One of the most important sets of financial decisions anyone will ever make is to set up their plan for retirement savings. While it may be decades away, small financial choices now add up to a massive difference in the future in terms of how much money you will have when you retire. With the uncertainty around Social Security benefits and the difficulty of planning something that far in advance with specificity, it’s critical to start early and to understand all of the different tools that people in the US have to save for retirement.
Individual Retirement Account, or IRA
The individual retirement account, or IRA, is a special kind of investment account that anyone can open. An IRA is important because it provides tax savings. There are two kinds of taxes that apply to retirement savings. The first is the standard set of income taxes that get taken out of your salary as you earn it. When you take the money you earn and put it into investments to let it grow over time, which is called making a contribution, eventually you need to sell your investments and cash out to pay for your retirement expenses. That is called taking a distribution. When you do that, the money is taxed again, so you face double taxation on it.
With an IRA, you can choose to protect your savings from one of these types of taxes. In a traditional IRA, you do not need to pay taxes for the contributions up front, although the balance will still be taxed when you take a distribution at the end. In a Roth IRA, you do pay taxes on contributions but not on the distributions. You can pick one type and start adding money to it and investing that money in mutual funds, stocks, bonds, or anything else you want. It is even possible to open one of each kind and contribute some money to each one.
However, every individual has an annual maximum amount that they can legally contribute to all of their IRAs, and you can’t contribute any more if you have multiple accounts. The max can change from year to year to account for inflation and other factors. Getting an IRA up and running and making regular contributions is a good goal to set because the investments will grow over time and provide money to use when you retire.
Employer-Sponsored Retirement Plan, Usually 401k
Another tool that some people have is an employer-sponsored retirement plan. For most companies, this is called a 401k. For non-profit organizations like colleges or government jobs, this will be called a 403b. These work exactly the same way as an IRA in terms of their tax benefits. However, they also have an extra benefit– employers often make matching contributions.
If their match is, for example, 3 percent, that means that if you contribute 3 percent of your salary to the 401k, then your company will add that same amount of money into the account for you out of their own pocket, so that you really get 6 percent of your salary in contributions. On top of that, employer-sponsored plans have a separate maximum from IRAs. So you can max out your IRA contributions and still be allowed to add money to your 401k.
Other extra benefits are a lot less common but still might be of use. For example, some employers have a separate plan that works like a 401k but can only be used for medical care and medical expenses in retirement. These usually have lower contributions but are still handy. For people who make high salaries, their employer might have an overflow plan, which is an extra savings plan to benefit people who have maxed out the legal level of contributions to their 401k.
Social Security Benefits
Aside from these plans, it is important to consider benefits like Social Security. Right now, Social Security is in an uncertain place. To ensure that the program has enough money to pay retirees, there are going to have to be reforms of some kind. Those reforms might involve lowering benefit levels, increasing taxes, a combination of both, or some other approach. It is difficult to predict what will happen, but Social Security is not going to disappear or go away entirely.
Calculating Retirement Savings
If you want to try to predict how much money you will have when you retire, consider using a compound interest calculator. These can help you forecast your accumulated savings under different conditions. Start with a compound interest calculator and add in how much you have saved now as the principal. Then you can add how much you plan to contribute across all of your plans, like an IRA and 401k.
For the interest rate, put down how much of a return you plan to get from your investments. Then for the timeline, enter how many years until you plan to retire and see what results you get. Experiment with it. For example, if you hope to get a 5 percent return, you will get one number. But then see what would happen if you only get a 3 percent return. Try seeing what would happen if you were to retire at 65 vs. if you were to retire at 70. These small changes can make a huge difference in your accumulation.
Many people don’t think too much about their retirement, especially when they are young. But starting to make contributions early, even if they start out small, will lead to a lot more accumulations because they grow at a compounding rate. It is very hard to catch up on this kind of saving late in life because there will not be many years of time for the money to grow before you need to withdraw it and use it to pay for the month to month expenses of living in retirement, whatever those might be for you.