Saving for retirement is something many people don’t think about until it’s too late. While you can start saving at any time, the earlier you start, the longer you’ll be able to take advantage of compound interest, creating an exponentially larger nest egg. Those with a 401(k) can get away without thinking about saving for retirement because their savings come straight out of their paycheck. But even if you don’t have a 401(k), there are still effective ways to start saving for retirement that have similar and sometimes better benefits.
Start an IRA
Whether you go with a traditional IRA or a Roth IRA, this is the first step you should take towards saving for retirement if you don’t have a 401(k). And the sooner you start, the better. You should choose a Roth IRA if you expect your tax rate to be higher in retirement than it is now. With a Roth IRA, there is no tax on your withdrawals in retirement, which can result in hundreds of thousands of dollars saved. In a traditional IRA, your contributions are tax-deductible that year, but your withdrawals are taxed in retirement.
The way an IRA works is you are allowed to contribute up to a maximum amount of money each year into an investment account. For 2020, the maximum contribution is $6,000 if you’re under 50 and $7,000 if you’re over 50. Once you open your IRA at a brokerage firm or a bank, you then select what you want to invest your money in, whether it’s stocks, bonds, mutual funds, or ETFs (exchange-traded funds).
For why you want to start your IRA as soon as possible, consider the following examples:
If you start a Roth IRA at 25 and contribute the maximum of $6,000 per year and assume a rate of return of 6%, your retirement account will be worth $1,055,703 if you retire at 67-years-old. The tax savings provided by your Roth IRA will total $342,155 over a regular taxable account.
But if you wait until you’re 35 to start funding your account, your retirement account will be much less bountiful. Assuming the same numbers as above, but starting ten years later, your Roth IRA will be worth $545,339 at age 67, and you will have saved $133,341 over a taxable account. That sum is still a substantial piece of your retirement puzzle, but it’s worth just over half of what your account would look like if you had started at 25.
What are the requirements for a Roth IRA?
To open a Roth IRA account, you must meet the following criteria:
- Earn an income
- Have a modified adjusted gross income of less than $189,000 for married couples or under $120,000 for an individual
Your modified adjusted gross income is your total gross income minus any deductions, plus any tax-exempt interest income.
If you’re married, both you and your spouse can open a Roth IRA and fund them each separately with the maximum amount, even if only one person is earning an income. With two Roth IRAs being fully funded each year, you may have enough money to live off of in retirement from these accounts alone.
If together you and your spouse make over $189,000 in modified adjusted gross income, you can still each fund traditional IRA accounts. And in this case, the traditional IRA account may make more sense for you since you’re already in a higher tax bracket. Other than the tax distinctions, the most significant differences between the two options are that you are required to take withdrawals once you turn 70-years-old with a traditional IRA, and you are not allowed to continue contributing to the account.
Open a Self-Employed 401(k)
If you want to be able to save even more money each year, you can do so if you qualify for a self-employed 401(k). If you are self-employed and do not have any employees, you’re eligible to open up a self-employed 401(k). The advantage of this account is that you can contribute up to $19,500 per year in 2020, and that money is tax-deductible the same way that it is with a traditional IRA.
You’re also able to make an additional payment to your account that is considered your employer contribution. This number can be as high as 25% of your income, up a to maximum of $57,000.
The limitations of a self-employed 401(k) are that you must begin to take minimum withdrawals at age 72. And if you make withdrawals before you turn 59.5, you may have to pay a 10% penalty.
Take Advantage of Catch-Up Contributions
Once you turn 50, you are allowed to contribute an additional $1,000 to your IRA accounts each year. While this small contribution increase may not seem to make much of a difference, you still have close to 20 years until retirement when you turn 50. With the power of compound interest, that additional $1,000 contribution each year could be worth close to $50,000 by the time you turn 70.
Invest in Stocks
When saving for retirement, you’re taking part in a 30 to 40-year plan that allows you to ignore fluctuations in the stock market. While bonds are safer, more stable investments, they make, on average, a 5% rate of return each year. That may sound like a decent return, but consider that the S&P 500 has averaged a 10% annual rate of return over the past 90 years, and you’ll start to see why you’re much better off going heavy on stocks if you have a long-term view.
In the short term, your account may fluctuate wildly. But knowing that you are investing with a decades-long approach allows you to ignore these fluctuations and trust that the market will continue to go up as it always has.
Don’t Put Off Saving for Retirement
This point is worth repeating one more time. While retirement may seem a long way off, each year you delay saving will cost you exponentially down the road. The good news is that, even without a 401(k), you have many options for creating a comfortable and sustainable nest egg in retirement. While you may not believe you have enough money to start saving right now, it all comes down to budgeting.
To contribute the maximum amount of $6,000 to an IRA account, you’ll need to save $500 each month. Any sacrifices that must be made to save this amount will be more than worth your time and effort once you retire.