Saving for retirement is going to be one of the biggest savings goals you will have in your lifetime. This is because it is a time in your life when you no longer have the working income you’ve grown accustomed to. If you plan on retiring at age 65, that could mean 20 to 30 years of no working income. Your goal is to build a large enough “nest egg” for yourself so that when you reach retirement age, you have enough to pay yourself a salary each year so that you can enjoy that long vacation without worrying if you’re going to run out of money.
When it comes to saving for retirement, what you do now has a huge impact on how great that long vacation is going to be. That is why it is important to do as much as you can, as often as you can.
Sounds easy enough, right?
There isn’t necessarily a wrong way to save for retirement, as long as you are saving. That said, there are approaches and account choices that will make building that nest egg a lot easier, depending on your current situation, your age, and your goals. A financial advisor will ensure that planning for your retirement is a part of your financial plan. They will work with you to make sure that you are saving in the most effective, and tax-efficient manner. However, it is useful to have a broad understanding of the topic so that you can work with your financial advisor, to achieve your goals. Before we get into account types and the best ways to save, let’s summarize the key concepts related to retirement savings.
Tax deferral refers to the postponement of certain types of taxes (generally income or capital gains tax) until a later date (generally retirement age). For instance, when you contribute to your 401(k), your money goes in pre-tax (meaning that the contribution is deducted from your salary before your tax is deducted). This untaxed money then grows within that account until you withdraw it upon retirement, at which point you will pay tax i.e. the tax payment has been deferred (postponed) from the date of contribution to the date of withdrawal.
In very simple terms, pre-tax retirement contributions are contributions that you make to your retirement plan from your salary BEFORE your salary is taxed. Post-tax contributions are the opposite, they are contributions that you make to your retirement plan from your salary AFTER your salary is taxed. To help explain this concept, here is a quick example:
Let’s say you have $100 of gross income (income before tax) that you want to contribute to your retirement plan. You have the option to put this full $100 into your retirement plan so you don’t have to pay tax on it now. Let’s say over the next 20 years that $100 grows to $500. Now you’ve reached retirement and you want to pull all $500 out to use. At this point, you will have to pay income tax on the $500 (since you’ve haven’t paid taxes yet). This is also known as a Traditional contribution.
The alternative to this is that you make a post-tax contribution of the $100. So the $100 of gross income would first be taxed – now you have $80 put into your retirement plan. Let’s assume that $80 grew to $400 after 20 years (less due to the lower initial investment). When you withdraw this $400 you get to take all of that money out tax-free because you have already paid tax on it! This is also known as a Roth contribution.
Paycheck deductions occur when your salary (either pre- or post-tax) is sent directly to your retirement plan before it reaches your bank account. The money is transferred by your employer on your behalf.
Personal contributions are contributions from your personal savings or checking accounts. If you make pre-tax personal contributions, you can later deduct those contributions from your gross income when you do your taxes.
One of the most powerful tools you have when saving for retirement is time. This is because the more time you have to save, the longer you allow your money to “compound”. Compound interest is interest on top of interest. Let’s have a look at an example:
What would happen if I said: “I will pay you 10% interest every week on the money you leave on my co ee table”. You leave $1 to see what happens. The first week, I put a dime on the table. There is now $1.10 on the table. But you decide to take the dime. So the following week there is still only $1 on the table. Again I put a dime of interest on the table, which, again, you take. That is simple interest. The interest you earn is calculated on the principal investment for every time period i.e. the $1. You will only ever earn a dime for each period of time.
Pretend that instead of taking the dime with you, you leave it on the table. Now there is $1.10 left on the table. So the next week I pay you $0.11 interest (10% of the $1.10) which you again leave, so now it’s $1.21 on the table. Now you get paid $0.121 cents in interest, so by the end of the third week you have $1.33, whereas in the first example you would only have accumulated $1.30.
When you compound the interest, what you’re doing is adding that interest back into the principal, which is the part of the money that’s earning interest. The more frequently the money is compounded, the more money you earn!
Because retirement planning is essential for the economy, certain employers match the retirement contributions of their employees when they use certain plans. This means that if you save $100 a month into your retirement plan, your employer can match some (or sometimes all) of your contribution, up to a certain percentage of your income and add that value of the corporation’s money into your account too. This is in essence free money! Employers often set minimum contribution levels to qualify. So if your employer offers you a match, make sure you are contributing enough to receive your full match!
Looking For Expert Advice?
Schedule a Free Estate Plan To Build Your Ideal Estate Plan.
Value Investing: A Planner's ViewFeb 26, 2020
Money Secrets: How Common is Financial Infidelity?Feb 14, 2020
Is Fashion Week's Tradition Effective in Producing A Return on Investment?Feb 8, 2020
Zoe Financial Welcomes Marie Chandoha, Charles Schwab Investment Management’s Former President and CEO, to Advisory CommitteeFeb 6, 2020
How Can I SECURE My Retirement?Jan 29, 2020
Inaugural Wealth Sentiment Study Reveals American's Feelings Towards Wealth ManagementJan 28, 2020
5 Ways To Start The New Year RightJan 11, 2020
The Freedom of Advice: Findings on the Value of an AdvisorDec 18, 2019
5 Ways to Beat Your 2020 Financial ResolutionsDec 11, 2019
6 Point Guide to 2019 End of Year Retirement ContributionsDec 9, 2019
It's Finally Bonus Season: Now What?Dec 2, 2019
Cyber Monday: How Digitization Is Changing ShoppingDec 2, 2019