Start Saving Early
Saving for retirement isn’t something to start tomorrow. Time is key, so the earlier you start saving for retirement, the more money you’ll have. Here’s a good example: Let’s say Keith and Sarah both invested $24,000 in their retirement funds over the years, but Keith began putting in money ($50 per month) at age 25 while Sarah began saving ($100 per month) at age 45.
Even though they both put in the same total amount, assuming that the market gives them both returns of 7% a year, Keith will have more than twice as much money for retirement as Sarah will when they each turn 67. Retirement funds invested in the market can keep inflation from whittling away at your spending power. The longer you give your investments to grow, the better.
Use the Best Accounts for You
Retirement accounts allow you to set aside a limited amount each year and provide tax incentives to leave that money alone until you retire and penalties if you take it out early. For that reason, every person should have some type of retirement account. Here are a few different options:
- The traditional IRA is set up so that your contribution each year may be tax deductible, and you pay taxes on your contributions and investment gains when you begin withdrawals at retirement. In 2013, a single person can contribute $5,500 to an IRA (or Roth IRA, below). Note that there are income restrictions.*
- The Roth IRA is different from the traditional IRA in that you pay taxes upfront at today’s tax rates. Your investment gains are never subject to taxes unless you withdraw the money early (before age 59.5). If you do, they’ll be subject to both taxes and early withdrawal penalties. Like the traditional IRA, there are income restrictions.*
- The 401(k) is a retirement account you can typically only get through an employer, and it holds money taken directly from your paycheck before taxes are withheld. In 2013, a single person can contribute $17,500, pre-tax, to a 401(k). Or $22,500 if you’re over age 50. The Roth 401(k) is also offered by some employers; it allows workers to contribute to a 401(k) with after-tax dollars.
You can maintain one of the accounts listed above, or a combination, but here’s the rub: Many people decline to use all accounts available to them, or decline to open an account at all. Any account, started early with only $20 a month, is better than no account at all.
To see which type of retirement account is best for you, use the flowchart offered here.
*See point 3 for income limitations
Understand the Rules
The 2013 retirement account contribution limits and income restrictions are as follows:
- The contribution limit on employer-sponsored plans (401(k), 403(b) and most 457 plans) is $17,500.
- The contribution limit on traditional and Roth IRAs is $5,500.
- The “catch-up” contribution for people ages 50 and older is $1,000 for IRAs and $5,500 for 401(k)s and employer-sponsored plans.
- You can contribute to a Roth IRA if your adjusted gross income is less than $112,000 filing alone, and $178,000 if you’re married filing jointly.
- With the traditional IRA, your ability to deduct your contribution on this year’s taxes will start to be phased out when your income is above $59,000 if you are single and $95,000 if you are married filing jointly—if you’re also covered under an employer plan at work. If your company doesn’t offer a plan, you may be able to deduct the entire contribution, regardless of your income.
Because retirement accounts are meant to be saved long-term and are taxed accordingly, early withdrawals are always subject to fees. For this reason, taking money out of your retirement account is a cardinal personal finance sin, with few exceptions.
Many people don’t understand the rules before they start. Basic things like which retirement account you can open and how much you can contribute carry costly penalties for misunderstanding. So as you get started (or as you rebalance), make sure you know the rules.
Save Enough to Get the Company Match
Some companies incentivize their employees to save for retirement by offering to “match” the contributions you make to your 401(k)—which means an added boost to the amount you invest each year.
For instance, a company might offer a 3% match, where it matches 50% of the first 6% that you save in the plan that year. Another company might also offer a 3% match, but match the first 3% of your contributions dollar-for-dollar, so it’s important to know how your company calculates its match.
People who have employers that offer to match and who still don’t contribute to their 401(k)s are giving up free money. Look at it this way: Would you turn down a raise? No? Then don’t turn down the match. Even if your company only matches a small percentage, you’re doubling any retirement contributions you make up to that point. That’s a good investment.
Update Your Beneficiaries Annually
Your beneficiary is the person who gets your assets if you die. It’s indelicate, but it’s critical to know how this works. Any financial account you open (including life insurance policies) asks that you designate a beneficiary to inherit your assets (or the policy payout). Many people neglect to update their beneficiaries over time (or to designate one in the first place).
What’s the big deal, you ask? The beneficiary form is considered a legal document and can serve as a will substitute, meaning it will hold up in court over your will, and whomever you’ve currently designated will be the recipient of your money. There have, in fact, been court cases that—when presented with a will and with a beneficiary form—have ruled in favor of the beneficiary … an ex-spouse.
If there’s no beneficiary designated, the money goes to your spouse, or, if there is no spouse, the money is paid to your estate. Which is why, if you’ve had a major life change, such as divorce, marriage, children or a death in the family, you want to ensure that the beneficiary on your account is the person you’d want to inherit those assets.
Consolidate Retirement Funds
Have you ever heard of a rollover IRA? “Rolling over” is just another term for consolidating. This means compiling all of your retirement accounts into one. For instance, a person might change employers and “lose” their old 401(k)—forgetting the password or which company held the account. People aren’t going out of their way to help you find your money, so it’s in your best interest to keep all of your retirement savings in one place.
A 2009 study found that nearly half of all United States employees cash out their 401(k)s upon leaving a job. By taking those distributions—in other words, withdrawing money from their accounts instead of rolling it into a new account—they’re taxed on that withdrawal as income and they have to pay federal and sometimes state penalties for the early withdrawal. And guess what else people don’t do? Plan for those taxes and penalties!
To consolidate, there are two options:
- Roll accounts into an existing 401(k) (the service provider holding your new account should be able to help with this).
- Roll accounts into a rollover IRA account.
Check Your Allocation
Your retirement accounts are comprised of investments, and investments are dynamic. The mix of investments that you have shouldn’t stay the same as your life changes around them—you are going to change that mix as you age.
Once you have the particular mix that’s right for your age and risk tolerance, you want to make sure that short-term market swings don’t change your mix. That’s where rebalancing comes in. Rebalancing restores your investments to their original proportions, assuming that’s what you still want. You should be doing it annually, to keep your investments from skewing away from your ideal mix.
Rebalancing is also a good time to think about whether your mix—or asset allocation—is still right for you. For instance, if it’s been a few years since you put your portfolio together and you started out aggressively, it may be time to consider making things a little more conservative. The closer you get to retirement, the less risk you should take with your money, since you’ll have less time to recover from big losses.
Many work retirement accounts will offer a pretty clear “automatic rebalance” option in the investment section of the website. If you’re rebalancing an IRA and the option isn’t obvious, give customer service a call—they’ll walk you through it.
Open Your Own Account
Many people don’t open their own retirement accounts because they think their spouse or partner will take care of them when it’s time to retire. But while we might plan for our financial future as a couple, every individual (even a stay-at-home parent) can open a retirement account—and you really don’t want to be without savings in your own name.
One out of every two marriages ends in divorce, which means you might not wind up with the savings you had expected. And, divorce aside, what happens if a spouse passes away and the surviving spouse isn’t the beneficiary?
Let It Be
Finally, step away from the retirement account.
What was that cardinal sin of personal finance again? Oh, yeah: taking money out of your retirement account. Too many people treat their retirement accounts like savings accounts, borrowing money against them or making withdrawals for big purchases.
By taking money out of a retirement account, not only have you undone the hard work it took to get that money there in the first place, you’re actually negating your retirement savings! You’ll face penalties and taxes on that money, plus you’ll jettison your savings when you have less time left to build them back up.
In short: Let it be. You’ll be glad you did when that boat leaves for Bora Bora.