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Retirement Savings: Everything You Need to Know

Retirement savings

Unfortunately, 1 in 4 Americans has no retirement savings accounts. This is why it's important to calculate retirement savings as soon as possible and get started saving immediately. If you want to have your dream retirement lifestyle, saving for retirement should be a component of your overall financial portfolio and wealth-building strategy.

That’s true whether you are a full-time employee, a self-employed business owner, or something else entirely. There’s a variety of different retirement savings accounts that you can leverage for your retirement financial goals.

Retirement savings account types

There are many retirement savings accounts to choose from. First, of course, you need to pick the right account that aligns with your financial situation and goals. Let’s discuss them below!

1. The 401(k) Plan

This is an employer-sponsored retirement savings account into which you can contribute part of your pre-tax income. There is, however, an annual cap on how much you can contribute. Many employers who offer the 401(k) plan will offer a match up to a certain percentage. However, that doesn't count toward your annual cap.

The great thing about the 401(k) plan is that you get to save the maximum amount of your income before taxes. But keep in mind that when you retire, your funds will be taxed at whatever your tax bracket is at that time. So when you calculate retirement savings, planning for taxes is a must!

In addition to the traditional 401(k), many employers offer a ROTH 401(k) to their employees. It works the same way as a ROTH IRA. The main difference is the contribution maximum is much higher than that of the traditional 401(k).

2. 403(b) & 457 (b) Plans

These plan types are almost identical to the 401(k) plan. But, they're offered to people who work as educators or in non-profit organizations (403(b)) or who work for the government (the 457(b)).

3. Traditional IRA

This is a type of retirement savings account that you can set up individually, independent of an employer. In addition, this account type is tax-deferred. That means you will have to pay taxes come retirement (age 59 1/2) when you start to withdraw your money.

Having your taxes deferred could actually be a good thing! It means that all your earnings and dividends have the opportunity to compound. Your total balance will grow much faster than if you were having taxes taken out upon contributing to the account.

IRA contribution limits, however, are much lower than 401(k). And if you make a withdrawal before you are eligible (age 59 1/2), you will be subject to income tax and a 10% penalty. There are exceptions and limitations if you decide to use your 401k to purchase a home. However, this is also not the best idea.

4. Roth IRA

This savings account type is similar to a traditional IRA but has some key differences.

  1. Your contributions are made post-tax, which means there is no deferred tax benefit.
  2. The earnings on your contributions will not be taxed come retirement age.
  3. You can make withdrawals on your contributions before you are eligible without any tax penalties.

Should I contribute to a traditional IRA or a Roth IRA? Traditional IRA vs. Roth IRA- which one is the best retirement savings account?

They are both great ways to grow your retirement savings. But to choose between the two, you have to determine what works best based on what you think your future tax bracket will be.

For example, if you think your future tax bracket will be lower than what you currently pay now, then a traditional IRA might be best for you since you don't pay taxes until later.

However, if you think your tax bracket will be higher than what you pay now, then a Roth IRA might be best for you since you would have already paid taxes on your contributions.

Many people have both types of IRAs. Ultimately, they are able to save more by leveraging the benefits of these retirement plans over the long term.

Wondering, "How many IRA accounts can I have?". We break it down in this article.

5. Other types of retirement savings accounts

There are also other types of retirement accounts, like the Self-directed IRA, Roth 401(k), Solo 401(K), Simple IRA, and the SEP-IRA:

The self-directed IRA

A self-directed IRA is a type of individual retirement account, which is governed by the same IRS rules as a traditional IRA and Roth IRA. However, unlike other IRAs, a self-directed IRA can unlock access to alternative investments that are typically not available within an IRA.

For example, real estate, limited partnerships, commodities, precious metals, livestock, cryptocurrency, and more.

The Roth 401(k)

In addition to the 401(k), many employers offer a ROTH 401(k) to their employees, which allows you to make contributions with your after-tax income.

It works the same way a ROTH IRA way does (see overview below), but the main difference is the contribution maximum is much higher and similar in terms of the amount to that of the traditional 401(k).

The Solo 401(k)

This retirement plan is also specific to those who are self-employed but have no full-time employees (with the exception of a spouse).

It offers many of the same benefits as a traditional 401(k), but with a solo 401(k), business owners can contribute both as an employee and as an employer, which allows them to maximize both their retirement contributions and business deductions. This plan also covers spouses who get an income from the business.

The SEP-IRA (AKA Simplified Employee Pension)

This retirement plan is specific to those who are self-employed (with or without employees) and allows you to contribute up to 25% of your earnings up to a certain amount, tax-deferred.

This account type is based on employer contributions only, and each eligible employee (if you have them) must receive the same contribution percentage from you as the employer.

Now that you are familiar with the different types of retirement accounts, it’s time to get started on the road to retirement savings!

But what if you’re just starting out and don’t earn much? Whenever the topic of saving for retirement comes up, I am often met with statements similar to the following:

I don't earn enough to save for retirement.”

“I’m waiting to get a better job before I start saving.”

“I’ll play catch up when I earn more.”

But saving for retirement on a small or low income is very possible! So here are some suggestions on how to save for retirement if your income isn’t quite where you want it to be.

The best way to save for retirement when you have a low income

Just because you are earning a low income doesn't mean you can't start contributing to your retirement savings accounts. Use these key tips to start!

1. Start where you are

Although you might be earning a lower income, you can start by contributing as little as 1% of your salary to your retirement savings. Then, make 1% increments every quarter or each time your income increases.

Even though it’s a small amount—you probably won't notice much of a difference in your paycheck—over the long term, you'll be saving a substantial amount of money.

2. Get the free money

If your employer offers a 401(k) or 403(b) and also offers a savings match, take it. So many people do not take advantage of their employer-sponsored match.

That’s a big mistake because it’s essentially free money! If you are just getting started with saving for retirement, you can set an initial goal to contribute just enough money to get the match.

3. No 401k? Leverage other options

If you don’t have access to a 401(k) plan through your employer, then there are other options. They include setting up a traditional and/or Roth IRA through your bank or via a brokerage firm.

The saving maximums are lower than a 401(k) or 403(b), but you can still save a lot of money over time. Self-employed? There are also several retirement options you can leverage if you are self-employed.

4. Determine how much you need to save for retirement

A key consideration to make is to determine how much you need to save for your retirement years. This would be based on how much you think you'll need each month multiplied by the average number of years that retirement lasts (20 to 25).

The easiest way to calculate retirement savings is to use retirement planning calculators. Here are a few of our favorite retirement planning calculates to get you started:

Using these retirement planning calculators can help you figure out how much you need to save so you can plan accordingly.

5. Automate your retirement savings accounts

After you've used the retirement planning calculators to calculate retirement savings, you should make saving easier by setting up automatic deposits. How?

Have funds auto-debited from your paycheck directly into your retirement savings account. 401(k) and 403(b) deposits are usually automatically pulled from your paycheck. However, if, for some reason, your deposits are not automated, make a payroll request to make it happen.

Automatic transfers take the stress out of saving. And you'll never forget to make a transfer again! Plus, you won’t get the chance to overthink whether or not you should make the transfer or not.

Have an inconsistent income? Just not ready to automate? Then set reminders on your phone around each pay period reminding you to make those transfers to your retirement accounts!

Putting off retirement savings until you make more money? Not a great idea.

This basically means that you could have to work longer than you expected in your old age and/or have to rely on government assistance to survive.

By putting it off, you lose valuable time to take advantage of the power of compounding— the key to growing your money long-term. So start with what you have now, no matter how small it might be. Those small amounts will add up in a big way over the long term.

What happens to my money in a retirement savings account?

When you put money into your employer-sponsored retirement savings accounts, you will have a few options to invest in various stocks, funds, and/or target-date retirement funds.

Target date retirement funds are funds in which the level of risk adjusts the closer you move to your target retirement age.

When you invest in your own individual IRA you can make selections from the entire stock market. I’m personally a huge fan of investing in index funds.

Once you get into that savings mindset, you’ll enjoy watching your savings grow, regardless of how little you’re able to put aside. Just remember, it’s critical to leave that money alone and not be tempted to withdraw it.

I’ve seen so many instances where people think of their retirement savings as their emergency fund or as savings for their short-term goals.

They feel they can leverage the money for minor emergencies, non-emergencies, and other financial obligations or goals they have through loans or withdrawals. But is this okay? My thoughts? It really isn’t a good idea unless it’s a dire emergency.

Here’s what happens when you take money out of your retirement savings

Withdrawing or loaning money from your retirement savings can have adverse effects on your wealth-building efforts over the long term for several reasons.

  1. You will lose the potential long-term gains/earnings you would get if your money remained invested and was working for you.
  2. You will lose out on the effects of compounding interest when you take money out of your retirement savings accounts.
  3. If you withdraw your money before your eligible retirement age (e.g., when you leave a company or from an IRA), you will be liable to pay income taxes as well as an additional penalty (10%) on the total amount withdrawn.
  4. If you are making a withdrawal from a non-taxable retirement account like a ROTH IRA, you will still be liable for income tax on your earnings as well as the 10% penalty based on the total amount withdrawn.

What does this look like in actual numbers?

Withdrawing money from your retirement savings

Let’s say that right now; you are considering taking $1,000 out of your retirement accounts as a withdrawal or a loan. Let’s also assume that the average return on your investment for the next year is ~8%.

At the end of that year, you’d have $1,080 in your account. Another year into the future, based on annual compounding with a return of 8%, you’d have $1,160 in 2 years from an original investment of $1,000.

Impact of an early withdrawal

If you decide to take this $1,000 as an early withdrawal, you’d have to pay the following (assuming a 30% tax rate):

  1. Early withdrawal penalty - 10% = $100
  2. Federal & state tax withholding = $300

The balance you would receive would only be $600.00

Taking a loan from your retirement savings

If you decide to take out a loan, depending on the timeframe of your loans, your $1,000 will miss out on the potential earnings and compounding. And while you won't be subject to paying a penalty or taxes since it’s a loan, you will be paying interest.

And like many people who borrow from their retirement accounts, you might have to reduce or stop your retirement contributions altogether to be able to make the loan repayments. So the lost opportunity is even greater.

However, if you left that money alone for 10 years, the potential future value of your $1,000 retirement savings could be $2,159. This assumes an average return of 8% over that 10 years (based on the historical performance of the stock market long term). Since this is an average return, it would be despite spikes and dips in the stock market.

$600 vs. $2159.

The difference is major.

And this is only based on $1,000.

If it was based on $10,000 it would be a difference of $6,000 vs. $21,590.

Yup, let that sink in.

So how can you avoid taking money out of your retirement savings?

It's important to avoid dipping into your retirement savings accounts. Here are a couple of tips to help you budget better for emergencies and other expenses.

Build up your emergency savings

To start, it’s important to focus on building a solid emergency fund. Your goal should be 3 to 6 months, but more is better. That way, if you need some extra cash due to an unexpected occurrence, you can leverage your emergency savings as opposed to having to tap into your retirement savings.

Don't have an emergency fund in place yet? Set an initial goal to get to $1,000 ASAP. Then, after paying off any high-interest debt, ramp up your emergency savings to 3 to 6 months of basic living expenses.

Start saving for your short to mid-term goals

Next, create savings accounts for your short to mid-term goals. This is basically the money you need to have access to in less than 5 years, like buying a house, taking a trip, or buying a car. Building these saving goals into your monthly budget will help ensure you are allocating funds toward them each paycheck. Over time, you’ll be surprised at the progress you make.

Having doubts about investing in a 401k?

Still not convinced about saving money in a 401(k)? I understand. Below, I address a concern I received from a reader. Hopefully, my response will help you make an informed decision about investing.

A while back, I posted a picture on Instagram of an old 401(k) statement. I started this 401(k) account with a zero balance. Over a 4-year timeframe, I saved $81,490 which included my 401(k) match. Shortly after I shared that post, someone left this particular comment:

“401(k)s are for chumps. Two-thirds of that money will be gone in taxes, (and) fees that you don’t know about, and that they are legally allowed not to tell you about.

You will be taxed at the rate at which you retire, which will be more than you are today. Inflation will cut that by 2% every year. It’s a big game and you are falling for it. Why would you put your money in a 401(k) when the banks just print more money?"

Drawbacks of a 401(k)

I’ll be honest and say that yes, I agree with a portion of their comments in regard to the following points. And I’ll add a couple more cons to the list:

  1. Some 401(k)s can be expensive, have hidden fees, and be very limited in terms of where you can invest.
  2. 401(k) contributions are before tax. That means when you start to withdraw it, you will be paying tax at whatever your future tax rate is. Future tax rates are hard to predict, but they could very likely be higher than the present day.

BUT this person is wrong in so many ways.

Advantages of 401(k)

Even though there are a couple of drawbacks of a 401(k), the advantages far outweigh them.

1. For many people, investing in a 401(k) is their first real introduction to investing

Before being exposed to a 401k, many people have never really been exposed to or had the opportunity to invest in the stock market. A 401(k) provides that opportunity and allows it to happen painlessly through automatic deductions from your paycheck.

Yes, there can be high fees, and you will be limited to investing in only what is offered through your plan. But investing in a 401(k) plan is a good start. It’s a great way to take advantage of an employer match if one exists. Plus, 401(k) plans have much higher contribution maximums than IRA.

How does 401k matching work?

401k Matching is something that some employers offer when you contribute up to a specific amount to their employer-sponsored retirement savings plan. For example, a common matching plan matches 100% for contributions up to 6%.

This basically means that if you put up to 6% of your salary in your 401k, your employer will match it by contributing 100% of up to 6% in your retirement account as well.

2. There is a great opportunity for pre-tax contribution growth

The growth of your pre-tax contributions, especially over the long term, may far outweigh any taxes or fees you incur when you start to make withdrawals from your account. In addition, the growth from your employer’s match may be able to take care of some or all of those taxes and management fees you incur.

3. Retirement is not a specific date; it’s a period of time that lasts for several years

Retirement can last upwards of 20+ years. That means when you retire, you won’t be withdrawing all your money at the same time. Your money still has more time to keep growing. You should have an investment strategy in place that transitions to making your investments more conservative as you age. This helps you hedge against major losses in a market decline.

You should (hopefully) be spending less in retirement than you did while working. That’s because your kids are out of the house, and your mortgage might be paid off. So your taxable withdrawals and, in turn, your taxable rate should be lower.

4. Your money doesn't need to stay in your 401(k) forever

Most people do not stay at their jobs from when they first graduate college until when they retire. A classic example, me! I switched jobs four times over an eleven-year period before I started working for myself.

This means that when you leave a job, you can roll over your 401(k) money into an IRA and invest it more cost-effectively (much lower fees) and with more transparency than your employer’s 401(k). You are not stuck there forever.

Should I roll over my old 401k to my new employer’s retirement plan?

Yes, when it comes to what to do with your old 401k, you can roll it over from one employer to another if permitted by your new employer. BUT, it’s important to keep in mind that in many instances, employer-sponsored retirement plans can be limited in terms of the options you can invest in. They also typically have higher fees.

If you are moving jobs, it’s better to move your retirement savings into your own IRA with a brokerage firm like Betterment, Vanguard, or Fidelity. There, you have access to the entire stock market and potentially much lower fees. I’m a huge fan of index funds because I know exactly what I’m paying in fees.

Start funding your retirement savings now

Don’t ever let ANYONE make you feel stupid for making smart money decisions. Do your research, determine your investment objectives, have a long-term plan that you adjust as necessary, and stay the course when it comes to pursuing your financial goals. Don't forget to use the retirement planning calculators to help you figure out how much you need for a comfortable retirement.

If I didn’t know anything and was just starting out with my 401(k), this person who left the comment could have influenced me the wrong way.

Based on their misguided advice, I could very well have invested nothing, gotten no free match, and lost out on the chance to build additional wealth by investing in my 401(k). Don’t let that happen to you!

Want to pursue early retirement? Learn exactly what you need to do to get started!

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