In an earlier article I mention how my father made me get my first credit card at the age of 16. He did this so that I could begin building credit in my early years that would be available to me later as an adult when applying for a car loan, mortgage, etc. Another thing he did at the same time was have me open a Roth IRA. He advised me that I would use this account for my retirement savings and that 10% of every paycheck I made in my part time job would be deposited into it. As a teenager who still lived at home I didn’t really have any leverage to argue, so I did what I was told despite the natural desire to keep (and spend) every penny I made in my first money-paying jobs. I didn’t know it then, but this was a critical first step in my financial life that pay off in a huge way when I retire.
Saving for retirement is one of those things we all know we should do but few of us actually get around to. The typical couple in the U.S. today only has around $5,000 put away for retirement. That is not going to be nearly enough when the average cost of retirement is over $700,000. With that in mind, what makes or breaks your future retirement will be how early you start saving for it. That’s where tools such as retirement accounts, 401(k) benefits and savings all come into play. These are all tools that you can use to start preparing for your long-term future, and I’ll give you an overview each one below.
Individual Retirement Accounts
An individual retirement account (IRA) is a vehicle for saving your retirement money. There are two types of IRAs: the traditional IRA and the Roth IRA. The difference between the two is very simple: how your deposits are taxed. If you open a traditional IRA account your money is taxed when you withdraw your funds after you reach retirement. In other words, you pay no taxes on the money now but will pay later when you start using the money. A Roth IRA is the exact opposite. Instead of paying taxes on your savings in retirement, you pay the taxes on it when you make the deposit. When you reach the retirement age you will be making your withdrawals tax-free.
What I really like about an individual retirement account is the flexibility. The account itself can take whatever form you want it to: a mutual fund, stocks, or even straight up cash. The biggest choice you will have to make is which form of IRA to have: a traditional version or a Roth. To make that decision you have to ask yourself a simple question: do you predict that you will be in a higher tax bracket now or when you retire? The answer to that question will determine which IRA is the best match for you. If you think that you will be paying more in taxes in retirement then you should consider opening a Roth IRA and paying taxes on your retirement savings now when your tax bill is smaller. If on the other hand, you think that you will be paying less in taxes when you retire, then the best option for you may be a Traditional IRA so you can delay that tax bill until later. There are some additional things to consider such as withdrawal rules, but this question will be the primary factor in your decision.
As I mentioned at the beginning of this article, my father had the foresight to make me open my own Roth when I was a teenager. I followed his directive to put 10% of everything into it, and by the time I left home it was such an ingrained habit that I continued to do it into my college years. It wasn’t until I started my career and began to think seriously about retirement that I realized what I had. Now that I know the long-term benefits I make sure deposit regularly every month. If you do not have an IRA set up for yourself, or you do and are not maximizing your contributions, I highly recommend that you get started right away. The sooner that you take advantage of this the more it will pay off for you later in life.
The 401(k) is a retirement account that is sponsored by your employer. You can usually set it up to automatically withdraw a certain percentage of your income each paycheck, that way you aren’t missing what you never see in your bank account. The cool thing about the 401(k) is that you have complete control over what is inside it. A 401(k) can exist in the form of a mutual fund, money market account, or even a Roth like we talked about above. It really comes down to how you would like to invest your money for the future.
The most popular benefit of the 401(k) is the employer match. If your company has this it means that they will put money inside your 401(k) up to a certain amount based on what you contribute. As an example, let’s say your employer says that they will match 50% of your contributions up to an annual limit of $2000. That means that for every $1.00 that you put into your 401(k), they will contribute $0.50 until they’ve contributed the max of $2000. So if you contribute $4000 that year from your own pay, your account will grow by a total of $6000! That’s a very good deal. Another form that an employer match might take is a percentage of your contributions up to a certain percentage of your salary. An example of this would be a 100% match of your contributions up to 5% of your annual salary. So let’s say you make $60,000 a year. That means they will match your contributions dollar for dollar until they give you a maximum of $3000.
If your company provides a 401(k) with an employer match you should definitely be taking advantage of it. Like most if not all retirement vehicles, a 401(k) has annual contribution limits. In other words, if you are not doing what you can to get every penny of that free money from your employer, then you are leaving money on the table that you will need when you hit the retirement age. Don’t shoot yourself in the foot by failing to take advantage of any opportunity your employer offers you to save for the golden years!
Saving and Investing
The IRA and 401(k) are the primary methods that people use to save money for retirement. The benefits that they come with are too good to pass up and can give you a strong tax advantage when it comes time to start using that money. However, these options all come with maximum contribution limits. Unfortunately for us, Uncle Sam is not too keen on the idea of us saving an unlimited amount of taxes to save for our retirement, and so the IRS restricts people from putting too much money into these accounts. However, if you’re fortunate enough to have been able to maximize your contributions for your 401(k) and IRA, you should not stop there. You can take that money and invest it in other ways. You should never feel like you’ve saved enough, since nobody knows what the future holds. Do everything in your power to save as much money as you possible can for your future.
How Should I Save?
A big question when it comes saving is what retirement accounts to prioritize. Dave Ramsay, who is one of my all-time favorite personal finance gurus, recommends that you always maximize your employer match first and then move on to your Roth IRA (assuming that the two are separate accounts). The logic here is very sound, since prioritizing your 401(k) ensures that you reap the benefits of any employer matches that are offered, which is a benefit you won’t see in a separate Roth account. After you’ve maximized your Roth contributions, you then go back to your 401(k) and save there until you hit that maximum contribution limit. This is a strategy that ensures that you get the most out of every dollar your save towards your future financial independence.
Hopefully this helped you understand the basic options available to start saving for your retirement! If there are any ways to save for retirement that I didn’t mention above, please tell us all about it in the comments below!