When entering the job market out of college, the concept of retirement seems like a lifetime away. Most people can’t even fathom thinking about retirement let alone save for it. And others know the day is coming, but they are relaxed in the notion that it’s too early to even begin thinking about saving for retirement.
Such thinking is certainly misguided. Regardless of the confusing retirement savings types, retirement is a natural part of life. It can be a wonderful experience for many families, especially those who planned early. It’s a new chapter in life, where people get to enjoy the fruits of their labor for the next few decades.
When money is carefully saved and invested, it can emerge to be a sizeable nest egg. Such savings will bring peace of mind to you when the reality of retirement hits. It means having enough money to take care of your housing, vacations, bills and unexpected expenses. You know, what retirement is supposed to be about. With that said, here is your step-by-step guide to saving for retirement!
The Best Time to Start Is the Present
It’s easy to get caught up in all the terminology associated with retirement. People get confused about retirement account types, potential tax benefits, choice of investments and other details. Trust me, it’s even hard for me as a Certified Financial Planner® to keep up with everything.
But the most important step you can take in saving for retirement is to actually begin – seriously. And, contrary to what some people think, it’s never too early to start. In fact, those who begin saving for retirement in their 20s have a much better chance of comfortably growing their nest egg in the coming decades – que the power of compound interest.
Trust me, saving for retirement in your 20’s is much better than starting to save for retirement in your 30’s, 40’s or 50’s. Keep reading and we’ll show you why.
Most people understand that every year you save money leading up to retirement, the more you‘ll have when you’re ready to stop working. But what many don’t see is that it’s the principle of compound interest that is the real reason why it’s so important to start saving early.
What is Compound Interest?
When financial experts are clamoring for people to begin saving for retirement in their 20s, it’s due to the concept of compound interest – yes, I know I keep saying this word but it’s just that important. It’s how your money will grow exponentially, with interest building on top of itself and then on top of that and then on top of that, etc. – sounds pretty cool, right?
Compound interest refers to “interest on the interest.” It’s why investors can grow money so significantly over extended periods. It’s not because they got insane returns in the stock market, but rather it’s simply due to compound interest – plain and simple.
Here is an example that will help illustrate the benefit of compound interest:
Say a 25-year-old decides to take $10,000 and invest it into an S&P 500 index fund and it returns an average of 8% per year.
When the first year is done, the investor has $10,800 thanks to the interest. Instead of taking the $800 and putting it in the bank, it’s invested back into the same fund. The second year, $10,800 delivers interest of $864.
That is $64 more than if the investor had only kept the initial $10,000, as compared to the $10,800. When assessing compound interest over two years, it doesn’t appear too impressive.
Going ten years into the future, the $10,000 investment in the S&P 500 fund with an 8 percent annual return results in $21,589.25.
The same $10,000 investment in the fund after 40 years will yield $217,245.21. Hence the power of compound interest. Pretty amazing isn’t it?
Now apply the same principle but also adding regular contributions over 40 years. It’s easy to understand why it’s so important to begin saving for retirement early in life.
“Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it.”
“Compound interest is the most powerful force in the universe.”
“Compound interest is the greatest mathematical discovery of all time.”
Believe it or not, but these are all quotes from Albert Einstein. That’s quite an endorsement if you ask me. If this doesn’t sway your opinion to the power of compound interest then I’m not sure what will.
Don’t Let Retirement Savings Types Scare You
If you don’t know anything about saving for retirement, it’s easy to feel overwhelmed. There are so many terms to learn and remember between all the retirement savings types. Between 401(k), 403(b), IRAs and other accounts, people get lost in the acronyms and number-letter combinations.
But there really isn’t anything confusing about these different types of accounts, except for their names!
401(k) and 403(b)
A 401(k) is a fancy name for an account you get through your employer. These accounts are funded by pre-tax payroll deductions. The 403(b) is a similar type of account for employees who work in educational or non-profit organizations.
There are limits on the employee contribution in a 401(k), currently at $19,500 in 2020. If you are 50 or older, it’s possible for you to contribute an additional $6,000. The numbers are typically increased by the IRS every year.
Your employer may also provide a match. A match is free money. If your employer offers a match, then run to your benefits department and get signed up for you 401k ASAP – I don’t want you missing out of free money and neither should you.
There is also the solo 401(k), which is suitable for self-employed individuals. It comes with a contribution limit of $57,000 for 2020, along with a $6,000 catch up option. But it’s only available to people who are self-employed and don’t have any employees.
Traditional and Roth IRA
Another type of retirement account is the individual retirement account or IRA. It’s different from the 401(k) or 403(b) because it’s not dependent on where you work. Anyone is allowed to open an IRA as long as you meet the income limitations.
In simple terms, it’s a savings account for your retirement money. But it’s also so much more, as it offers significant tax benefits. The specifics to those tax benefits will depend on the type of IRA.
For instance, there is a traditional IRA, Roth IRA, SEP IRA and SIMPLE IRA.
Traditional IRA contributions are tax deductible. Tax is only taken on the money when the individual hits retirement and is ready to withdraw. In contrast, a Roth IRA is taxed on contributions but not at the time of withdrawal.
There are limits on contributions to the traditional and Roth IRA. The amount is set to $6,000 in 2020 but, if you’re 50 and older you are able to add an extra $1,000. There are income limits to contributing to a traditional or Roth IRA. They change on an annual basis and there are a few caveats. Make sure to check the IRS website to ensure you fall within those limits.
There is also the option of a nondeductible IRA. It’s an account where contributions are not tax deductible. But there is an advantage: investment returns are tax-deferred until you withdraw money at retirement. So it does have some benefit, even if it’s less than the above two IRAs.
A nondeductible IRA is good for someone who doesn’t fit the income limits of either a Traditional or Roth IRA.
SEP and SIMPLE IRA
A SEP IRA is useful for self-employed individuals or small business owners. Many business owners choose the SEP IRA over a 401(k) because it’s easier to set up and less expensive. If you have no employees, you will only be opening the account for yourself.
With a SEP IRA, it’s necessary to cover employees provided they meet certain requirements. But the employer is able to deduct employee contributions from their business income, which secures a lower tax rate.
These contributions can go up to 25 percent of an employee’s annual income or $55,000, whichever is less.
A SIMPLE IRA is another option for small business owners. With such a plan, employees can contribute up to $12,500 per year, while employers can match that up to three percent.
A SIMPLE IRA is the way to go if employees are mostly funding the account themselves, while a SEP IRA is better when the employer will be making the contribution.
Don’t Rely on Social Security
Social Security taxes are taken out of most people’s checks. And many can justifiably assume they will be receiving social security benefits at retirement.
The issues with Social Security are twofold. The first issue is that even at existing levels, it’s probably not enough to sustain someone at retirement.
And there’s the chance that future governments will lower the funding available to the program. It’s best to plan retirement without relying on social security. If there is any Social Security money available to you at retirement, consider it a bonus!
But what you may be able to rely on is your employer!
Many employers do offer to match their employees’ contributions to their respective retirement accounts. Ask your current employer about their matching policy. When you are seeking a promotion or a job elsewhere, always enquire about their retirement plan and what it includes.
And when matching is offered, ensure you are getting the maximum contribution. The goal is to save more, but at least you are getting a small percentage of employer matching if you can save enough to reach that threshold. Again, the match is free money or a way to basically double your money every paycheck. I guarantee you won’t find a better return than that!
Put Your Money to Work
Now that we have an understanding of the different types of retirement accounts, it’s time to think about how to invest that money.
Stocks are the most obvious and valid investment for a retirement account. Why? Because they should provide superior returns over the long run.
People are scared off by stocks due to market volatility. But the truth is that even if there is a crash, the market has always bounced back. Just look at the market in today when compared to 2008.
With that being said, you want to have a good mixture of stocks, bonds and cash in your retirement portfolio. Check out How Do I Invest My Money and Why Investing Doesn’t Need To Be That Complicated for some tips on how to invest your money.
Don’t Try to Play the Market
It’s so tempting to try and play the market - or have someone play it for you. Many people assume you can only reach a million or two for retirement through clever stock picks.
But picking individual stocks for your retirement money is typically a loser’s game. A single investor is most likely not going to beat the market over the long-term. If you want to have fun picking stocks, go ahead. But stick to less than 5% of your overall portfolio.
As someone saving for retirement, you want the benefits of diversification. Mutual funds and ETF’s are where you want to be investing – preferably those that stick to the indexes.
These are funds that track broader markets, such as the S&P 500 or smaller segments of the market. They are easy to get into and the expenses can be extremely low – which means more money in your pocket.
The best investments are the most diversified ones. Even with ETFs and index funds, it’s important to invest in a few different ones. Spreading the money out among international and domestic stocks, small cap and large cap stocks, and even others is best the way to go.
It also might make sense to throw in other types of investments, such as commodities or real estate. But these can be added later when your portfolio of index funds and ETFs have started to take shape.
Actively managed mutual funds are another option, but they come with higher fees. They are also not as successful as many people assume. Yes, some mutual funds, where professionals actively pick the investments, will outperform the market. But, for the most part, they typically fall short – high fees are tough to overcome.
In fact, research from Morningstar in 2015 showed that less than 22 percent of large-cap stock funds beat the market from 2005 to 2014. The problem is that many of these funds come with much higher fees. Even if they do beat the market, it’s taken away in fees.
To learn more about investing, check out Why Investors Can Do Some Dumb Things (Me Included).
Started Too Late? Don’t Panic
If you are in your 30’s, 40’s or 50’s and haven’t started saving for retirement, don’t panic. You are late to the party, but you’re not alone in your predicament. Millions of Americans barely have any savings, let alone a retirement account.
Instead of panicking, start saving from today. Talk with your employer and see if they offer a 401(k) or another retirement account. Ask about their matching policy. Open the type of IRA that best suits your needs.
Then begin saving. Add the maximum you can every year. See if the catch-up option on the accounts applies to your situation. If it does, add that amount too. The key is to start with what you can afford and then increase it 1-3% (or more) each year. It’s called the “baby step” method and works like a charm.
It’s tempting to get into extremely aggressive investments if you are in your 40s starting to save for retirement, but diversification is still key. Sure, you can look to index funds or ETFs that are classified as riskier but don’t get too crazy. It’s better to save a bit less than to lose most of your nest egg due to an excessively risky investment.
And instead of pushing your luck with risky investments, it may be better to push your retirement a few years back. Instead of retiring at 65, you may need to work until you are 70. It’s unfortunate, but it’s a consequence of late planning.
Many individuals choose to phase out of working life, especially if they didn’t start saving early enough. It involves taking on fewer hours at 65 but still continuing to work. Even if you are working part-time for the next five to ten years, you can make up for the lack of savings from your 20s and 30s.
Only Cash Out at Retirement – Very Important
Many individuals are tempted to cash out their retirement accounts at an earlier age (before 59.5). You may be facing some financial troubles or maybe you see an investment opportunity somewhere else.
Please don’t do it! There’s a ten percent penalty, along with income taxes on 401(k)s and IRAs. And you’re just sacrificing your retirement.
Trust the process. Let your money continue accruing interest until you are ready to retire. Then you can start thinking about withdrawing it.
A quick run through of the different retirement accounts will help you understand their unique characteristics. Depending on where you work, you could open a 401(k) or 403(b).
Whether you can or not, you should also look at opening a traditional or Roth IRA. Then begin saving money and adding it to those accounts. Try to add the maximum every year, but every contribution helps! There are lots of retirement savings types but, most importantly, keep it easy on yourself and just start with one.
Planning for retirement is scary. But it’s best to “rip off the band-aid” and get started on the process. If you are scared about how much you will need to save, you can use a retirement calculator tool to help you get an idea. Get started today!
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