By Nancy Mann Jackson, Grow
Listen, we get it.
You’ve already been told a million times already that you should be saving money for retirement.
But when you’re decades away from retiring, it’s easy to prioritize more immediate financial goals ahead of this one. In fact, nearly 60 percent of 18- to 34-year old investors say they’ve already withdrawn from their retirement accounts, according to E*Trade Financial research.
Putting off saving or raiding your retirement fund early can be tempting, but it can have big consequences. That’s because setting yourself up for a comfortable post-work life really comes down to two things: investing as early as possible and leaving your money alone to grow.
It helps, too, to have a good sense of how much you need to save now in order to support the life you want later. Here’s how to determine your retirement goal, pick the best retirement account for your needs and devise an investing strategy that’ll serve you for decades to come.
Step #1: Calculate your retirement savings goal.
There are two easy rules of thumb you can follow when it comes to saving for retirement: One is to plan to invest 10 to 15 percent of your income for retirement, and the other is to aim to save enough to cover about 80 percent of your pre-retirement annual income.
But without a personal retirement savings goal in mind, it’s hard to know if you’re on the right track to fund the kind of retirement you want.
To determine how much to save for retirement, start by thinking about your future. The average American life expectancy is about 79 years, according to the CDC’s National Center for Health Statistics, so if you want to retire at 65, plan for your money to last at least 15 years—and possibly much longer, depending on your lifestyle, health and family history.
You’ll always want to estimate your annual living expenses, including taxes, housing, food and health care. According to the Bureau of Labor Statistics, “older households” (those run by someone 65 or older) spend an average of $48,885 per year. Of course, that can vary according to where you live and other factors—for example, you may have a mortgage now, but will it be paid off by age 65?
Then think about any extra costs you’ll want to budget for, such as travel, gifts, hobbies and entertainment. Add those expenses to your annual total, then plug that number into an online retirement calculator that can show you how much to save monthly in order to achieve your goal.
Step #2: Decide which retirement account is right for you.
There are a lot of retirement accounts out there for you to choose from. We’ll walk you through some of the most popular options available, and keep in mind that you can often use more than one to invest for your future.
401(k). You’ve probably heard of this one before, and it’s okay if you don’t know what it means. If you have access to an employer-sponsored retirement plan at work, it’s likely a 401(k) plan. A 401(k) is a type of retirement account that allows employees to make pre-tax contributions directly from their paychecks. Then the money grows tax-free until it’s time to take distributions in retirement.
Each year, the IRS sets limits for max 401(k) contributions. In 2019, you can contribute up to $19,000 (plus an extra $6,000 if you’re 50 or older). Because these funds are meant for retirement, there’s a 10-percent penalty on any withdrawals before age 59½, and you’ll pay regular income taxes on the money taken out.
The best part of a 401(k)? Some businesses will contribute to employee accounts, too, through something called an “employer match.” So for example, your employer may offer to match 50 percent of your contributions up to 6 percent of your salary. In that case, if you contribute 6 percent, you’ll have a total of 9 percent of your salary invested for retirement.
403(b). Like a 401(k), this employer-sponsored retirement plan allows contributions of up to $19,000 (or $25,000 for those 50+) in 2019, and may come with an employer match. Early withdrawals before 59½ are taxed at your ordinary income rate, and you’ll pay a 10-percent penalty. The main distinction from a 401(k) is that it’s for nonprofit and government employees.
Some 403(b) plans have gotten a bad rap because they can be more regulated than 401(k)s. In fact, a 2016 study showed that 403(b) savers may be losing almost $10 billion per year due to excessive investment fees—so do your homework before picking a plan.
Traditional IRA. An Individual Retirement Account (IRA) is another type of retirement account available to just about anyone with an income, or even a spouse with an income. Contributions are made after taxes are taken out, but you may be able to deduct your contributions now, potentially lowering your tax bill, depending on factors like your household income and access to a retirement account at work.
In 2019, you can contribute up to $6,000 ($7,000 if you’re 50 or older). Your money grows tax-free, and you pay income taxes upon withdrawal in retirement. Like with 401(k) and 403(b) accounts, these funds are meant for retirement, and you’ll pay a 10-percent penalty plus ordinary income taxes on withdrawals prior to age 59½. However, there are some exceptions, such as paying qualified college expenses or purchasing a first home.
Roth IRA. With a Roth IRA, you also contribute after-tax cash, but the funds grow and can be withdrawn totally tax-free. You cannot deduct any portion of your contributions today. However, because you’ve already paid taxes on the money, you can withdraw your contributions anytime without paying additional taxes or a penalty. But withdraw your investment earnings before age 59½, and you’ll pay ordinary income tax and a 10-percent penalty.
There are income limits governing who can open a Roth IRA: Single people who earn less than $120,000 and married couples earning less than $189,000 can contribute up to $6,000 in 2019. If you make more than the income limit, you may still be able to contribute to a Roth IRA, but not max it out. To see whether you qualify to contribute to a Roth IRA, examine this table from the IRS.
SEP IRA or Solo 401(k). A Simplified Employee Pension (or SEP) is another type of IRA that’s available to self-employed people or small business owners. In 2018, you can contribute up to 25 percent of compensation or $55,000 (whichever is less). If you have employees the IRS deems eligible to participate in your plan, you have to contribute to their SEP IRAs, too. Tap your money before age 59½, and you’ll pay regular income taxes and the 10-percent penalty.
A solo 401(k) is a retirement plan designed specifically for business owners without employees, like freelancers and solopreneurs. It also offers a high contribution limit of up to $55,000 for 2018. You can choose either a traditional (pre-tax contributions that are taxed upon withdrawal) or Roth version (post-tax contributions that can be withdrawn tax-free). Like a Roth IRA, you can withdraw Roth solo 401(k) contributions anytime without penalty, but withdrawing any investment earnings before age 59½ will cost you penalties and taxes.
Brokerage account. A brokerage account is simply an account you can open at an investment firm, and buy and sell any stocks, bonds and funds you choose.
Because these accounts aren’t retirement-specific vehicles, there aren’t any inherent tax benefits. So it’s up to you to closely manage your tax liability on investments. The tradeoff is that you have the freedom to do your own thing, whenever you want: The IRS doesn’t dictate when you can withdraw money, and there are no contribution limits.
If you need the money before retirement, you can access it penalty-free. Just remember that you may be missing out on future earnings on potential stock market returns.
Step #3: Commit to saving for the long term.
Whatever account you choose, it’s important to make a habit of investing and stay committed to your long-term goals. The most successful retirement savers and investors stick to a few basic rules of thumb:
- Diversify. Avoid the temptation to put all your (financial) eggs in one basket. On the a basic level, a well-diversified portfolio should include a mix of both stocks and bonds. One easy way to accomplish that is by investing in funds, like exchange-traded funds (ETFs) that trade like stocks, which allow you to invest in literally hundreds of different stocks and bonds at once. This way, if some of your investments are down, others should hold you up.
- Keep a close eye on fees. Look for low-cost funds if you’re choosing your own investments, and read the fine print on any brokerage or investment agreements, including those provided by your employer. You want the money you’re socking away to go toward your own retirement, not to exorbitant fees.
Stay the course. Retirement is a long-term goal, and investing for it is a long-term process. Stock prices go up and down all the time, but those who remain committed have historically experienced higher returns. Don’t give in to knee-jerk reactions; practice patience and stick with your plan!