A Beginner’s Guide to Saving for Retirement
You know you should save for retirement, but it can be so overwhelming trying to figure out how you should go about it. It feels like retirement investment has a whole vocabulary of its own, and it’s even hard to determine how much to save. You might read articles saying people should save at least a million dollars for retirement, but you know you’ll never be able to save that much. Don’t throw up your hands in despair, though: The most important thing to understand about saving for retirement is that the best time to start is now. Whether you are 18 or 58, the sooner you start putting money away for retirement, the more money you’ll have.
The Power of Compound Interest
Compound interest is the magic that makes the money you save turn into ever-larger amounts of cash. As time goes by, your money earns interest, and that amount is added to the total. But each time more interest is added to the total, you then earn interest on that higher amount: Basically, you earn interest on your interest, so the total amount you have grows more quickly.
An example shows how powerful compound interest can be. Imagine that Avery (age 22), Brian (age 32), and Carter (age 42) all start a job on the same day. They each sign up to contribute $100 a month to their retirement plan, and they get 5% annual interest on the investment. They work for ten years, which means they have invested $12,000. During the initial ten-year period, they earn $5,802.82 in interest, bringing their account total up to $17,808.82. Now, imagine no one touches their account until they retire at age 62, and the investment grows by 5% each year. That means that Carter’s money will grow for an additional ten years, Brian’s for 20, and Avery’s for 30. Carter’s account will have $28,844.17 upon retirement, Brian’s will have $46,984.12, and Avery’s will have $76,532.18, but they all only put in $12,000. The earlier you start saving, the more time your money will have to work for you!
Choosing the Right Plan
Once you’re convinced that now is the right time to start saving for retirement, you need to figure out how to do it. Retirement accounts can feel like a never-ending string of letters that make no sense. Start by consulting your employee handbook or your HR manager: The most accessible place to start investing is with a retirement account your employer offers. You especially want to find out if your employer matches your contributions. If they do, contribute at least that amount to your retirement account. You also might be eligible to have multiple different kinds of retirement accounts at once.
- 401(k) or 403(b): The fundamental difference between a 401(k) and a 403(b) is that nonprofits, religious organizations, some school districts, and some government organizations offer 403(b)s, while for-profit companies can offer 401(k)s to their employees. For employees electing to invest, there is little functional difference. Both are easy to invest in. If your place of employment offers one of these plans, contact your HR department or plan administrator to enroll. Your pre-tax contributions are deducted from your paycheck. In 2019, you can invest $19,000 if you are under 50 and $25,000 if you are 50 or older. Typically, the plan will let you choose from a multitude of investment vehicles for your money (usually, this is a mix of bonds and stock-based mutual funds). Employers are also allowed to contribute money to your account.
- Solo 401(k): People who own a small business are allowed to establish an individual 401(k). Solo 401(k)s allow entrepreneurs to contribute as both the employee and employer. The limit for 2019 is $56,000 for those under 50 and $62,000 for those 50 or older.
- IRA: An Individual Retirement Account (IRA) is set up by you at a financial institution of your choice. People under 50 can contribute $6,000 a year, while those older than 50 can contribute up to $7,000 a year in 2019 for traditional and Roth IRAs (if they meet income requirements). People are allowed to have both 401(k)s/403(b)s and IRAs.
- Traditional IRAs are tax-advantaged retirement plans that allow you to deduct the amount contributed to your IRA from your income for tax purposes. Anyone can open and contribute to a traditional IRA, but there are income limits for how much of your contributions can be deducted from your taxes. Additionally, you are not taxed on any growth until you withdraw the money from the account. There are penalties for early withdrawals, but withdrawing money to purchase a home is allowed without a penalty. It’s best not to treat your traditional IRA as a source for emergency funds; if an emergency crops up, explore options like a title loan instead. Once you turn 70 1/2, there are mandatory withdrawal requirements for a traditional IRA.
- Roth IRAs are available for single people making less than $137,000 or married couples who file joint tax returns making less than $203,000. However, singles earning more than $122,000 or couples making more than $193,000 are not allowed to contribute fully to a Roth IRA. Roth IRA contributions are made with post-tax dollars; therefore, your contributions are not tax-deductible. However, since you funded the account with post-tax dollars, you will not pay taxes when you withdraw money from the account after age 59 1/2. In addition, there are no mandatory withdrawals. You can also withdraw the amount of your contributions (but not any earnings) at any time before age 59 1/2 without incurring a penalty.
- A simplified employee pension (SEP) IRA is typically chosen as a retirement savings vehicle by self-employed entrepreneurs and/or small-business owners. Business owners can contribute the lesser of up to 25% of your income or $56,000 in 2019. However, if they have employees, the employer must contribute to the SEP IRAs of all employees who meet the requirements. Small-business owners choose SEP IRAs over solo 401(k)s because they are simple to set up and manage.
- Employers with fewer than 100 employees can set up IRAs with fewer administration and paperwork requirements. Employers electing to use simple IRAs can choose to match employee contributions or make unmatched contributions. Employees younger than 50 can contribute up to $13,000, while those over 50 are allowed to contribute $16,000.
- Health Savings Account: People with some high-deductible health insurance plans are allowed to save money in a health savings account (HSA). Individuals can contribute $3,500 a year, while families can contribute $7,000. Those 55 and older can contribute an additional $1,000. Although you are allowed to use money in your HSA to pay for approved medical expenses (like eyeglasses, prescriptions, and copays), you are also allowed to let the money in your HSA roll over indefinitely. In retirement, you can withdraw money from the account for medical expenses tax-free. Money withdrawn after age 65 for any other reason is subject to income taxes. Your employer is also allowed to contribute to your HSA.
Putting Your Money to Work
What comes after opening the retirement account that’s right for you? Now, you have to decide how to invest your savings. First, give up any idea of picking individual stocks or paying a stockbroker to pick stocks for you. Research shows that investors in individual stocks rarely make money long-term. Plus, financial adviser and trading fees add up. Actively managed mutual funds charge high operating costs, also known advisory fees or expense ratios. Passively managed mutual funds, also known as index funds, mirror part of the stock market (like the S&P 500), have lower overhead expenses, and typically outperform actively managed funds, too.
Most people don’t invest all of their money in the stock market. People in their 20s and 30s should shoulder a higher amount of risk and invest heavily in the stock market: Even if the market falls, you’ll have enough working years to recoup the losses, and the higher risk comes with higher rewards. As you get older, into your 40s and beyond, you’ll want to move your money out of stocks and into safer assets, like bonds. If you don’t want to figure out how to balance your money between stocks and bonds, look into a target-date fund. When you choose this sort of fund, you’ll input your age and the year you’d like to retire, and the fund automatically balances so your amount of risk makes sense for your retirement timeline.
How Much to Save
Now that you understand compound interest, know the difference between the various types of retirement accounts, and understand how to invest your money, your next step is to figure out how much to save. Most experts suggest saving between 10% and 15% of your annual pre-tax income. However, it’s crucial to take stock of your entire financial picture. For example, when did you start saving for retirement? Will you own your home outright when you retire? Will your children be out of school? Try using an online retirement calculator to see how much you should aim to save. But remember that the most important thing is to save something. Even if you can’t save what the calculator says you should, you’ll be glad to have each dollar you put aside when you reach retirement age.
Having a healthy retirement plan is important and it may be tempting to “dip into” one’s retirement savings in order to make ends meet during times of financial hardship. Before doing so, consider alternative lending solutions that may be available to you and do not jeopardize your retirement plans. TitleMax offers customers personal loans and vehicle title loans that may be suitable solutions to emergency situations that require immediate attention.