Ben Todd | Apr 16, 2017 | 3
Beginners Guide To Saving Towards Retirement
Many of the younger crowd think saving for retirement isn’t something they have to worry about for years to come. This simply isn’t the truth, you should start saving for retirement even at a young age. It’s never to early to begin saving for retirement and it really isn’t all that difficult. This article will explain how you can start to save your money for retirement.
To begin saving for retirement you will need to do the following:
- start saving for retirement immediately
- open retirement saving accounts such as a 401 K, a Roth IRA, or a traditional IRA.
- contribute to your 401k and take advantage of your employer matching your 401 K contributions
- invest the money in ETF’s or Target Date Funds (with the help of an advisor)
- do not touch your retirement accounts until you are aged 59.5 or older.
The first step is to make the decision to start putting money aside for retirement. It might not seem rational to start saving for retirement at a young age, however the earlier you start saving, the less money you will have to save over the long run because of compound interest.
The following is a great example of saving money now, compared to down the road. If you were to contribute $5000 into your retirement account every year starting at age 25 to 65, with an average rate of return of 5% you would have $615 000 by age 65. Keep in mind this isn’t taking into account increased contributions, this is if you continually contributed $5000 per year. Now, if you didn’t start contributing till age 32, using the same figures in the previous example you would only have $395 000 by age 65. Thats still a good amount, however starting at age 25 earns you almost double then what you would have if you started at 32.
Your retirement savings will accumulate over time with the power of compound interest. Compound interest is the interest calculated on the initial amount, and also interest on the accumulated interest of what was earned in previous periods or years on the loan. Basically compound interest is really interest on interest, which makes your savings grow at a faster rate then just simple interest.
1. Open Retirement Accounts
There are two primary retirement accounts you need to open to start your savings for retirement. These are a 401K and an Individual Retirement account(IRA)
A 401 K is a retirement savings plan which is offered through your employer. A set amount from your pay check is invested into your 401 K, and no taxes are paid until the money is taken out. You can contribute up to $18 000 per year. Also your employer might match your contributions to your 410 k. Sign up for your companies 401K if you do not already have one. Also contributions to your 401K reduce your taxable income, the more you contribute to your 401K the bigger the reductions it will be to your taxable income. So if you needed a little bit of if incentive to start contributing to your 401K that was it.
An IRA is an individual retirement account that allows the individual to contribute pre tax income towards investments such as stocks, bonds, and mutual funds. These investments will be tax deferred with no capital gains tax or dividend income tax. The money is tax deferred until the individuals can start taking the funds out, which you can do at age 59.5 or later. For the year 2016, your IRA contributions cannot be more then $5500 or $6500 at the age 50 and older.
There are a few different types of IRA’s such as Roth IRA’s (which we recommend you use) and a SEP IRA’s which is for self employed individuals.
Social Security Benefits
Some younger individuals might be saying, “I will just get social security benefits when I retire, so I don’t anything else.” This is completely false, as social security benefits will not be enough to lived comfortably during retirement. When people in their 20’s and 30’s are set to retire, the social security system could be a be a lot different with the possibility of reduced payments. When it comes to retirement, just think of social security benefits as an added bonus for you.
Employer Contributions To Your 401 K
If your employer offers a match contribution to your contributions you make to your 401 K, then it is a must that you contribute enough so you can get the highest match from your employer. For example, if the highest match is half of 8% of your pre tax income, then make sure you contribute the 8% so you would then get another 4% contribution from your employer, so it would be like your putting away 12% of your income for that year. Using this employer match can really add up allow your money to grow to a larger amount.
Check with Human Resources through your employer to see what the company policy is on this subject. Keep in mind, employers contributions to your 401K are usually vested. What this means is you have to work for your company for a certain amount of years before the money is yours to keep. For example, if your company has a 5 year vesting schedule, you will get 20% of their contribution to keep as yours for each year you work there. So after 5 years it would add to you having 100% of the money as yours. So if you leave the company before the 5 years is up, then the unvested portion will not appear on your balance.
Contributing enough to get the maximum match from your employer is the minimum you should be saving. If you get raises over the years, use that to your advantage for retirement savings as you should increase the amounts you contribute to your 401K after each raise.
Now, if your company doesn’t offer a 401K, or doesn’t offer a match to your contributions then you should open up a Roth IRA.
- A Roth IRA is similar to a traditional IRA except that you pay the taxes when you contribute the money and not when you take money out of it. So you do not have to worry about being taxed on the money in your IRA when you take it out down the road.
- The maximum you can contribute to an IRA is $5500
- You can make contributions up until April 15th to make IRA contributions that will be counted for the last year.
It is good to know that if you have maxed out your contributions to your IRA and still want to save more for retirement, then you can toss that money into your 401K, just be sure you do not go over the 401 K limit of $18000. Overall, you can contribute $23 500 per year towards your retirement with your 401K ($18000) and your IRA($5500).
2. Investing Your Retirement Money
Now that you have both your IRA and 401 K accumulating money, it is time to invest some of that money to help your retirement funds grow. When it comes to investing you will have many options such as stock, bonds, mutual funds, and more.
If your in your 20’s and 30’s you should start to invest your retirement money into stocks. Why stocks you ask? Well stocks have the potential to earn you the highest rate of return out of any investment. If you are in your 20’s or 30’s your risk tolerance should be very high because you have plenty of time for the markets to go back up if the markets dive, like in 2008. Do not worry the markets always go back up after big dives, its part of the cycle.
Once you hit your 40’s and 50’s then it can be time to take your money out of stocks and put it in safer investments such as bonds, and mutual funds
3. Investing In The Market
When it comes to investing in stocks, please do not pick your own stocks, you’ll will just be setting yourself up for failure. You could have your financial advisor help you choose, but even they fail to beat the market averages when it comes to individual stocks.
What is recommended is to invest in Exchange Traded Funds (ETF’s) and Target Date Funds. You can use any brokerage to invest in ETF’s or Target Date Funds as explained below:
Exchange Traded Funds
It is highly recommended to invest in Exchange Traded Funds (ETF’s). An ETF is a financial product that tracks an index, commodities, bonds or a number of assets like a mutual fund would. However the big difference is ETF’s trade on the actual stock market, and their prices will fluctuate throughout the day just like a normal stock. Brokerages offer several ETF’s to choose from, so make an appointment and discuss the available options.
The following is an example of how an ETF would work:
Let’s say you invested in an ETF that when oil prices rise, the ETF rises in price too. So lets say oil is continually rising in price for a week, that week your ETF, which trades on the stock market, would also continually rise in price. ET
There are several ETF’s available, however you can invest in ETF’s that track the performance of the S&P 500 or the Dow Jones. There are ETF’s for gold prices, ETF’s for mining stocks etc. The key when choosing ETF’s would be to diversify your holdings to minimize your risk. For example if you were invested in Oil, gold, large cap stocks, mid cap stocks, mining stocks, and international stocks, you would have done a good job spreading out your investments to reduce the risk. If one of those sectors falls, its fine because you have invested in a variety of sectors.
Target Date Funds
Target Date Funds will automatically manage your portfolio for you, and as you get older they will rebalance your portfolio into investments with less risk. Unfortunately, Target Date Funds run automatically, so they do not consider your personal risk tolerance, nor do they allow you to change the investment setup the fund has done. Furthermore, the fees for using a Target Date Fund can be pretty high.
However, if you are one that doesn’t like to choose their investments and rotate your investments over the years then a Target Date Fund would be best for you. They are still very effective investment tools used by many.
4. Do Not Regularly Check Investments
Once you have all your accounts all set up, with your regular contributions going in and investments all picked out, then it is best to leave the accounts alone for a while. If you check your account one day and its down because of the stock market, you might be tempted to sell and miss the inevitable rebound. It is a long term investment over many years, so the day by day actions do not really matter.
5. Do Not Cash Out Before Retirement
Do not cash out your 401 K or your IRA no matter how tempted you might be. Over the years something might come up where you need extra money, but do not take the money from your 401 K and your IRA. Doing so before the age of 59.5 years of age will get you a 10% penalty as well as some income tax issues when it comes to filing your taxes.
There is nothing wrong with taking a look at your retirement investments every few months just to make sure nothing drastic happens, otherwise that should be the only times you should check it out.
There you have it, you’ve now learned about the accounts needed to start saving, how to contribute, and where to invest the money to see your savings grow over time.