If you haven’t been saving for retirement, putting even a little away on a monthly basis can have a huge impact on your future quality of life – especially if you invest in a tax-advantaged retirement account like your employer’s 401k plan or an IRA. This is because of compound interest: If you don’t have to pay taxes on the interest your account earns, that interest stays invested and earns yet even more interest – and the longer you’re invested, the more money you can make. For example, a mere $50 invested every month for 30 years will turn into almost $75,000 if it earns 8% annually – even though your total investment was only $18,000.
But you need time to see that kind of return, which is why it’s essential to start saving now.
1. Employer-Based 401k Plan
Investing in your employer’s 401k plan is simple – you decide how much you want to invest and what you want to invest in. For example, when I started I chose mutual funds that focused on aggressive growth and international companies. But since I’ve built up a little of a nest egg, I’m more comfortable investing in less aggressive funds like balanced funds that invest in large cap companies and bonds.
Contributions to your 401k are deducted from your salary on a pre-tax basis, which means you won’t pay taxes on them. And if you’re lucky, your employer will contribute matching funds up to a certain percentage of your salary. It’s crucial to take advantage of this if it’s offered – because if you don’t contribute at least as much as your employer will match, it’s like turning away free money.
You can invest up to $17,000 in your 401k for 2012, or $22,500 if you are 50 or older. Be aware, however, that since you don’t pay tax on 401k contributions, you will pay income tax on withdrawals. You may also be penalized an extra 10% on early withdrawals – or withdrawals you make before the age of 59 1/2. What’s worse is that qualifying to withdraw money early can be a huge hassle. In other words, don’t invest money you might need before retirement in a 401k – put that money in a Roth instead. That said, some 401k plans allow loans, which let you access monies pre-retirement without penalty or taxes. You must pay interest on loans though and have to repay the loan on schedule or potentially face the taxes and penalties you were trying to avoid.
2. Roth IRA
A Roth IRA is easy to open online through a brokerage or mutual fund company, and you have a wide range of investments to choose from – but keep it simple and invest in a mutual fund or exchange trade fund (ETF) that matches your risk tolerance and interests. Perhaps the greatest benefit to the Roth is that you can withdraw money tax-free when you retire and you can access all your contributions tax-free at any time. In fact, I make sure to fully fund my Roth IRA every year – that way if I run into an emergency that exhausts my emergency fund, I don’t have to be penalized for tapping contributions. So if you want to save money for retirement, but aren’t entirely sure you won’t need it beforehand, put it in a Roth IRA.
However, unlike the 401k and traditional IRA, you have to pay income tax on contributions. Also, if you withdraw more than your total contributions before you turn 59 1/2, you may have to pay income tax and a 10% penalty on the excess amount. But there are certain exceptions for which you can withdraw earnings early without the penalty – like using funds to pay for qualified education expenses or a first home.
For 2012, you can invest up to $5,000 in a Roth IRA, or $6,000 if you are 50 or older. But not everyone is eligible to open a Roth IRA: you or your spouse must have earned income, and you must meet income eligibility requirements which depend on your filing status.
3. Traditional IRA
If you really like getting a tax deduction today, you may prefer to invest in a traditional IRA over a Roth IRA. A traditional IRA bears some similarity to the Roth – it can be opened through a brokerage or mutual fund company and you can choose between a range of investments. But the most notable distinction is that you may be able to deduct traditional IRA contributions on your taxes. And like the 401k, you will pay tax on all IRA withdrawals plus a 10% penalty on early withdrawals. There are some exceptions to the early withdrawal rule where you won’t be assessed the 10% penalty but will still have to pay taxes.
To open a traditional IRA, you or your spouse must have earned income, and your income must not exceed a certain amount depending on your filing status. In fact, you may be eligible to contribute to a Roth IRA but not to a traditional IRA as income eligibility requirements differ. If you decide (and are eligible) to contribute to both a traditional and a Roth IRA, make sure you understand the contribution limits. The maximum contribution limit to a traditional IRA is $5,000 for 2012 or $6,000 if you are 50 or older.
However, the limit applies to both types of IRA accounts. For example, if you are younger than 50, you cannot contribute $5,000 to a traditional IRA and a Roth for a total contribution of $10,000. Your total contribution to both accounts must not exceed $5,000. The same reasoning applies if you are 50 or older, except the limit increases to $6,000.
4. Low-Fee Mutual Fund
Chances are you’ll be invested in one or more mutual funds in another retirement account. But you may also want to supplement that with mutual fund investments outside of a retirement account so you can access them without penalty whenever you want.
For example, if you’re already maxing out a Roth, a low-fee mutual fund could be another way to save long-term without making yourself subject to early withdrawal penalties. That said, you won’t get the tax advantages when you invest outside of a retirement account – but you won’t have eligibility requirements or contribution limits either. In other words, anyone can invest. Just be aware that you will pay tax on capital gains and any dividends you receive.
With any long-term investments, its important to pick a fund with a low annual expense ratio. A simple way to do this is to choose an index fund or ETF that aims to match a benchmark index like the S&P 500. However, since a mutual fund outside a retirement account won’t enjoy the same tax advantages, it’s ideal to choose a mutual fund with low turnover – one that doesn’t buy and sell holdings often, as this will result in excessive capital gains tax. In fact, if you choose an ETF, you typically won’t experience capital gains unless you sell your shares.
Two good companies to consider that offer low-cost mutual funds and ETFs are Vanguard and Fidelity.
When it comes to retirement investing, the first rule is to do it and stick to it. Establish direct deposit on a monthly basis from your checking account to a Roth or traditional IRA, in addition to taking advantage of your employer’s 401k or other retirement plan.
The second rule is to diversify. Investing solely in your company’s stock, for example, could completely wipe out your savings if the market or your company turns sour. Talk to a financial advisor or read up online about how to properly diversify your investments according to your age and risk tolerance.
But whatever you do, don’t be one of the many who remain completely unprepared for years of retirement. Start small if you have to – but start today.
What are you doing to save for retirement?