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Personal Finance 101: How Do I Even Start With Saving for Retirement?
Mindy writes in:
I know I am supposed to be saving for retirement but I don’t even know where to start. I went to the HR office to ask but the people there just immediately start tossing terms that I don’t understand and Wikipedia does the same.
This is a great question. I’m going to go through this as slowly as I possibly can, in simple language. For some readers, this might be overly fundamental and boring, but I’m trying here to not lose anyone who might be curious about saving for retirement but doesn’t know where to start. I am choosing to simplify things in a few places and focusing on the big picture rather than overwhelming details.
So, let’s get started.
Saving for retirement is really important for most people. Without some retirement savings, people have to rely on Social Security, Medicare, a pension (which is basically paychecks from your employer once you’re retired – most people aren’t lucky enough to have one), their families, and charity. Most of the time, people who don’t have savings keep working until they literally can’t work any more. That’s not a future that a lot of people want.
The first thing you need to know about retirement savings is that any time you put money aside anywhere for the purpose of using that money when you retire, you’re saving for retirement. If you stuff cash in your mattress and intend to start pulling it out when you’re 65, you’re saving for retirement. If you go down to your local bank and put money in a savings account with the intent of pulling it out when you’re 65, you’re saving for retirement. The act of putting money aside for retirement is the single most important part of retirement savings. Everything else is less important; it’s just details and ways to get a little more value for your retirement savings dollar.
The government recognizes that this is a big and important financial goal for a lot of people, so they’ve done a few things to help out anyone who wants to save for retirement. Mostly, they’ve created a few special kinds of accounts for people to put their retirement savings in. These accounts come with advantages, mostly in the form of causing you to pay less taxes and thus keep more money in your pocket.
The most common account, and the one that most people brush up against in their retirement search, is the 401(k). Some employers call it a 403(b) or a 457 or a TSP or other names, but they’re all more or less the same thing. If you ask your human resources officer at work about a “401 K,” they’ll know which particular variation is available at your workplace, if any.
Think of a 401(k) as being like a special kind of savings account. The only difference is that money in a normal 401(k) goes into the account directly from your paycheck before taxes are taken out. Let’s say you make $10 an hour and work 40 hours, so your weekly check is $400. Normally, without a 401(k), you would have taxes taken out on that $400 – if they take out 10%, that means your take-home pay is $360, because they took out $40 for taxes. Makes sense, right?
Well, let’s say you choose to put 10% in that 401(k) each paycheck. That means that instead of figuring out taxes on $400, they figure out taxes on $360. 10% of $360 is $36. So, if you’re putting 10% in your 401(k), first that $40 is taken out of your check and moved into the 401(k) and then 10% of what’s left – $36 – is taken for taxes. Your take home check is now $324, but you’re putting $40 away for retirement. You’re actually paying $4 less in taxes this way – it goes home with your paycheck instead.
What you need to know here is this: when you contribute to a 401(k), your paycheck will go down, but it won’t go down as much as the amount you contribute.
What’s the catch? How can that be right? The trick with a 401(k) is that you’ll have to pay income taxes on that money in retirement. When you take money out of that account in retirement, it’s just like a paycheck and you’ll have to pay taxes on that money then. However, when you’re retired, you’ll probably be paying a lower tax rate, so you’ll still save money in the long run.
Some employers make a 401(k) into an even better deal by offering matching contributions. They’ll put an additional $0.50 or $1 into your account for every dollar you put in. If this is available to you, don’t turn it down because it’s free money for retirement.
So, a 401(k) is just a program operated by your employer that lets you save money for retirement by taking it directly out of your paycheck. There’s a bit of a tax advantage for doing this compared to just saving it yourself. Plus, some employers offer additional bonuses or match your contributions.
Next, let’s talk about what “Roth” means. If you see an account with the word “Roth” before it, it means that it deals entirely in “take home” dollars, after taxes are already paid on it. Some employers offer a Roth 401(k) option.
Let’s go back to that $400 example. You earn $400. You want to contribute $40 to to your Roth 401(k) at work each paycheck. First, taxes are taken out of that paycheck as above, leaving you with $360, then the Roth 401(k) contributions are taken out, leaving you with $320 that you take home.
You’ll probably notice that contributing $40 per paycheck to a Roth 401(k) leaves you with less money in your paycheck ($320 in this example) than contributing $40 per paycheck to a normal 401(k) ($324 in this example). What gives?
It’s because of that word “Roth.” Roth 401(k) plans allow you to take out all of your contributions tax free when you’re retired. You will never, ever have to pay taxes on that money, provided you simply wait until retirement. You don’t have to pay money on the interest earned while it sits in the account, either! It’s all tax free when you take it out. You just pull the money out when you’re retired and don’t worry abut the taxes because there are none.
Regardless of whether you’re considering a Roth 401(k) or a regular 401(k), you’re almost definitely saving at least some money on taxes. That’s the advantage of such accounts. Now, which one you choose is another matter, but I am of the belief that it’s almost impossible to say which one is “better” because no one knows what tax rates will look like in 20 or 30 years. So, you really shouldn’t worry too much about it. My gut instinct is that for most people making under $100K, Roth accounts are probably better, but that’s simply a feeling.
What if your workplace doesn’t offer any sort of account like this? Your best option is probably a Roth IRA, which is kind of like a do-it-yourself version of a Roth 401(k) as described earlier. You can sign up for a Roth IRA with many, many different investing firms just like you would sign up for a bank account (I personally use Vanguard for mine – there are many other good companies out there, though, like Fidelity, for example) and you deposit money much like you would into a savings account. Today, this is usually done electronically – you sign up to have money automatically taken out of your checking account once a week or once a month and put into your Roth IRA. Just as with the Roth 401(k), when you reach retirement age, you can take money out of the Roth IRA completely tax free, even on the money you gained while it was in the account.
The important thing to note here is that with all of these different options (which really aren’t all that different – they’re all just accounts), you are given a lot of options once the money is actually deposited in the account. You can choose what the company managing your account does with that money, and it’s often that point that people struggle with. You’re given the option to invest in stocks, bonds, and many other things, and the more you study those options, the deeper the rabbit hole seems to go.
First of all, the simple act of putting the money in the account is the most important thing you’ll do, period. What option you choose is of far, far less importance than the choice to simply save for retirement at all. Do not get stressed out over the options. You basically can’t make a wrong choice. Think of it as being like a menu at a restaurant where everything’s pretty good – you can basically close your eyes and point at the menu and you’ve got a worthwhile meal.
If you’re not sure what to do, the easy answer is to just choose a Target Retirement fund. Figure out what year you will be 70 (take your birth year and add 70) and then choose a Target Retirement fund that most closely matches that year. Let’s say you were born in 1983. Add 70 to that, giving you 2053. You’d probably want to choose a Target Retirement 2055 fund. Put all of your money into your chosen fund and don’t worry about it.
Obviously, you can keep going on and on and on and on with details about what account is best and what investment to choose. The truth is that the differences between them don’t matter a whole lot unless you have a very large balance in the account. It’s honestly not worth worrying about it, especially if worrying about it means that you wait even a day to start contributing.
I want to finish by repeating what I said earlier:
The act of putting money aside for retirement is the single most important part of retirement savings. Everything else is less important; it’s just details and ways to get a little more value for your retirement savings dollar.
Just save. Don’t get hung up on the details too much. If your employer has a 401(k) account or something like it, sign up. Contribute what you can afford, especially if your employer matches it. If you don’t have a 401(k) or something like it at work, sign up for a Roth IRA on your own – it’s really not hard – and contribute a little each week out of your savings account. When you decide what investment option to choose, choose a Target Retirement fund. That’s all you really need to do. Every little bit helps.