When it comes to saving for retirement, there are a lot of factors to consider. How much do you need to save each month? What type of account should you use? And when can you start withdrawing money without penalty?
Here’s a breakdown of the basics you need to know to save for retirement:
How Much to Save for Retirement
There is no magic number when it comes to how much you should save for retirement. But a good rule of thumb is to save at least 10-15% of your income each year. This may not be possible for everyone, so start with what you can and increase your savings as your income goes up.
As Mackenzie Stewart points out, “You don’t run into a gym and immediately lift 200lbs… You warm-up. You start small, and then work up to the big numbers. You gradually build the muscle. Retirement investing is the same way.”
(For pro-tips on saving without a six-figure salary, check out this article.)
When to start saving for retirement?
ASAP. Saving for retirement can seem like a daunting task, but it’s important to start early so you can take advantage of the power of compound interest.
Depending on your age, goals and current earnings, your ideal savings number can fluctuate.
For example, if you’re in your 20s or 30s and have a long time before you retire, don’t stress too much. It’s best to have a long-term outlook and put away 10% or even more of your income into retirement savings through automated savings
On the other hand, if you’re nearing retirement age and have less time to save, you’ll need to save more each month. For example, if you’re 60 and want to retire at 65, you should be saving about 25% of your income every month. That would mean setting aside $1,250 per month towards retirement.
Calculating Your Retirement Savings Goal
Two prime theories for how much is enough in retirement dominate the financial planning world
The 4% Retirement Plan
Dividing current income by 4%, which shows the total amount needed for retirement.
Example: $50,000 salary.
$50,000 ÷ .04 = $1.25 million for retirement.
The 4% Retirement Plan says you’ll need $1.25 million. The idea is that if you had $1.25 million in retirement savings (earning 4% return), you could withdraw $50,000 a year for more than 30 years.
The downfall of the 4% rule
Financial experts have pointed out that it may not be realistic for investors moving forward since bond yields aren’t the same as when this rule was first developed.
It also doesn’t take any sources of income into consideration other than investment returns.
The 70%-to-80% Rule
This rule states that to keep our standard of living in retirement, we’ll need 70% to 80% of present income. (Split the difference at 75%. )
Example: If you currently make $50,000, the goal is $37,500 per year.
The exception to traditional retirement savings advice: F.I.R.E.
F.I.R.E. stands for “financially independent, retired early” and people pursuing F.I.R.E. have a whole different retirement savings strategy to deal with.
Which Type of Retirement Accounts to Use
Now that you know how much to save for retirement, the next question is: where should you save it?
There are a few different options when it comes to saving for retirement. The most common options are 401(k)s and individual retirement accounts (IRAs).
401(k)s are employer-sponsored plans, which means that you save for retirement along with other employees who are part of the same plan. There are two types of 401(k)s: traditional and Roth.
With a traditional 401(k), your contributions are tax deductible, meaning that your taxable income is lowered by the amount you contributed to the plan. When you withdraw money from the plan upon retirement, you will pay taxes on it. This also means that if your tax rate in retirement is lower than when you were working, then a traditional 401(k) can be beneficial because you’ll ultimately pay less in taxes.
There are some limitations to it, however. The employee contribution limit for 401(k) plans is $20,500 in 2022, up from $19,500.
With a Roth 401(k), the contributions go into the plan after they’re taxed, and so there is no tax deduction. However, when you withdraw the money upon retirement, you will not have to pay any taxes on it, regardless of what your tax rate is at that time. This can be advantageous if you expect your tax rate in retirement to be higher than it was when you were working.
Individual retirement accounts (IRAs) are another option for retirement saving. The most popular types of IRAs are traditional and Roth. You can contribute up to $6,000 per year to either type of IRA – a combined limit across all types of IRAs you may have. The traditional and Roth IRA contribution limits are the same, but what you do with that money when you retire is where things get different.
With a traditional IRA, contributions in the account grow tax-deferred during your working years. However, withdrawals from your traditional IRA in retirement will be taxed as income. With a Roth IRA, your contributions grow tax free while you’re putting money into the account, and withdrawals in retirement are also tax free, however, that’s because they were already taxed before they go in the account.
In order to invest in a Roth IRA, you must have earned income from a job or self-employment activity. In other words, there is no way to open a Roth IRA if all your income is from investments such as dividends and capital gains. If you’re not sure whether you meet the requirements, talk to a tax professional.
So, which is better: a Roth or Traditional IRA?
It depends on your personal financial situation. If you think your tax rate will be lower in retirement than it is now, then a traditional IRA may be best for you. But if you expect your tax rate to be higher when you retire, then a Roth IRA may make more sense.
When Can you Start Withdrawing from Retirement Funds without Penalty?
You can start withdrawing from retirement funds without penalty at age 59 1/2. However, you may still have to pay taxes on the money you withdraw depending on the type of retirement account you have.
Here’s a rundown of the basics of what you need to know to save for retirement:
Decide if you’ll use your employer benefits or open an account on your own.
Decide if you want a Roth (taxed now) or Traditional (taxed later) account.
Figure if you want to set aside a set dollar amount or percentage of your income.
Make sure once the funds are in your retirement account, you put them INTO investments like a Target Date Fund or Exchange Trade Funds.
Work up to your employer match if it’s offered or get close to it.
Keep an eye on fees.
Most importantly, start ASAP and don’t worry about it being too little.