Credit Karma Guide to Saving for Retirement
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Few things inspire more terror in planning for your financial future than retirement. Your ticket to financial freedom is hiding somewhere in all of those weird acronyms, rules and mind-boggling amounts of money. But how do you make sense of it all?
First, you need to know what retirement account options are available to you and how much to save. Next, decide on what investments you want to put into your account. Finally, saving consistently can ensure you reach your retirement savings goal on time.
Hiring a certified financial planner is a good idea for sorting out the details and fine-tuning your retirement plan, especially if you don’t feel confident going it alone. But it still helps to come to the table with some knowledge of how it works.
Luckily, it’s not too difficult to understand the basics of retirement planning. We’ll get you started with what you need to know.
How do retirement accounts work?
When you save in a regular savings account, you get one interest rate and that’s it. A retirement account is different, however, because you can choose which types of investments to put in it and which offer the opportunity to earn a higher (if unguaranteed) rate of return.
There are also tax benefits to saving your money in a retirement account. For example, some types of retirement accounts — like traditional IRAs or 401(k)s — allow you to exclude your contributions (i.e., the money you add to the account) from your taxable income.
The trade-off is that you may be taxed on that money plus any interest you’ve earned when you take it out during retirement. In addition, you may be able to deduct all or part of your contributions depending on whether you are covered by a retirement plan at work. Other retirement accounts — like Roth IRAs — don’t allow you to deduct your contributions from your income each year, but in return, you could get to take that money and all the earnings out tax-free during retirement.
One downside of many retirement accounts is that you generally can’t access the money you’ve saved until age 59½ without paying an early-withdrawal penalty and potentially being taxed on the withdrawn amount as income (although there are some exceptions).
It’s designed to be difficult on purpose. It helps you to continue saving, while discouraging you from withdrawing cash every time you need extra money. To be sure you won’t have to tap into your retirement account whenever you have a financial emergency, make sure you have an emergency fund.
Retirement savings can be confusing, but they’re important to understand so that you can get started preparing for retirement.
When should I start saving for retirement?
Immediately. You should consider starting to save now, even if you’re in debt or living paycheck-to-paycheck. In this case, you should budget your money, cut back your expenses, and even look for ways to earn more money. Hopefully all those things together will allow you to start saving for retirement.
It’s simply too important not to start saving now. Here’s why.
Let’s say you start saving $400 per month in a standard S&P 500 stock market index fund at age 24 after graduating from college. The S&P 500 index has an average 7-10% annual return, according to historic data.
If you retire at age 65, you’ll have a whopping $1,030,125.94 to spend in retirement (assuming you get a 7% return compounded annually). But you’ll have only put in $196,800 of your own money — the rest will be from interest. In other words, for every single dollar you put in, you’ll have earned $4.43.
Let’s say you wait until you’re earning big money in your later years, though. (After all, it is tough to save). If you instead saved $400 per month starting at age 35, you’ll only have $453,411.77 in retirement.
You’ll have put in $144,000 of your own money, meaning that you’ll only have earned $2.26 on each dollar you saved on your own — about half as much than you’d have if you had started saving earlier.
How much should I be saving in my retirement accounts?
According to Jeff Brainard, founder and CFP® at Columbine Wealth Planning, “There is no one ‘right’ answer, but I think people should at least invest enough in their retirement accounts to take advantage of their company match. Shooting for 10% to 15% of your income is a good rule of thumb, as well.”
If your employer offers a matching program, making sure that you at least contribute enough to your retirement account to take full advantage of any matches offered is a smart move. These company matches are essentially free money: If you contribute a certain percentage, your company will match a percentage of it up to a given portion of your salary.
How do I know if my company offers a retirement-matching program?
Keep in mind that not all companies offer matching on employee retirement savings contributions. Ask your HR representative if it’s available at your work, and, if it’s not, ask them to consider starting a match program. You can look into opening a retirement account with a bank in the meantime.
For example, if your company offers a dollar-for-dollar 4% match, that means your company will contribute the same amount as you up to 4% of your salary. If you earn $2,500 per month and contribute $100 to your workplace retirement account (i.e., 4% of your salary), your employer will also deposit an extra $100 into your account for you to keep. It’s part of your benefits package and the only guaranteed 100% return on your investment — don’t neglect to use it!
And of course, if you can swing more, do it! No one ever said, “I wish I had less money to spend in retirement,” after all.
How much do I need to retire?
This is literally the million-dollar question. How much exactly do you need to have saved for retirement when all is said and done? Unfortunately, the answer can get complicated.
This is because it can be hard to predict how much money you’ll need in retirement. What kind of lifestyle would you like to live? Will you be a homebody or a jet-setter? Will your home be paid off? Will you downsize to a tiny house? How healthy will you be? How long will you live? You get the picture.
Another monkey wrench is that you won’t have to fully fund every last cent of your retirement on your own. You’ll likely qualify for some Social Security, and you may get insurance through Medicare.
If you’ve invested, your money will also be put to work for you through compound interest. This is what could really skyrocket your retirement savings forward.
Of course, that’s not entirely helpful today. If you’re truly looking for a back-of-the-envelope calculation, follow the Rule of 25 (alternatively known as the 4% rule): Multiply your desired annual income in retirement by 25. That allows for a safe return rate from the stock market. For example, if you want to have $50,000 a year in retirement, you’d roughly need $1,250,000.
Things get pretty murky when considering how you’re going to reach that level. For example, what types of investments should you put your money in as you get closer to retirement? Should you buy an annuity? What the heck is an annuity anyways? These and other questions show why it can be helpful to see a fee-only certified financial planner.
What are the different types of workplace retirement accounts?
Retirement accounts generally come in two flavors: workplace retirement accounts that you can get through your job (or your own business, if you’re self-employed) and individual retirement accounts, called IRAs for short.
Here are the types of workplace retirement plans you’re likely to see.
- A 401(k) is the most common type of plan. As of 2018, you can contribute up to $18,500 per year in this type of account if you’re under 50 and up to $24,500 per year if you’re 50 or over. Many employers also match your contributions into this type of account up to a certain percentage. For example, they may match 100% of the first 3% of your salary that you contribute to your account.
- A 403(b) is very similar to a 401(k), but it’s usually offered to employees of certain tax-exempt organizations and public schools.
- A 457(b) is also very similar to a 401(k), but it’s meant for employees of state and local governments as well as certain tax-exempt organizations.
- A thrift savings plan is offered to federal government employees and is also similar to a 401(k).
- A SIMPLE IRA (not to be confused with a Roth IRA or traditional IRA, which you can open on your own) is a type of retirement plan that is popular with small-business owners because it’s simpler to manage. Your boss is required to make some sort of contribution to your account, and currently you yourself can contribute up to $12,500 per year if you’re under age 50 and up to $15,500 per year if you’re age 50 or over.
- A SEP IRA is popular with self-employed business owners and freelancers, and you can even set one up for yourself if you work another “traditional” job. For 2018, contributions made to a SEP IRA cannot exceed the lesser of $55,000 per year or 25% of the employee’s compensation.
What do I do with my retirement accounts if I change jobs?
You have a few options if you move to a different job.
You can leave your retirement account in its current account and let it grow on its own, only to come back to it later when you need the money. Be aware that you may have to pay fees for your account that your previous employer covered while you worked for it.
If your new employer has a retirement plan, you can transfer the money into your new retirement account. You can also transfer it over to an IRA and manage it yourself. In these cases, you’ll need to contact both your old and new account managers to coordinate the transfer.
What is an individual retirement account?
An IRA is an account that you can open on your own, outside of an employer’s workplace retirement plan. You can use it to supplement your retirement savings outside of your employer’s workplace plan. Alternatively, if your employer doesn’t offer a workplace retirement plan, you could use an IRA as your primary retirement savings vessel.
You’ll hear two words over and over when you’re picking a retirement account: traditional and Roth IRAs. Read on to learn more about the differences.
Traditional IRAs can offer you an up-front tax advantage. Your contributions to a traditional IRA may be deductible from your taxable income, which can reduce your overall tax burden in the year that you make the contributions. However, you’ll have to pay taxes on the money when you withdraw it from your account.
If you choose to open a traditional IRA, you should keep in mind that the deduction you can take may be limited if you or your spouse is covered by a retirement plan, like a 401(k), at work. For 2018, if you or your spouse has a workplace plan in addition to the traditional IRA, you can still take a full deduction up to your contribution limit each year, as long as your modified adjusted gross income is at or below $63,000 (if your filing status is single) or at or below $101,000 (if your filing status is married filing jointly). If neither you nor your spouse is covered by a workplace retirement plan, you can deduct the full amount of your contributions.
You cannot take a tax deduction for your Roth IRA contributions. But on the flipside, you’re actually allowed to take out that money, as well as the earnings, in retirement completely tax-free as long as it’s a qualified distribution.
Roth IRAs might sound great, but you need to make sure that you’re below the income limits before contributing. For 2018, if you’re a high-income earner, you can only contribute the full allowed amount to a Roth IRA if your modified adjusted gross income is less than $120,000 (if your filing status is single) or less than $189,000 (if your filing status is married filing jointly). If you make $135,000 or more as a single filer, then you’re not allowed to contribute at all. If you make somewhere between $120,000 and $134,999 as a single filer, then you’ll be able to contribute a reduced amount. Similar rules apply for other filing statuses. To see how much you’re allowed to contribute to your Roth IRA, check out this handy IRS table.
With both types of IRAs, you typically can’t withdraw any of your money before retirement age (59½) — though there are exceptions — without paying an additional 10% tax penalty. Roth IRAs are a little more complicated. You may be able to withdraw the principal early without having to pay taxes on it, but you may still have to pay a 10% early withdrawal penalty if you withdraw when you’re under age 59½. If you clear out a Roth IRA, principal and interest gains included, then you’ll have to pay taxes on the interest (but still not the principal), along with the 10% early-withdrawal penalty.
You can save in both a Roth IRA and a traditional IRA if you so choose, but the total amount you can contribute across both accounts is also capped. You can contribute up to $5,500 per year across both types of accounts if you’re under age 50 and $6,500 per year if you’re age 50 or over.
Each type of account comes with income limitations and restrictions, so make sure you thoroughly research each option. Reach out to a financial planner or your brokerage for more information on which is right for you.
What is a qualified distribution?
A qualified distribution is a payment or distribution made from your Roth IRA that meets certain requirements set out by the IRS. Read more about qualified distributions in IRS Publication 590-B.
How do I open a Roth IRA or traditional IRA?
The actual process of opening a Roth IRA or traditional IRA is easy. The difficult part is deciding where to open it.
IRAs are generally offered through companies called brokerages. A brokerage is just a place that allows you to invest in different things, such as index funds, stocks or bonds. A brokerage such as Vanguard or TD Ameritrade might allow you to handpick your investments, or you can choose a robo-advisor, like Betterment or Personal Capital, to allocate your investments for you.
When looking for a brokerage, some things to look for is a brokerage that charges low fees, has good customer service and offers a wide range of investments to choose from (especially if you’ll be picking them out yourself).
Once you decide on a brokerage, it’s pretty simple to open an account. Read through and complete the forms, provide a government-issued photo ID, and link your bank account. After you transfer your money, all that’s left to do is choose your investments.
How do I choose the investments for my retirement account?
If your workplace offers a retirement plan, “you’re probably going to have 15 to 20 different options to choose from,” says Clint Haynes, founder and CFP® at NextGen Wealth.
These might take the form of stocks, bonds, mutual funds, index funds, exchange-traded funds, or real-estate investment trusts. Each one of these assets comes with its own risk level. Generally high-risk investments offer the potential for higher returns, but there is no guarantee. Low-risk investments tend to have lower returns, but your money is typically more protected.
You can decide which mix of assets to hold in your investment portfolio depending on your goals, how long you plan to invest, and your risk tolerance at the time. This process is called asset allocation. This is where talking to a financial professional can come in handy, although it is possible to do it yourself if you’re motivated to do the research.
Choosing which investments to hold in your retirement account — whether it’s a workplace retirement account or an IRA — requires a fair amount of work on your part. You need to understand the potential risk and returns involved with each investment option, along with any associated fees for buying and holding an asset.
Furthermore, your risk and return needs may change over time. When you get closer to retirement, advisers may suggest investing in more-conservative investments, so you don’t lose all your cash to a wild market swing right before retirement.
If all of that sounds intimidating, don’t worry. You also have other options, such as investing with a robo-adviser that can handle the asset allocation for you (if you’re using an IRA) or investing in target date (or lifecycle) funds, which most workplace retirement plans and brokerages offer.
“With target date funds, you generally pick the fund that matches up the best with when you think you’re going to retire — say, for example, 2045,” Haynes says.
Then, the managers of the fund automatically choose and update your asset allocation over the years for you. “It’s the set-it-and-forget-it option,” Haynes says.
Target date funds, while convenient, generally have higher fees associated with them than more general index funds or ETFs, so you’ll want to balance the ease with the cost. As with any investment, if your fees are too high, then they can significantly cut into your returns.
Bottom line: Do your research and ask for help if you need it!
What if I don’t have enough money to save for retirement?
“The Hitchhiker’s Guide to the Galaxy” says it best: “Don’t panic.”
Still, we do need to face some cold, hard truths.
“Gone are the days when companies give us pensions,” says Derek Hagen, a certified financial planner at Flourish Wealth Management. “You have to take control of your own destiny. If you don’t think you have enough to save, then there’s a good chance that your lifestyle is higher than your salary can support.”
That’s why the first step is to create a budget and see where you can reduce your expenses. It might not be the most fun thing ever, but it can help you in the long run.
You can also start small. If all you can afford to save right now is $25 per month, rest assured that $25 can still go a long way as it earns interest over time. If you start saving this amount when you’re 20, by the time you retire at age 65 you could have $88,941 saved up (assuming 7% interest compounded annually)! But, you should still set goals for when you can slowly bump up your savings.
Haynes recommends increasing your retirement contributions by 1% to 2% per year.
That way, “you’re starting off with something you know you can afford.”
If you slowly increase how much you’re saving over several years, you’ll eventually be maxing out your retirement account.
“It may not have that much of an impact on your paycheck, because you did it in baby steps,” Haynes says.
Before you know it, you could be well on your way to a fully funded retirement account, even if you’re not saving anything right now.
The great thing about saving for retirement is that it’s largely a set-it-and-forget-it deal, with only occasional check-ins required. You need to put in up-front work and then let your savings machine tick in the background for you with an occasional checkup.
First, decide on a target level to save for retirement. Remember, you don’t have to immediately start saving this much if you absolutely can’t afford it yet, but this should be the goal you shoot for in the long run.
If you’re employed, make an appointment with your HR or finance representative to see if you are contributing enough to your retirement account to get the full match. If not, and you can manage it, get it adjusted so that you are. And if you’re self-employed, make sure that you are actually saving up for retirement (no free passes for you!).
Finally, mark your calendar to reassess your retirement savings strategy at least once a year. Can you increase your savings rate just a notch higher? Take a look at your asset allocation, if you’re doing it on your own, to see if you need to make any adjustments. Do you feel confident about your investment choices?
If you have any questions or hesitations, consider hiring a fee-only certified financial planner to help you out. That way, you may be able to avoid less-than-ideal funds offered by commission-based advisors.
Saving for retirement doesn’t have to be a pipe dream. You can do it, with hard work, dedication and maybe even a little help.