The pandemic has a lot of Americans uncertain about the future. People have lost jobs, made career changes, lost loved ones, etc... So if you're concerned about your future, you are not alone. One way you can help secure your future in these uncertain times is by preparing for retirement. But preparing for retirement is an abstract idea you've probably heard of before. What does that even mean practically? How does one do it? Well, let's start with WHEN.
"When should I start preparing for retirement?" is a question financial advisors get asked every day. And the answer is clear: Now. Immediately. As soon as you can. But does that apply to people in their 20s who are decades away from even thinking about retirement? The answer is a resounding yes. Your 20s are exactly the time you should begin preparing for retirement. As Alanis Morissette said, time has a funny way of sneaking up on you. Before you know it, you'll blink and wonder where the time went. Wealth builds slowly year upon year, so you will want to start saving as soon as you can to build as big of a nest egg as possible. And it makes even more sense to do it young while time is on your side and while you don't have as many responsibilities and expenses, like children's college tuition, medical expenses, a mortgage, etc... And if you wait too long to start saving, it could affect if and when you can retire. Even if you are living at home with your parents working your first job, working part-time, and paying off student loans, whatever money you can save for your retirement will help.
Now that we know when to start saving for retirement, let's delve into WHY. Two words: compound interest. This concept is best explained as "interest on interest." Basically, it is the interest on your money AND on the interest, your money earned, which is always growing. This applies to savings accounts as well as investment accounts. Over time, with interest growing each year, it really adds up, especially if you invest your money, as investments can return 7% a year, all of which gets put back in and continually grows. It may be helpful to think of compound interest as interest building on itself. And the best part is you don't even have to do anything. You will earn interest without lifting a finger or adding another dollar to your account/investment. It's a little like planting a money tree (I wish!)--you plant a dollar, which grows and sprouts more dollars. The interest will accumulate on its own, but the money will grow even more if you continue saving and adding money to the account each year.
We know when and why to start preparing for retirement. Now, let’s explore HOW. There is no hard and fast rule on how to make the most money to save for retirement, but financial experts generally advise that investments are the way to go. Money sitting in a savings account will not earn nearly as much as investments, as interest on savings accounts is minimal. Of course, due to market fluctuations, there is a risk in investing, especially if you play the stock market. But if you make sound investments in mutual funds, index funds, etc…, that risk is reduced.
401(k) Retirement Plan
This kind of retirement account is offered by employers for their employees’ benefit. With it, pre-tax earnings are deducted from your paycheck and invested in a manner of your choosing. Companies who offer a 401(k) match money that you contribute to the account, though all companies differ on how much they match. A common matching policy is 3% of their employee’s salary, or more specifically, 50% matching on up to 6% of the employee’s salary. So your employee will contribute 50 cents for every dollar you save up to 6% of your pay.
Unfortunately, contributions are limited to $19,500 a year or $26,000 if you are 50+; you can’t withdraw money until you’re 59 ½ (or you’ll pay a 10% penalty in addition to full taxes), and you must begin withdrawing money once you reach 70 ½. But because the contribution is pre-tax, you will not pay taxes on that money until you withdraw it. This kind of retirement account brings with it a double tax break: First, it lowers your taxes in your highest earning, working years. And second, when you take the money out in your retirement years, you will be in a lower tax bracket, so the money will be taxed at a lower rate.
Individual Retirement Account (IRA)
This is a retirement account into which you can contribute up to $6,000 a year (or $7,000 if you are 50 or older). There is no employer matching and there is no income restriction. All money in an IRA grows tax-free, and you only pay taxes when you take the money out. In addition, because your contribution is made with pre-tax money, you can deduct that contribution from your taxable income. One downside is the Required Minimum Distribution (RMD), which requires that beginning at age 72, you must withdraw a certain amount each year and pay taxes on it. There is no way to predict if this will still be a requirement when you retire, but for now, it is. There is also a Rollover IRA with money “rolled over” from another retirement plan, such as a 401(k).
This is an individual retirement account that differs in how it is taxed. You contribute to this account with after-tax money, and it is not tax-deductible. The money invested grows tax-free, and when you withdraw the money decades later, that withdrawal is tax-free. To say it more clearly, you pay taxes on the money you put in, so the money you take out is tax-free. There is also no RMD, and you can keep the account indefinitely without withdrawing funds. This account is especially beneficial for those who believe they will pay higher taxes (due to being in a higher tax bracket) in their retirement years than they do now. The downside is that there is an income limit. You cannot contribute to a Roth IRA if you make $140,000 (or $208,000 for married couples), and the contribution limit is also $6,000 or $7,000 if you are 50+. Like a traditional IRA, there is no employer matching, and you alone contribute to this account. You can withdraw at any time with no tax or penalty, as long as it is a qualified withdrawal.
This is a standard interest-earning bank account. You alone contribute to this account. There is no employer matching. You can put in and take out whatever you want whenever you want without penalty. The downside is that interest rates are generally very low, so this kind of account will not earn much interest on your earnings. But if you’re looking for a safe way to save money, a savings account is a valid option as long as your expectations are realistic.
The Bottom Line
To retire comfortably, experts believe you will need between 70-80% of your pre-retirement income. So it is never too early to start preparing for retirement. And you don’t have to contribute the maximum allowable contribution if you can’t afford it. Any money you can save and invest will help in the future. The key is starting as soon as you can with as much as you can afford, so that money has time to build on itself over the course of your life.