyle choices. Or more simply put, save first before you spend. When you retire with a bunch of money in the bank, you'll be glad you chose that route.

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