Saving for Retirement
Why do so many people put off saving for retirement?
It's simple. We don't want to sacrifice our younger years. Sipping mojitos by the pool at our retirement home when we're older sounds great, but it’s not worth missing out on doing what we want in our 20s and 30s.
We shouldn't be sacrificing any period of our life for potential future happiness.
However, most people don't realize that the best way to enjoy as much of our lives as possible is to start saving for retirement as early as possible.
Look at the following example...
Jane wants to retire at the age of 65 with $500,000. She decides to invest in a retirement account with an average annual return of 7%.
In scenario 1, Jane begins saving for retirement when she turns 25. She needs to invest $190 per month to reach her target. In scenario 2, Jane doesn't begin saving for retirement until the age of 45. Now, Jane needs to invest $960 every month to reach her retirement target.
In the second scenario, Jane will need to be very frugal in her 40s and 50s, and likely won’t have the money to do things she enjoys. In the first scenario, Jane is able to spread out her investments over her entire working life, meaning no period of her life will be significantly impacted.
The other upside of scenario 1 is Jane only needs to invest a total of $91,435 to reach her target. This means her money will grow more than 5x. In scenario 2, Jane needs to invest a total of $230,358, and her money will only grow about 2x.
That's an extra $140,000 that Jane could have spent buying her dream car, traveling the world, or starting her own business.
Retirement plans are special investing accounts with tax benefits that you don’t get with regular trading accounts. Although the tax benefits are great, in most cases you aren’t able to begin withdrawing money until the age of 59.5. If you need to take money out before then, there are significant penalties.
When adding money to a retirement account, you shouldn’t plan on needing any of it until your 60s.
IRA vs 401k
The two most common retirement plan types are an IRA and a 401k.
An IRA is a retirement plan that you set up yourself. When you invest money towards your IRA, the amounts are deducted from your taxes. For example, if you earn $50,000 a year, and invest $5,000 towards an IRA, only $45,000 of your income would be taxed.
A 401k is similar to an IRA, and also allows you to deduct investments from your taxes. The difference is that a 401k is set up through your employer. Your investments typically come straight out of your paycheck. The main advantage of a 401k is that employers often offer to match a portion of your investments, which is essentially free money.
If you work for an employer that offers a 401k match, and you don’t plan on changing jobs frequently, then a 401k is probably the best option for you.
If you’re a contractor or entrepreneur, a 401k might not be an option for you, so you should open an IRA.
If you plan on changing jobs frequently, you will need to manage separate 401ks with each employer. It may make sense to open an IRA instead.
Keep in mind that you can have both a 401k and an IRA. I personally invest some money in a 401k to take advantage of my employer match, and then I put the rest of my money in an IRA. However, I would recommend just starting with one plan at first.
Note: In 2020 and 2021, the maximum annual contribution is $6,000 for an IRA and $19,500 for a 401k (if you’re under the age of 50). If you’re planning to invest large amounts each year, you may need both an IRA and a 401k.
Roth Retirement Plans
You may have also heard of a Roth IRA or Roth 401k.
These are very similar to a Traditional IRA or 401k. The difference is that Roth plans allow you to prepay your taxes.
When you make investments to a Traditional IRA or 401k, you’re able to deduct them from your taxes. This saves you money in the short term. However, you will be taxed when you withdraw money from your account in the future.
When you make investments to a Roth IRA or Roth 401k, your investments are not tax-deductible. However, when you withdraw money from your account in the future, your earnings will not be taxed.
Choosing Traditional or Roth
When choosing between Roth or Traditional retirement plans, keep in mind that the difference shouldn’t be too significant.
Look at the example below…
As you can see, if the current and future tax rates are the same, your retirement account will have the same amount no matter which plan type you choose.
When determining which plan type to pick, you should consider what your tax rate will be in the future.
If you expect to have a higher tax rate in your 60s, you should choose a Roth plan to prepay your taxes at your lower current tax rate.
If you expect to have a lower tax rate in your 60s, you should choose a Traditional plan so that you pay taxes at your lower future rate.
If you aren’t sure, and don’t want to worry about future tax rates, I recommend just choosing a Roth plan. That way you can pay taxes up front and not worry about it in the future.
IRA Withdrawal Requirements
Note: This only applies to IRAs and not 401ks
Another important difference between a Traditional and Roth IRA is the withdrawal requirements. A Traditional IRA requires you to begin withdrawing money at the age of 70.5 (as of 2020). Because you haven't paid taxes on this money yet, the government wants you to take out money, so they can get their cut.
With a Roth IRA, there are no withdrawal requirements. The government already taxed your investments, so they don’t care when you decide to start taking money out. If you don’t expect to need your retirement savings until your late 70s or 80s, it may be a good idea to choose a Roth plan. This will allow you to continue letting your investments grow until you actually need them.
I chose to go with Roth plans since I wanted to prepay taxes at the current rate. I also would like the flexibility to wait until my late 70s or 80s to withdraw money from my Roth IRA.
Want to Learn More About Saving for Retirement?
Check out my book to learn:
How to set up your retirement account
What to invest in
How much to invest
How to automate your investments