Learning how to invest for retirement can feel daunting, but you don’t need to know everything to create an effective retirement investment plan. Understanding the basics of retirement accounts and the different investment options is a good place to start.
The importance of investing for your retirement
For many people, retirement is a long-term goal. You set aside a small amount of money each month for years. Then, once you stop working full-time, you use the money for living expenses. Someone who retires at 65 may need to rely on their retirement funds for 20-plus years; so the earlier you start investing for retirement, the better.
Saving vs. investing
It can be helpful to look at how investing differs from putting money in a savings account, especially when you account for how compound interest—earning interest on interest—can boost your money’s growth over time.
Generally, people use a low-risk savings account to set aside money for emergencies or for money they plan to spend in a couple of months or years—perhaps to travel, purchase gifts, or buy a home. You might earn a little interest on your savings, but the main goal is to have the money when you need it.
How compound interest works
Let’s look at what happens if you contribute $250 a month to a savings account that offers 3% annual percentage yield (APY) versus an investment account that returns an average of 10% per year. (A realistic estimate based on average stock market returns over time.)
The sooner you start, the more time you have for your money to grow.
How much money should you save for retirement?
It can be difficult to determine exactly how much you should contribute to your retirement investment accounts each month or year. One general rule of thumb is to invest 10% to 15% of your annual income (before taxes) for retirement. However, you may want to aim for a higher rate if you’re starting later in life. You might be able to set aside less of your money if your employer also contributes to your retirement account.
The amount you invest for retirement may also vary depending on:
- Your age and when you want to retire
- The lifestyle you want in retirement
- Your current investments
- Your expected returns on your investments
- Additional income during retirement, such as Social Security and rental income
A retirement calculator can help you determine how much you need to save. You can also play with a calculator to see how different savings rates can impact your retirement years, or how changing your lifestyle or adding an income stream during retirement would impact how much you need to save today.
Some people start with what they can afford today and try to increase their contribution amount by 1% every six months or year. They may make a larger jump in their savings rate after getting a new job or raise.
Traditional vs. Roth IRAs
Individual retirement arrangements—also called individual retirement accounts, or IRAs—are a common way to start investing. You need to have earned income for the year to contribute to an IRA. However, unlike the workplace retirement plans listed below, you can open an IRA on your own and it won’t be tied to an employer.
You can open an IRA with many banks, credit unions, brokerages, and financial advisers. When you do, you may be able to choose between a traditional or Roth account. The primary difference is how and when you’ll pay taxes:
- With a traditional account, you may receive a tax deduction for the contributions you make during the year. Additionally, your retirement investments can grow tax-deferred, meaning you won’t pay taxes on the money you earn until you withdraw it.
- With a Roth account, you contribute after-tax dollars, which means you never receive a tax deduction for your contributions. However, all your withdrawals—including all your investment earnings—could be tax-free later.
You can have both types of IRAs at the same time. But your total combined annual contributions can’t exceed the annual contribution limit for the year.
Workplace retirement plans
In addition to deciding between traditional and Roth accounts, you may be able to use one or several common types of workplace retirement plans. These may be available from your employer, or you may be able to open one on your own if you freelance or run a business. Both 401k(s)s and 403(b)s can also be traditional or Roth accounts, if the provider offers that option:
- 401(k): A 401(k) is an employer-sponsored retirement plan. You can have money sent directly to your 401(k) every pay day. Some employers also offer a matching contribution to your account. Your investment options and fees may depend on the company that manages the 401(k).
- 403(b): A 403(b) is similar to a 401(k), but for nonprofit and tax-exempt organizations, such as schools, hospitals, charities, or religious organizations.
- Simplified Employee Pension (SEP) IRA: You might want to open a SEP IRA if you're self-employed or own a small business. They have higher annual contribution limits than non-SEP IRAs. However, they have to be traditional IRAs, and if you have employees, you must make equal contributions for all eligible employees, including yourself.
- Savings Incentive Match Plan for Employees (SIMPLE) IRA: Another traditional IRA option for the self-employed and small-business owners. You might benefit from higher contribution limits than with a traditional IRA. You also don’t necessarily have to contribute to every employees’ account, but you may have to match a portion of employees’ contributions.
Each type of retirement investment plan has its own rules. For example, there may be qualification requirements for who can open or contribute to a specific type of plan. There are also annual contribution limits, which often increase every couple of years.
Because they’re intended for retirement investments, you may also have to pay a penalty if you withdraw money from your retirement account (including IRAs) before you’re 59 ½ years old. There may be exceptions for certain situations, such as when you use the funds for medical expenses or to buy your first home.
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