Table of Contents
- Why Save for Retirement?
- How Much Will You Need to Retire?
- What Percentage of Your Income Should You Save for Retirement?
- What Are Some Good Ways to Save for Retirement?
- Roth IRA vs. Traditional IRA vs. 401(k)
- Actions to Consider in Your 20s
- Actions to Consider in Your 30s
- Actions to Consider in Your 40s
- Actions to Consider in Your 50s
- What's the Cost of Not Saving for Retirement?
- Bottom Line
It's never too early or too late to start saving for retirement. There are certain considerations, such as choosing the right retirement account types and knowing approximately what percentage of your income to save for your age, that can help you be successful. If you're looking for more information on how to save for retirement, here's what to keep in mind.
Why Save for Retirement?
The primary reason to save for retirement is to help provide financial security later in life. Unless you expect to win the lottery or inherit millions of dollars, you'll need sufficient savings to pay living expenses during retirement. It's possible you may have sources of income in retirement, such as Social Security, pensions or part-time work, but these may not be sufficient to meet your entire income needs.
How Much Will You Need to Retire?
A good place to begin learning how to save for retirement is to estimate how much you will need to retire. An exact amount can be difficult to forecast, especially if retirement is still decades away. But you can calculate a close estimate by making a few basic assumptions. For example, many financial experts estimate that most people may need as much as 80% of their pre-retirement income to retire.
What Percentage of Your Income Should You Save for Retirement?
The percentage of your income to save for retirement depends upon several factors, such as your current age, how many years you have until retirement, how much you've already saved, the expected rate of return on your investments, and how long you expect to live after you retire. However, there are some general guidelines that financial professionals may recommend.
For instance, in your 20s, you may want to try to save 15% of your salary for retirement. If this savings rate doesn't fit your budget at first, consider starting with a percentage that's affordable and increase slowly each year. You may also want to try to save at least one times your annual income by age 30, then increase the multiplier by one every five years: Try to have twice your income saved by age 35, three times your income by 40, four times by 45, and so on.
Every person's retirement planning needs are unique. It's important to meet with a financial professional to discuss your situation. You may also find it helpful to use a retirement calculator to get a more accurate estimate of your savings needs.
What Are Some Good Ways to Save for Retirement?
There are multiple strategies and ideas around how to save for retirement. Here's what to consider.
Time is your best friend when it comes to saving and investing for retirement. This is because compounding interest from your investments can add up over time. For example, with an average rate of return of 7%, you could double your money approximately every 10 years. For instance, if you invested $500, it could be worth $1,000 in 10 years. But in 40 years, it could be worth $8,000. Invest $500 per month for 40 years and you could have $1.3 million. Just keep in mind that investments cannot guarantee growth and they may lose value over time. This example of a 7% assumed rate of return is used for illustrative purposes only, with all examples in this paragraph using the same assumed rate. Past performance is not an indication of future results.
Maximize & Increase Savings Rate
The amount of money you save will depend on your personal finances. You should aim to save as much as you can afford and are comfortable with. If you have to start small, saving something is better than not saving at all.
It's also wise to periodically increase your savings rate (or contribution amount to your retirement account). For example, if you get a pay raise of 3% of your income, you may choose to increase your retirement account savings by 1% or 2%. This way, you'll increase your retirement savings while you still take home more money.
Consider Investing Aggressively
The investment types you choose will directly impact your average rate of return and how much you end up saving for retirement. Investing aggressively means accepting more risk for the potential of higher returns. Again, remember that investments cannot guarantee growth and they may lose value over time.
Automate Your Savings
Automating your savings can make things easier and may help you stick to your plan. For example, you can have your 401(k) contributions automatically deducted from your paycheck and allocated to your chosen investments. Most financial institutions also offer a systematic investment plan for individual retirement accounts (IRAs), where you can have contributions automatically taken from your bank account on a periodic basis, such as monthly.
Use Tax-Deferred Retirement Savings Vehicles
When you use a tax-deferred savings vehicle, such as a traditional IRA or 401(k), you can invest more of your own money, as you are not paying taxes on contributions or dividends while the money is in your retirement account — only when you make withdrawls.
Roth IRA vs. Traditional IRA vs. 401(k)
The two types of accounts used when saving for retirement are IRAs and employer-sponsored retirement plans, such as 401(k) plans. When learning how to save for retirement, it's important to understand their potential benefits and the differences. Here's what to consider.
Roth IRA Benefits & Who Can Contribute
Contributions to a Roth IRA are made on an after-tax basis and growth is tax-deferred. Withdrawals are tax-free and penalty-free if made at or after age 59½ (and you've owned the account for at least five years). Roth IRAs may be a good option for people who expect to be in a higher federal income tax bracket in retirement when withdrawals are expected to begin, as they may not owe taxes if they meet certain qualifications. It's a good idea to meet with a financial professional to discuss your individual approach to retirement planning.
Traditional IRA Benefits & Who Could Contribute
Contributions to a traditional IRA are made on a pre-tax basis, and growth is tax-deferred. Withdrawals are taxed at the individual's highest federal income tax bracket and required minimum distributions begin at age 72. The 10% early withdrawal penalty is waived at age 59½. Traditional IRAs may be right for people who can benefit from reducing their current taxable income — for example, a high net worth individual.
401(k) Plan Benefits & Who Can Contribute
A 401(k) plan is an employer-sponsored retirement savings account that an employee can contribute to. Employee contributions are made through payroll deductions, and the employer may make matching contributions. It's generally recommended to contribute at least enough to a 401(k) to receive the full employer match, if one is offered.
Note that there are other differences between IRAs and 401(k) plans. For example, there are certain income limits and contributions limits for making qualified contributions to IRAs. For 2020, the maximum contribution amount for IRAs is $6,000 (or $7,000 for those age 50 and older). The maximum contribution amount for 401(k) plans in 2020 is $19,500 (or $26,000 for those age 50 and over).
Actions to Consider in Your 20s
- Get started with a 401(k) or IRA: For many people, saving for retirement begins in their 20s. Consider taking advantage of your employer's retirement plan, such as a 401(k), especially if they offer matching contributions.
- Consider a Roth IRA: If you don't have a 401(k) option at work, or if you want to supplement your savings with another retirement account, your 20s can be a good time to open a Roth IRA. This is because after-tax contributions may make sense earlier in life when you're more likely to be in a lower tax bracket.
- Maximize savings rate: In your 20s, you may have fewer financial responsibilities, which means you may be able to afford to save a higher percentage of your income.
- Invest aggressively: Since you won't need to begin making withdrawals from your retirement accounts for 30 or 40 years, you may be more comfortable taking more risk with your investments.
Actions to Consider in Your 30s
- Start/continue to increase 401(k) contributions: If you've not started a 401(k) plan, and you have one available through your employer, you should likely take advantage of it now.
- Maximize Roth IRA contributions: If your 401(k) does not offer Roth contributions, consider supplementing your 401(k) with a Roth IRA. The maximum contribution is $6,000 in 2020.
- Continue to invest aggressively: As you're still 30 or more years until retirement, you might want to choose more aggressive investment strategies.
Actions to Consider in Your 40s
- Increase 401(k) contributions: Try to contribute at least enough to your 401(k) to receive the maximum matching contribution.
- Maximize Roth IRA contributions: Although your tax rate is likely going up, it may still make sense to make after-tax contributions to your retirement accounts. If your 401(k) does not offer Roth contributions, consider supplementing your 401(k) with a Roth IRA.
- Continue to invest aggressively: Since you're still 20 or more years until retirement, you can likely afford to continue investing in riskier investments.
Actions to Consider in Your 50s
- Fully maximize 401(k) contributions: Many Americans are in their peak earning years in their 50s. This may translate to peak savings years as well, especially if the children have grown up and moved out. The maximum 401(k) contribution is $19,500. Starting at age 50, you can make a catch-up contribution of up to $6,500, bringing the total maximum 401(k) contribution in 2020 to $26,000.
- Consider pre-tax contributions to retirement accounts: Since you may be in your peak earning years, you may also be in the highest federal tax bracket of your life. For this reason, making pre-tax (traditional) contributions to your 401(k) or to a traditional IRA may make sense and help reduce your taxable income.
- Invest less aggressively: Now that you may be within a decade from making withdrawals from retirement accounts, it likely makes sense to reduce market risk.
While taking these actions in your 20s, 30s, 40s and 50s may help you prepare for retirement, they are not comprehensive.
What's the Cost of Not Saving for Retirement?
Many financial experts generally say you'll need at least $1 million in retirement savings to live comfortably in retirement for 30 years. Because of the combination of time and compounding interest, it's smart to start saving for retirement when you're young. Not starting early can reduce your ability to save enough to live the life you want during your golden years.
Learning how to save for retirement can be simple if you consider starting early, automating your savings, and using tax-deferred savings vehicles. It's also important to remember that investments come with risk, and retirement planning can be increasingly challenging as you age and your finances become more complex.
Before you invest and choose which retirement savings accounts may be right for you, it's important to understand your tolerance for risk and to keep in mind the associated tax benefits and consequences. If you need additional guidance with retirement planning, consider seeking the help of a financial professional.