A Crash Course in Starting and Growing Your Retirement Savings
Want to know why most younger adults don’t think much about saving for retirement? Probably because there’s a lot to think about. Furthermore, many mistakenly believe that they should wait until they’re making big bucks (whenever that will be) to begin setting money aside.
Admittedly, with so many different types of retirement accounts, IRS rules, and other options, often times the benefits of these accounts get lost in the shuffle. Moreover, knowing where to start with all of it can be overwhelming. Don’t fret — I’m here to help.
The bottom line is that you should start saving for retirement as soon as you can. So, to help get you started, let’s take a look at why starting now is so important, what the big benefits of having a retirement account are, and a few tips for successfully growing your savings.
Start Early, Start Small
Why It’s Important to Begin Saving Early
The eternal irony is that, while young people are probably the least inclined to pay any mind to their eventual retirement, starting your savings as early as possible is key to having a prosperous retirement. Beyond the added principal you’ll build by contributing for longer, what’s really lucrative is the interest. In fact, the monetary differences between beginning your savings at age 25 and age 35 are simply staggering.
My go-to example of this comes from a report by JP Morgan Asset Management and published by Business Insider. This hypothetical first compares two different investors: one who contributed $5,000 a year for 40 years (age 25 to 65) and another who did the same but for 30 years (age 35 to 65). While the difference in their principal is only $50,000 at age 65, their total returns are far different. Assuming a 7% annual return, the 40 year saver would retire with $1,142,811 compared to just $540,741 for the 30 year saver. As you can see, that 10 year head-start led to a nest egg more than twice as large. Not bad, huh?
If there’s one thing about that example I don’t like it’s that, for many, setting aside $5,000 a year for retirement at age 25 is just not realistic. Don’t worry — you don’t need to contribute massive amounts of your income each year to maintain a retirement account. Furthermore, the majority of IRAs and Roth IRAs don’t have minimums, meaning you can start your account with just a few dollars.
When my wife was first getting started with her Roth IRA, she told me she’d set aside $10 a week to contribute to her account. This meant she was putting $520 a year toward her retirement savings — a far cry from five grand but definitely not a bad start. Even today we keep that $10 a week tradition alive while also contributing to a 401(k) (more on that later) and occasionally making larger contributions when we can.
Be sure to check out the “Retirement Savings Tips” for more ideas on turning your small change into big dollars.
What’s Different About a Retirement Account?
At this point, you may be wondering what makes retirement accounts so special. After all, couldn’t you just set aside money for retirement in a normal savings account? Well, you could, but there are a number of reasons why that’s not the best financial idea.
Topping the list of why retirement accounts are better than savings accounts is the interest you earn. If you have a traditional savings account at one of the too-big-to-fail banks, chances are you only earn about .01%. Even over the course of 30 to 40 years, that’s still not going to amount to very much. Meanwhile, there are plenty of different retirement options that typically offer much better returns – 5-10%. To be fair, there is risk involved with many of the retirement options. That said, even safer options like money markets still often boast better returns than a regular savings account.
Another major benefit of retirement accounts is their tax-sheltered status. Depending on what type of account you choose, this could mean a couple of different things. For regular IRAs and 401(k)s it means that your contributions aren’t taxed at the time you make them. So, if you make $30,000 for the year but contribute $5,000 to an IRA, your taxable income would be $25,000. Of course, when you do go to make withdrawals at retirement age, you’ll then have to pay tax on those pulls.
For Roth IRAs, the situation is reversed. While you pay taxes on your income upfront, your withdrawals (and gains!) come tax free as long as you’re over a certain age. Even though this is often a better deal overall, some young savers without much to their names may balk at needing to pay taxes upfront.
Incidentally, even Roth IRAs can help your current tax bill if you qualify for a Savers Credit — more formally known as a Retirement Savings Contributions Credit. Depending on how much you earn per year, you could qualify for a tax credit just by contributing to a retirement account. For example, in 2017, a married couple filling jointly that made less than $37,000 would be entitled to a credit equal to 50% of their contributions up to $4,000. Sound too good to be true? You can check out the IRS page dedicated to this magical program for yourself.
A Few Notes
Due to all these benefits, there are limits and downsides to retirement accounts as well. First, IRAs and Roth IRAs put restraints on how much individuals can contribute to their accounts each year. For 2017, that limit is set at $5,500. 401(k)s also have maximum contributions, although the threshold is far higher (currently $18,000).
Perhaps the biggest downside to retirement accounts is how inaccessible your money is. Well, it’s not exactly inaccessible per se but, once you put your money into an IRA or 401(k), it’s very expensive to get it back out. That’s because, with all the tax benefits the government is giving you to save, they really don’t want you tapping your account for anything other than its intended purpose. To dissuade you, withdrawals you make before you’re 59 and half are subject to a 10% penalty on top of any taxes you’ll need to pay on the funds. As someone who’s raided their 401(k) in the past, let me tell you it’s not worth it!
There are a few exceptions to this retirement account tax nightmare. For one, since taxes for Roth IRA contributions are paid upfront, you are technically able to make withdrawals from your principal (but not your gains) without penalty. And while you can’t take money out of your 401(k) permanently without charge, many accounts do allow you to take out a loan. These loans have their own set of pros and cons — e.g. low interest rate but lost gains — so be sure to carefully considering such an option.
In the end, the best practice is to just leave your retirement savings alone until, well, retirement.
Sign Up For Your Employer’s 401(k)
If you are eligible to sign up for a 401(k) at your job, do it! This is not only the hands down best way to get your retirement savings started but could also result in you getting some free money.
Let me explain: a 401(k) is a retirement account typically set up with your employer. What’s great about this is that you can decide on what percentage of our income you want to contribute and have the money automatically deducted from your paycheck. Better yet, a number of employers offer other perks such as matching funds and profit sharing.
For matching funds, typically your employer will contribute the same percentage of your income as you contribute up to a certain limit. Be aware that limit will vary greatly on the plan, but it’s not unheard of to get matching up to 4% in some cases. Additionally, some employers go one step further and gift their employees with profit sharing. Again, the amount of profit sharing you may get is dependent on a great many factors, but it is another way to build up your retirement nest egg.
So with all of those benefits be sure to check with your supervisor or human resources department to see if you are eligible to join your company’s 401(k) plan.
Try An App
As I mentioned, there’s no harm in starting small with your retirement savings and growing them overtime. One potential way of doing this is to check out an app called Acorns. This app helps you set aside money without even really thinking about it. To achieve this, you first need to link your credit and/or debit card to Acorns. Doing so will then allow it to do what they call “Round Ups.” Whenever you make a purchase, Acorns will essentially round the price off to the nearest dollar and deposit the “loose change” into your account. So, for example, if you bought a cup of coffee for $4.35, Acorns would take an extra $.65 from your bank account and add it to your balance. From there, the app actually invests your money in a mix of stocks and bonds, which you can adjust to be more aggressive or conservative. You can read more about Acorns is this review.
While Acorns won’t directly allow you to contribute to your retirement account, there are a couple of advantages to using such an app. For one, it will give you a bit on an introduction to the world of investing, which you’ll want to know a bit about before your put your IRA into a mutual fund or other investment option. Secondly, Acorns makes it easy to cash out your money and deposit it back in your bank account. In turn, you could take that money and move it to your retirement account. Of course, Acorns and other apps do charge a small monthly fee so, if you’re disciplined enough to set money aside on your own, that might be a better plan.
Leave It In Peace
Just as I recommend contributing to your retirement account and not touching the funds, it’s also not always helpful to keep too close of an eye on your funds. If your 401(k) or IRA is invested, you will have up days, down days, up months, down months, etc. etc. etc. This can be exciting or depressing depending on the results, but you shouldn’t put too much stock (pardon the pun) into these short term changes. Remember: saving and investing for retirement is a long game. In many cases, the best plan of action is to stay the course and not panic. Case in point: investors who held on through the 2008 financial crisis came out on top when all was said and done. That said, you will want to get more conservative with your investments as you get closer to retirement, but that’s a conversation for another time.
Between the different accounts, contribution limits, taxes, and more, there’s a lot of confusion that surrounds retirement savings. However, when you break things down, it’s really not all that complicated. In fact, you can start saving for retirement with just a few dollars and grow it into something much more sustainable by the time you retire. So what are you waiting for?