I Want to Save for Retirement

Laura Shin
Posted

Understand why retirement is important.

You kind of, sort of think you know that you should start saving up for retirement … someday.

Well, the day you start is today. Contributing money toward your retirement will be one of your priorities from now until the day you leave the workforce. To find out why, check out our article, Saving for Retirement 101. Plus, learn what not to do when it comes to retirement in Top Retirement Mistakes to Avoid. Then we’ll get you started.

Learn this lingo.

As you dive into retirement brochures and websites, you may come across a fair amount of retirement account lingo. Read over these terms so it’s not all gibberish to you.

  • Qualified retirement plan: A retirement plan that the Internal Revenue Service has deemed eligible to receive tax benefits.  
  • Tax-deferred accounts: Retirement accounts such as a 401(k) in which the account holder pays taxes later, when funds are withdrawn from the account.
  • After-tax accounts: A retirement account, such as a Roth IRA, in which the contribution is made with money that has already been taxed.
  • Pretax contribution: A retirement contribution made with money before taxes are taken out, usually to a tax-deferred account.
  • Post-tax contribution: A retirement contribution made with money after taxes are taken out, usually to a Roth IRA, which will not charge the account holder tax when the money is withdrawn.
  • Matching contribution: An amount of money an employer pledges to contribute to an employee’s retirement account as long as the employee makes a certain level contribution.
  • Rollover: The transfer of money from one retirement account to another without having to pay taxes on the move.

Find out what retirement savings programs are available to you through your employer.

If you’re self-employed, skip down to step number eight. But if you have a full-time job, then definitely look into the retirement programs your employer offers, because such plans usually have tax benefits (though retirement accounts you set up on your own can also have tax benefits). The most common types of employer-sponsored retirement programs are:

  • 401(k)s: A 401(k) is offered primarily by private companies and allows employees to have contributions to their retirement accounts taken out of their paychecks. The account holder does not pay taxes on the contributions herself, but pays taxes on the money distributed from the account.
  • 403(b)s: A type of retirement account that is similar to a 401(k) but is available to public education institutions, non-profits and ministers.
  • 457s: A 401(k)-like retirement account for governmental employers.
  • Roth 401(k)s: This type of retirement account is like a regular 401(k) except for the way it is taxed. Unlike a regular 401(k), the contributions are taxed before the money is deposited into the account. However, that means that when the funds are distributed in retirement, the recipient does not have to pay any taxes! Though not as common as a traditional 401(k), the Roth 401(k) is becoming a more popular additional offering.
  • 401(a)s: Also known as a “money purchase plan,” a 401(a) does not allow the employee to choose the amount he or she contributes to the plan. The company contributes to the plan on its own or mandates that all employees deduct a set percentage from their paychecks as a contribution.

Some employers, in addition to one of the above retirement plans, may offer pensions, in which the employer contributes money toward a pool of funds that are then distributed to employees when they retire. Pensions are becoming much less common, though, with only 13% of Fortune 500 companies offering them to newly hired workers in 2011. That’s down from 17% in 2010 and from 89% in 1985.

Find out whether your employer offers a matching program and, if so, how it works.

Sometimes, companies will add money into your retirement account to create incentive for you to save for retirement. Let’s say your company contributes 50% of what you contribute up to 6% of your salary. So, if you make $100,000 and you contribute 6% of your salary, then your company will chip in another 3%, and you’ll be socking away 9% of your salary each year, while actually only taking 6% out of your salary. Basically, you’ll be getting 3% for free! Let’s try another example: your company has an even more generous plan that matches you dollar for dollar up to 6%. That means that if you contribute 6% of your salary, you’ll actually get to save 12% of your salary every year even though only 6% is being taken out of your paycheck.

Not all companies match, and this is by no means the only reason to be saving, but if your company does, it is a great incentive to get started.

Determine how much you need to live on.

You should contribute to retirement as least as much as you need to in order to take full advantage of your company’s match, and if you can contribute more, as much as what works for your budget. But it’s a bit tricky figuring out how much you can contribute toward retirement since it isn’t easy to predict how it will affect your paycheck. (Since the money comes out pre-tax, you can’t assume that contributing $200 to retirement every paycheck will just knock $200 off your current paycheck.) An easy backwards way to figure out how much you can contribute while still leaving you enough to live on is to follow this quick rule of thumb: tally up your essential monthly expenses—housing, daily transportation, utilities, groceries. Multiply that number times two: this is how much your take-home pay needs to be in order for you to have a properly balanced budget.

Determine how much your retirement contribution will be.

Play around with this calculator to see how much your paycheck will be based on various retirement contribution scenarios. In “results,” you want the net income number to equal your target balanced-budget number (twice your monthly essential expenses). If you don’t know how much of your paycheck to allocate toward various expenses, learn how to do your budget right here!

Sign up for your work retirement program and meet the minimum requirements necessary to receive a full match, if offered.

Now that you know how much you’ll need to live on per month and how your retirement contribution will affect your paycheck, sign up for your work retirement program, making the contribution you need to get the full match from your company and that still works for your monthly budget. For instance, if you’ll get full matching from your company with a 5% contribution, but you have calculated that you can contribute 10% of your paycheck and still have a balanced budget, then by all means, contribute 10%. However, if you need to contribute 5% to get the full company match but find that you can only contribute 3% without jeopardizing your budget, we suggest you try to redo your budget, earn some side income or cut some expenses in order to be able to contribute 5%.

Choose a diversified investment portfolio.

Each retirement program offers different types of investments. You should base your choices on your own individual risk tolerance, which is a way of measuring how big a loss you are willing to risk for potential gains. Many retirement programs offer risk tolerance quizzes that will then recommend investments to you. If you want to test your own risk tolerance here, take our quiz.

With every raise, increase your retirement contribution until you’ve reached the maximum contribution.

The government mandates limits on contributions to certain types of retirement accounts. (The reason the government doesn’t let us contribute as much as we want is that the wealthy could then exploit 401(k)s by contributing exorbitant amounts of money to them in order to avoid taxes.) The limits vary every year. For 2012, the limit on contributions to employer-based accounts such as 401(k)s and 403(b)s is $17,000; for Roths and traditional IRAs, the limit depends on your income, tax filing status and age. (Read more at the IRS website.)

If you’re not currently contributing the maximum, increase your retirement contribution with every raise. So, if you receive a 3% raise, increase your retirement contribution by 3%, continuing to live on the same budget. Also, if you want to speed up the increase in your contributions, then aim to boost your contribution by 1% every six months. Each time, also re-do your budget, finding a new expense to cut, or coming up with a new way to make side income so you don’t have to cut costs.

Choose an Individual Retirement Account (IRA).

IRAs are useful no matter your employment status (but you can only contribute to one if you have earned income–or are married to someone who does). If you’re self-employed or your employer doesn’t offer a retirement account, you’ll need to open your own. If you have an employer-based retirement account and you’ve reached the maximum contribution and want to save more for retirement, then you’ll need to open an IRA as well.

These are the main types of IRAs:

  • Traditional IRAs: This type of retirement account is similar to a 401(k) in how the account is taxed. In a traditional IRA, the money you contribute now will get you a tax deduction (up to a limit), plus, your money won’t be taxed as it grows. However, when you withdraw the money during retirement, the money will be taxed.
  • Roth IRAs: A Roth IRA is different from a traditional IRA in that you pay taxes upfront at today’s tax rates. In return, you never have to pay taxes on your investment earnings. However, in order to contribute to a Roth IRA, your income has to be under a certain threshold, depending on your tax filing status. In 2012, if you file your taxes as single or head of household, your modified adjusted gross income has to be below $125,000 in order for you to contribute, and if you are married filing jointly, your combined income cannot be more than $183,000.
  • Self-Employed Pension (SEP) IRAs: A SEP is an IRA commonly used by people who own their own business or are self-employed. The owner of this business may contribute to the SEP and take a tax deduction for contribution. Employees do not pay taxes on their SEP contributions, but they pay taxes when the money is paid out. People who have SEPs must also have traditional IRAs, into which the employer will deposit SEP contributions.
  • Spousal IRAs: If you’re not working but have a spouse who is, a Spousal IRA is a great fit for you. It can either be a traditional or Roth IRA, and your spouse can contribute to it as long as you file a joint tax return.

Use our flow chart below to see which type of IRA is right for you:

Set up your chosen account.

Use the guidelines in the I Want to Open an Investment Account checklist. Before setting it up, make sure you have created your budget so you have a clear idea of how much you can afford to put toward your IRA every month.

If you have a retirement plan at work, you may not be able to get a tax deduction for contributions to a traditional IRA. However, you can still save more beyond what you are putting in your employer-based account and have the money grow tax-deferred, which means you won’t pay taxes on it until you use the money.

Calculate how much you need to save for retirement.

The biggest hurdle to saving for retirement is just starting. So, congrats on getting yourself set up. But now you must be wondering how much you need to put away. Now is the time to calculate that. Check out this calculator to see:

  1. How much retirement will cost you.
  2. How much you’re on track to have by the time you retire, based on your current contributions.
  3. Whether you’re putting away enough, and if not, how much you need to contribute.

Schedule regular transfers from your bank account to your IRA or Roth IRA account.

Now that you know how much you need to be saving up every month, let’s see how we can get you there. If at the moment you can’t contribute the amount you’ll need in order to hit your retirement goals, start with whatever you can manage now with your budget.

Set up your contributions so you fund your IRA throughout the year gradually with each paycheck, rather than trying to put away one big lump sum. These regular transfers you set up to fund your IRA are called Automatic Clearing House (ACH) debits.

Once you’ve maxed out your all of your qualified retirement accounts, consider opening a separate brokerage investment account.

If you’re now contributing the maximum to your employer-based account and to your IRA, you can always contribute more to an investment account. (But it’s best to do this only if you have saved up an emergency fund and have no credit card debt.) Follow this checklist to learn how to open an investment account. Again, set up regular contributions to the account to fund it gradually.

If you’re far away from your goals, don’t panic! Redo your budget to free up some money so you can contribute a bit more.

Every little bit counts, so aim for smaller increases more frequently (like 1% every quarter) rather than a big increase “when you can afford it”—which is likely to be put off indefinitely until you realize you’ve been meaning to increase for five years and haven’t. If you’re looking for ways to free up some money, take our Cut Your Costs Bootcamp, or complete our budgeting checklist.

Review your accounts at least once a year.

Don’t just open these accounts and forget about them! Check in on your accounts once a year to see if your investments still make sense for your age (i.e., the years you have until retirement) or in case your risk tolerance has changed. If it has, it may be time to adjust the mix of investments in your portfolio. Also be sure to re-run your retirement income projections (Step 10) every few years to make sure you’re still on track.