One of the most significant goals of personal finance is saving for retirement. Despite retirement being decades away for many, its careful planning takes just as long. Many individuals postpone the start of saving and planning for retirement, but the sooner an individual starts to save, the better they will be decades down the road. Read on to learn how to save for retirement.
Getting a Head Start
One of the most important steps in saving for retirement is simply starting early. In a perfect world, an individual would start saving and planning for retirement at the age of 18. The reality is the majority of individuals start to save and plan for retirement much later, some start at 25 or 30, others start at 40. There is a particular reason why everyone should start saving as early as possible and that is due to the compounding effect.
The compounding effect is the capacity of an investment to generate earnings. These earnings are not spent, but continue to be reinvested, after which the newly invested capital is capable of earnings its own returns. As a quick example, you invest $5,000 into ABC stock, which earned you a return of 10% and you now have $5,500. Instead of spending the earned $500, you keep the account untouched. In the following 2nd year, the investment grows another 10% to $6,050. If left untouched, your initial investment of $5,000 will grow into $12,968.71! That is also not taking into account any monthly contributions or tax advantages, and this shows how important it is to start saving as early as possible.
401K
One of the best drivers of retirement investment growth has been the 401k. There are many types of 401k plans, but the most important and most widely used are the Roth 401k and the tradition 401k. Overall, both are quite similar, but there are a few small differences between them. Both are retirement investments account that individuals can contribute to over the years while also offering tax benefits.
Roth IRAs are contributed to by individuals after having paid taxes on their income. The Roth IRA account grows tax free. At the age of 59½, you are they able to withdraw funds from the account without any penalties or additional taxes. Individuals who us Roth IRA over traditional IRAs is they expect their income to be taxed in a higher bracket after their retirement. Despite the account growing tax free, there is no tax deferability and no current-year tax benefits. Contributions are limited by the Internal Revenue Service (IRA) and change from year to year, with contribution limits increasing.
Traditional IRAs is another popular 401k choice for individuals looking to save for retirement. Your contributions into a tradition IRA after tax or pre-tax, with your retirement account growing tax deferred. However, the income you withdraw after the age of 59 ½ is taxed as income. The tax deductibility aspect of tradition IRAs allows you to get instant tax benefits at the end of the year. Unlike Roth IRAs, you will be forced to make withdraws from the account with traditional IRAs, which is not mandatory when you have a Roth IRA. Read What is an IRA and How to Invest with an IRA.
Saving
Saving money in the beginning can be a tedious task, but eventually, it becomes a habit. The difficult part is getting into the habit of saving and investing. There is a large debate over how much an individual will need to save for retirement and to be comfortable during retirement without risking a dwindling retirement account. Individuals will need to save as much as they rationally can. The length of savings can be vary greatly depending on if an individual is expecting an inheritance, how long they want to work for or at what age they want to retire at.
To start, individuals will need to put an amount, any amount, into a savings/retirement account every month or week. It could be as low as $10 per month, or $150 per week. It is good to have a savings habit started and once it is started, you can then increase its frequency and amount. The important part of saving is to start as soon as possible along with investing.
If your for-profit employer offers a retirement savings plan, take full advantage of the plan! Especially if they match your contributions. Many individuals find employers who have a match ratio of 1:1, meaning each dollar you invest into the account, they will match a dollar. Other employers offer less, but no matter what they offer, take full advantage of it. Essentially, it is free money from your employer.
Reducing spending
One of the main aspects of savings for retirement is being able to reduce your overall spending. Doing so will eliminate many different spending habits that can be quite unnecessary to your financial goals and will help you reach your financial goals faster.
There are many different ways of reducing your spending such as keeping your car for longer, cooking at home more often, canceling memberships that are rarely used and start doing more things around the house yourself. Many of these activities can be quite cheap and convenient to do, but over the course of time, they add up quickly into the hundreds, if not thousands per year. This means individuals are able to now save hundreds per year with little effort.
Index Funds
An important aspect of retirement investment growth is the use of index funds, which is essentially a basket of bonds or stocks that is designed to mirror the returns of certain industries and commodities. In the last decades, index funds have grown tremendously in popularity due to their ease of use, especially considering that investors do not have to pick & choose the various stock composition, due diligence is not required and the trading of index stocks has never been easier.
There are many different types of index funds available on the market. The ones you will need to focus on are the ones that offer their holders broad exposure to different markets and industries. This in turn will offer the investor excellent growth potential as many indexes mirror entire stock indexes, such as the Standard & Poor’s 500, Dow Jones Industrial Average and the NASDAQ. Examples of excellent index funds that are the most widely used are the Shelton NASDAQ-100 Index Direct, Vanguard S&P 500 ETF and Vanguard Russell 2000. There are other ETFs that may offer higher returns at higher levels of risk due to their volatile nature (such as energy markets or commodities for example) and it is not recommended individuals invest in these.
For many individuals, retirement is decades away and many don’t even think about it until it may be too late. Which is why starting to save for retirement as early as possible is one of the most important financial decisions you can make. The amount needed to retire has been a debate amount financial experts for decades now with no decisive answer. Some say $1 million, others say $4 million. The answer is different for every person as every person has their own goals and their own circumstances.
Figuring out how much you need to save is dependent on many factors that only you can decide on, such as the lifestyle during retirement, location of retirement, and health to name a few factors. We understand saving for retirement can be an overwhelming task spanning decades, from the saving and investing, the sooner you start to invest, the better you will financial be decades into the future. So, start saving!
Read How to Create a Financial Plan.
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