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This post was originally published in February of 2017. Here’s the new and improved version!
How Do I Save For Retirement?
Saving for retirement is not as complicated as the investment world makes it sound! All you need to do is:
- Select a retirement account
- Select the investments (assets) in your retirement account
- Automate your contributions
This post is your one-stop-shop for the complete retirement account overview. If you have questions about the nitty-gritty details of any step, please leave a comment or email Michelle at michelle@savingsandsangria.com.
Step 1: Select Your Retirement Account
You have three basic options with retirement accounts:
- 401(k)
- IRA (stands for Individual Retirement Account)
- Roth IRA
Yes, there are other account options available, but these three are the standard and will work for almost everyone.
1. 401(k)
401(k)s are often available through your employer. If your employer does offer them, you should strongly consider this option first. Why? Tax breaks, simplicity, and possible free money!
Tax break – the government WANTS you to be a successful saver because they don’t want to have to support your sorry tush when you retire! So they offer incentives to help.
401(k)s are pre-tax accounts which means the government lets you set aside your retirement savings and won’t consider it part of your income for tax purposes. This is what people mean when they say “pay yourself first”. You’re paying yourself even before you pay the IRS!
There is a limit to the government’s generosity. They don’t want to offer unlimited tax breaks, so they limit the amount you can contribute to your retirement account. You can currently save up to $19,000/year in your 401(k), though you probably won’t be anywhere near that limit. This limit increases every year to keep up with inflation.
Tiny catch: the government will tax the money as normal income once you start pulling it out of your account when you retire.
Simplicity – your employer takes the money out of your paycheck automatically and deposits it in your 401(k) plan. Once you sign up, you don’t really have to think about it until you leave that job and need to take your 401(k) money with you (which we’ll cover in a future post).
Possible free money – here’s the best part. Many employers will match your retirement contributions up to a point. When you contribute to your 401(k) every pay-period, your employer will contribute some extra money for you! There’s usually a cut-off point like 3 or 5% of your income, but who cares?! Free money!
The catch: your employer might have a clause that allows them to take back their match if you don’t stay with the company long enough (usually 3 or 5 years). It’s worth asking your HR Rep so you understand the rules.
2. IRA
Anyone can open an IRA because it’s not sponsored by an employer. But it’s similar to a 401(k) in that IRA contributions are pre-tax, so you’re still paying yourself first. The contribution limits are more restrictive on an IRA. The current limit is $6,00/year. This amount may sound like a lot, but it is totally doable! Here’s how you can find $6,000/year to max out your IRA.
Your employer isn’t involved, so they can’t take the money right out of your paycheck for you. You just need to open an IRA and invest money from every paycheck yourself. Then when you file your tax return, you’ll get a statement from your IRA so you can deduct the contribution amount from your taxable income.
Same tiny tax catch: like with the 401(k), the government will tax your money as normal income once you start pulling it out of your account when you retire.
And no employer involvement means no employer match. Sorry.
3. Roth IRA
The Roth IRA is the odd duck of the three retirement plans because this guy is not pre-tax. You have to use your after-tax-has-already-been-taken-out-of-your-paycheck dollars to fund it. The cool thing about this is that the money in the account won’t be taxed as you take it out when you’re retired!
That is a really important difference if you’re on the younger side. Think about this for a sec: the great thing about those pre-tax accounts is that you can probably afford to contribute more because you don’t have to worry about the taxes right away. So your larger contributions will help your account balance grow faster because of compound interest. If you don’t know about the magic of compound interest, check out The $831,751 Reason to Save for Retirement While You’re Young and Broke.
But the younger you are, the more time you have until retirement for your retirement savings to earn interest. So if you pay the taxes now with a Roth, instead of waiting until you retire like with a 401(k) or IRA, you still have time for compound interest to turn your lower contribution amount into the same huge balance. And you wouldn’t have to pay income tax on this money once you start using it in retirement!
Also, if you’re younger, you’re probably in a lower tax bracket now than you will be in the future because you probably make less money now than you will in the future. So it makes sense to pay your taxes now at the lower tax rate than to pay your taxes when you start pulling the money out at retirement.
Other than that big tax difference Roth IRAs are similar to IRAs. They are not employer-sponsored and they have the same $6,000 contribution limit.
Which account is for you?
If your employer offers a 401(k) with matching, take it no matter how long you have til retirement! Don’t ignore free money!
Otherwise, your best option depends on your time til retirement. If you’re under 35-ish, a Roth IRA is probably your best bet even if your employer offers a 401(k). Being able to pull out your money at retirement tax-free is awesome if you have a bunch of time on your side.
If you’re over 35-ish, an IRA is probably your best bet. If you haven’t started saving for retirement yet, you might want to consider using a 401(k) (even if there’s no employer match) AND an IRA. With the IRA contribution limit at just $6,000/year, you might want to be saving more money than that being closer to retirement.
How to Open an Account
401(k) – easy: just talk to your HR Rep, and he or she will walk you through it
IRA or Roth IRA – also pretty easy! Banks and investment companies allow you to open accounts online. We love Fidelity and Betterment accounts! In our experience, both websites are easy to navigate, and they have great resource libraries for those who want to dig deeper.
Step 2: Select Your Investments – Your Asset Mix
When you open a retirement account, your money sits in, like, a waiting cell. Your account servicer might pay you minimal interest or none at all. The way you force your account money to make money for you is to invest it in different assets (stocks, bonds, etc) within the account. These different investment assets are called your asset mix.
This is where most people get scared because there are about a billion options for investments. This is also where most posts on retirement leave you hanging because it can be crazy complicated. Most bloggers (and in fact, many financial journalists!) don’t want to try to explain this part. But your retirement account is pretty much worthless without taking this step because you won’t get the growth you need to make sure you have enough to retire.
Now, you could spend hours and hours reviewing prospectuses and trying to calculate the estimated returns for each asset mix combination to maximize your investment growth, but that’s not what we’re about at Savings and Sangria. We’re about going simple over trying (praying!) for optimal. Anything is better than nothing. So here’s simple:
1. All hail index funds
Index funds are AWESOME! They’re basically big groups of stocks or groups of bonds. When you invest in an index fund, you’re automatically investing in a bunch of different companies instead of putting all your eggs in one basket. This is what investors mean when they talk about “diversifying your portfolio”. Index funds = automatic diversification!
Index funds, unlike mutual funds, are passive. The fund follows the ups and downs of the index as a whole (the S&P 500 is a common index for index funds to follow). Mutual funds, on the other hand, are actively managed by a fund manager. But weirdly, index funds nearly always perform better than mutual funds, and index fund fees are way lower than mutual fund fees.
The fees for mutual funds average around 0.84% of the account’s balance, but index fund fees are only .11% (source). These fees are automatically deducted from the returns generated by your account, so they don’t come out of pocket.
You can learn more about index funds and mutual funds here: The Biggest Mistake Smart People Make With Their Money.
2. Decide on your risk tolerance to select which index funds
So, you’re convinced index funds are the way to go. But which index funds? Yup, there are about a million of these to choose from. And you want to pick more than one. Here’s why: the index fund groupings are categorized: they might be all domestic bonds or all foreign stock. So even though they’re auto-diversified, it’s smart to diversify further by choosing index funds from different categories.
Some categories have the potential to earn better returns than other categories. But these high-return funds are usually riskier. The younger you are, the more time you have for the market to fluctuate like crazy until you retire, so you can go riskier in hopes of higher returns. Then, as you get closer to retirement, you adjust your asset mix to make it less risky.
Generally speaking, bonds are the safest. Short-term investments are also lower risk. US stocks are riskier, so they usually provide better returns over the long run. And foreign stocks are considered riskiest.
Here’s a general idea of the risk level of some common asset mixes:
Betterment offers some great tools for helping you with this hard part. Their Retirement Guide lets you enter your basic financial info and retirement goals, and they recommend an asset mix suited to your lifestyle.
Once you know which categories are best for your situation, you look at the few funds in each category to make your final pick. You can look at the return rate trends to see which have performed best in the past. It’s not necessarily an indication of future performance, but you’re not a stock analyst or a fortune teller, so it’s probably your best bet.
Don’t get paralyzed by the number of choices or fear of choosing the wrong funds. Choosing any of the funds is better than not choosing!!! Seriously. Even if the one you choose ends up performing worse than the others in the same category, it will still be far, far better than keeping your retirement money in the waiting cell doing nothing!
Step 3: Automate
To ensure success, you MUST automate your accounts so that your investment is automatically contributed after every pay period. You also need to automate your account to automatically invest your contribution every pay period in your chosen asset mix (so you never accidentally leave money in the waiting cell).
All retirement accounts have these automated options. Take advantage of them! If fool-proofs your future livelihood by eliminating your choices and forcing you to do what’s best for you in the long run, no matter how you’re feeling about saving and investing today. Check out Fool-Proofing Savings for Guaranteed Financial Success.
Start saving and contributing to your plan now! Even if you can only do $20/week, do it! Then follow our advice to save more and more until you’re saving $6,000/year. Your future self will thank you for it!
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