Don’t simply retire from something; have something to retire to.
-Harry Emerson Fosdick
There’s no question that saving money is incredibly important to personal finance. How much of your income you decide to save can have a huge impact on your financial health. It can and will affect every part of your financial big picture, from your retirement to a future home to your kids’ college tuition.
Since I graduated college and started my job at this software company, I’ve taken saving for retirement very seriously. My job offers a 401(k) with matching, as well as an HSA. Naturally, I took advantage of both, and started by contributing 7% of my pre-tax income to my 401(k). I kept it this way for the first year, then lowered my deduction to 3% (my company’s minimum contribution limit in order to get the match).
I also signed up for a Roth IRA through Vanguard, so that I could have some more pre-tax savings in retirement.
How much you should save for your golden years is completely dependent on where you are in life. A teenager working his or her first job will probably have different savings goals than someone closer to retirement. There is no catch-all for savings amounts, but there are general expert recommendations for how much you should save.
Know what your savings goals are
Let’s assume that you want to know how much you need to retire with. Most experts recommend tucking away between 10 and 20 percent of income (or more, if possible), towards retirement. Or, you can start at the end and work backwards. First you need to figure out how much you want to live off of annually in retirement.
The 4% withdrawal rule
There is a standard 4% withdrawal rule that experts use to determine how much you’ll need to for retirement.The 4% rule is simple: In your first year of retirement, withdraw 4% of your nest egg, and increase that amount each year to adjust for inflation.
So let’s say you retire with $1,000,000. In your first year, withdraw 4%, or $40,000. If inflation is 2%, then the second year, withdraw $40,000 + (2% of $40,000) = $40,800. In the third year, that number would be $41,600, and so on every year after that.
You can also start at retirement and work backwards. To find out how much money you need to save in order to retire comfortably, take the annual spending amount and divide that by 4%. For example, say you want to live off of $50,000 a year after you retire. So you would need to save $50,000 / 4% = $1,250,000 over the length of your career.
Understanding compound interest
Compound interest is a critical component of saving for retirement. Simply put, compound interest is the basic principle that your money will collect interest, which will be added to your balance. When that money is reinvested, that balance plus the interest will collect interest, thus growing on itself.
Here’s an example of the power of compound interest working in your favor:
Let’s say you start saving for retirement at the age of 18, until the age of 65. If you invest $500 per month at an average return rate of 6%, you’ll have $1,533,387 at 65. If you invest the same amount at the same rate, but start at the age of 30, that amount drops to $708,725. Starting just 10 years later at the age of 40, that number drops to $348,938.
So as you can see, giving your investment time to grow is extremely important. The earlier you start saving, the better.
401(k) plans are critical to building a financial foundation for your retirement. A 401(k) is an employer-sponsored retirement vehicle that lets you invest a predetermined portion of each paycheck, prior to your regular payroll taxes being deducted. Those funds remain set aside for you, tax free, until you withdraw them for retirement.
Since 401(k)s are invested, the money will grow via compound interest. Thus, the most important aspect of 401(k) investment is time. The longer you have money invested, the more you will have in retirement. So it’s incredibly important to get started as early as possible.
There are limits, though, to how much you can stash in a tax-free 401(k) account each year. For instance, in 2017, the limit is $18,000 if you’re younger than 50 years old and $24,000 if you’re over 50.
If you don’t reach the maximum for the year, you can’t go back and make up for it later, so make sure to get as close to the max as possible.
Typically, 401(k) funds aren’t supposed to be withdrawn until your retirement. If you withdraw prior to retirement, there will be stiff penalties. So, it’s considered best practice to never touch 401(k) funds if you can help it.
Employers match 401(k) contributions
Some employers offer to match your 401(k) contribution. While the percentage of those matching funds vary from employer to employer, there are some who match 100% of your contribution, essentially doubling your dollars. Oftentimes, the amount of an employee contribution increases the longer you stay with a particular company.
If your employer offers a 401(k) match, make sure you contribute enough to take advantage of the match. This is free money that you can’t get back later. Many employers require you to contribute a minimum amount, usually 3% of your pre-tax pay, before they match your contributions.
IRAs and Roth IRAs
An IRA is an account that lets you protect your retirement money and save on taxes. Unlike 401(k), which can only be set up by your employer, you can set up either an IRA yourself.
IRAs come in two flavors: traditional or Roth IRAs. The main difference between the two is in the income limitations and restrictions. With a traditional IRA, anyone younger than 70½ years old with any income can contribute. There are no income limitations for the traditional route.
With a Roth IRA, if a single tax filer’s adjusted gross income is less than $117,000, they can contribute. From $117,000 to $132,000 a single filer can make a partial contribution. For incomes greater than $132,000, individuals are ineligible to contribute.
The adjusted gross income limitation for a married couple to make a full contribution is $184,000. From $184,000 to $194,000, partial contributions are a viable option. Over $194,000 of joint income, and the married couple is no longer eligible to contribute.
Regardless of what type of IRA you choose, there is a maximum annual contribution limit. At time of writing, individuals under the age of 50 can contribute $5,500 to a retirement account. For those over the age of 50, that number jumps to $6,500.
Withdrawing from an IRA
Contributions you make directly to your Roth IRA can be withdrawn without taxes or penalties at any time you wish. With a traditional IRA, you can only withdraw money without penalty after age 59½. Withdrawals after that age are treated and taxed like ordinary income.
Before choosing either type of IRA, decide when you’re best able to afford paying taxes on that money.
I personally decided to go with a Roth IRA, because I anticipate my salary (and therefore my tax rate) to go up as I get older. Thus, I’d rather pay taxes now, since they will be less.
A Health Savings Account (HSA) lets you contribute a portion of your salary into a specialized savings account designated specifically for health care expenses. With the cost of medical care steadily on the rise, an HSA is a smart way to manage present and future medical expenses.
While it’s somewhat similar to having a 401(k), there is one major difference. With a health savings account, you never pay taxes on the money you withdraw from your account as long as that money is used to cover medical expenses.
That means you save money on taxes when you contribute to the account and when you withdraw from it.
Your HSA contributions do more than save taxes on both ends. Depending on the choices your financial institution offers, you might also earn interest on those dollars. Some banks invest your account funds for you, which will help them to grow over time.
HSAs and HDHPs
If you enjoy relatively good health and don’t suffer from a chronic medical condition, an HSA is a smart way to manage health care costs now and during your retirement. Keep in mind that HSAs are typically paired with an HDHP (high deductible health plan).
HSAs are paired with HDHPs because it is a good way to pay for medical expenses only when you need them, as opposed to having a premium taken out of each check.
An HDHP is current health insurance with low premiums, but high deductibles. This means that you will pay little or nothing up front for health care costs, but will have to pay more out of pocket in the event of a medical expense.
I have an HSA through my employer. I’m lucky enough to be in relatively good health, so I know that an HSA will benefit me in the long run.
I hope that this has been an informative opener to retirement saving. I’ve only begun to scratch the surface of all of the options that you have for preparing for your retirement.