Have you been putting off saving for retirement because you don’t know where to start? The jumble of 401(k)s, IRAs, contribution limits and tax implications may seem daunting, but we’ll help you parse out the basics and get you ready to save up for your golden years.
When should you start saving?
Immediately! Remember the miracle of compound interest. If you invest $1,000 when you’re 22 and your account grows at a rate of 4 percent annually, you’ll have $5,400 by age 65 without you having to do a single thing. If you wait until you’re 40 to invest that same $1,000, you’ll have only $2,666 when you’re ready to retire. If you’ve avoided enrolling in your company’s 401(k) or contributing to an IRA, time to face the music: You can either save a little now, be forced to save a lot more down the line or settle for a much later retirement.
There are two exceptions to this rule. One is if you have high-interest debt. Pay off your credit cards, personal loans and other debts with high interest rates first, then focus on saving up. Think of it this way: There’s only one way to get a guaranteed 15 percent return on your investment, and that’s paying off your 15 percent APR credit card. The other exception is if you don’t have a rainy day fund. Make sure you have enough money to get by three to six months of unemployment before investing into less-accessible retirement accounts.
How to save for retirement
The easiest way to save for retirement is to take the decision out of your hands. If your company has a 401(k) program, enroll in automatic deductions so that money goes from your paycheck to your account without you lifting a finger. If you have an IRA, set up an automatic transfer from your checking account to your IRA – or at least from your checking account to a savings account, and set a reminder to manually transfer from your savings account to your IRA.
In terms of priorities, it’s best to allocate your money in this order:
• Invest in your company’s 401(k) up to the limit of its matching program, if it offers one
• Contribute the maximum ($5,500, or $6,500 if you’re over 50) to your IRA
• Contribute the maximum ($17,500, or $23,000 if you’re over 50) to your company’s 401(k)
Where to save for retirement
Now we get to the age-old question: Roth or traditional? There’s more nuance to this, of course, but the basic difference between Roth and traditional retirement accounts is the tax treatment. Roth accounts are paid with post-tax income, so there’s no upfront tax benefit, but you don’t have to pay taxes when you withdraw. Traditional accounts, on the other hand, are paid with pre-tax income but are taxed on withdrawal.
Typically, if your income is lower than you expect it to be over the course of your working life (for example, you’re just entering the workforce), you’re better off with a Roth. If you’re in a higher tax bracket, traditional is preferable. One exception is if you think your income will fall drastically in the next few years (you’re going to grad school or taking time off to be with your family). In that case, you’re better off putting your money in a traditional account and “rolling over” to a Roth during your low-tax-bracket years.
The complicated jargon surrounding retirement accounts may seem off-putting, but trust me: A little work now will help make your retirement years truly golden. And even if you make small mistakes, such as choosing a high-fee fund or going with a Roth account when traditional would have been better, think of it this way: when it comes time to retire, you’ll feel the effect of not saving far more than the effect of making a few mistakes along the way.
Anisha Sekar is the chief consumer advocate at NerdWallet. Read more of her work on the Money-Saving Tips blog.