There are many ways to save for retirement, but how do you know which is best? In this article, we’ll explore some common ways people save for retirement and which way is best.
Let’s take a look.
You have to invest
This probably goes without saying, but in order to effectively save for retirement, you have to invest in the stock market.
The days of stashing money in a a CD at your local bank and getting 16% returns are long gone.
You simply cannot do that anymore. Interest rates nowadays are so low, you’d be lucky to get 1-2% returns – that’s just not gonna cut it.
An even worse way to save for retirement would be to stash money in a simple savings, checking, or money market account–or even worse, your mattress–and getting even less than 1% returns.
The fact is, you have to invest in the stock market in order to have a real chance at building wealth. This is likely the only way you can ensure you’ll have enough for retirement.
Related: How to Get a Good Return Investing
The best way to save for retirement is to invest in retirement savings accounts, like IRAs and 401(k)s. This is the preferred method because of the tax-advantages you’ll get when doing so.
Let’s look at the 401(k) first.
Most employers offer 401(k)s to their employees, and these can be great vehicles for retirement.
Generally, employers will even match a certain percentage–which is basically free money being invested for you (pretty good deal). You don’t want to miss out on that if you can help it.
If your employer matches dollar for dollar–let’s say up to 4%–that means when you invest 4% of your income, your employer will also invest 4%. That’s a total of 8% of your salary, which is pretty substantial.
Pro tip: If your employer matches any amount at all, plan to invest at least that amount so you get the free match–nothing beats free.
Related: Best Funds for Your Company 401(k)
One advantage of the 401(k)–and also Traditional IRA–is the tax-deferred savings, meaning you won’t pay any taxes on that as income. You won’t have to pay taxes on that income until you start withdrawing it in retirement.
So, if you make $40,000 a year and you invest 4% towards your 401(k), your taxable income is reduced by 4% (or $1600), so you won’t have to pay taxes on that amount.
While that is an awesome tax-advantage to have while saving for retirement, it’s not near as good as the tax-advantages of contributing to a Roth. If you can do both, even better!
What you’ll want to do is contribute to your 401(k) first–whatever the company match–and contribute the rest towards a Roth.
For example, if your company matches 4% and you contribute 4% to your 401(k), you’ll want to invest the additional 11% towards a Roth. That’s 15% total, which is what most experts recommend (more on that in a moment).
But first, why do a Roth at all?
We’ll explore that answer next.
A Roth IRA is another tax-advantaged savings plan for retirement–although, I think it’s way better than the 401(k) or Traditional IRA.
A Roth grows tax-free, while the other two options grow tax-deferred.
That means a Roth, 401(k), or Traditional IRA–if invested in the same mutual funds–will all accumulate the same amount of savings. However, the Roth will allow you to take advantage of the most amount of savings because it’s tax free.
Related: Best Vanguard Funds for a Roth IRA
I often give a $40,000 example to illustrate this.
Here’s how it works.
If you make $40,000 a year, and contribute 15% of your income towards retirement–which is the recommended amount–you could save hundreds of thousands of dollars (if not millions) in taxes.
With a 401(k) or Traditional IRA, your contributions are tax-deferred–meaning you won’t pay taxes on the income until you draw it.
So, if you make $40,000 and contribute 4% towards a company 401(k) or Traditional IRA, you will decrease your tax liability by that amount.
If 4% of $40,000 is $1600, that means you’ll only pay taxes on $40,000 minus $1600–$38,400.
If your tax rate is currently 15%, you will pay $5760 in taxes per year–that’s $172,800 over the course of 30 years.
If you go with a Roth instead, your contributions are post tax–which means you invest money that’s already been taxed. Also, when it comes time to withdrawal that money, you still will not be taxed on it.
So, if 4% of $40,000 is $1600, that means you will still pay taxes on the full amount of $40,000.
If your tax rate is 15%, you will pay $6000 in taxes per year–that’s $180,000 over the course of 30 years ($7200 more than you would have paid with the tax-deferred option), but here’s where it gets interesting.
Your growth, whether 401(k), Traditional, or Roth, will be the same (if invested the same).
That means the principal amount at retirement over 30 years will be around $1.7M (under certain assumptions–I’ll explain later).
But, with a 401(k) of a Traditional IRA, we will have to pay taxes on that amount.
If we assume the same 15% tax rate, that’s $255,000 we’ll have to pay in taxes.
Whereas on a Roth, we pay no taxes! The entire $1.7M is ours!
Even if we factor in the amount of extra taxes we paid on the front end ($7200), that still leaves us $247,000 ahead.
The Roth is just a way better option. We are able to shield millions of dollars from being taxed, allowing us to save hundreds of thousands of dollars (if not millions) in taxes.
Most financial experts will recommend investing 15% of your income towards retirement. This seems to be an amount proven to be successful.
Most millionaires are first generation rich–meaning they didn’t inherit their wealth–they built their own wealth during their own lifetime.
They did this by saving and investing, avoiding debt, and living below their means. They also did it by using the types of retirement savings accounts we’re talking about here–IRAs/401(k)s.
If you aim to invest 15% of your income towards retirement, that leaves you with 85% to take care of everything else–that should be plenty.
Unfortunately, most people don’t save 15% for retirement (if any at all), which is why most people don’t have enough for retirement.
15% seems to be a “tried and true” blueprint for real wealth building. If you shoot for that, you will likely be okay–there are plenty of self-made millionaires to prove it.
15% seems to be the magic number. If you can invest 15%, definitely do it. If you can’t, work towards that goal.
But, again, why is 15% so important?
Well, the best reason I can think of is because wealthy people did it–perhaps we should do the same.
But here’s why it works.
If we go back to the $40,000 example, we can figure out why 15% actually works.
For example, if we make $40,000 a year and invest 15% of that towards retirement, that will make us a millionaire in less than 30 years.
Let’s assume an average rate of return of 12% per year (which is what the stock market has done, historically, over any 30-40 year period).
If we make $40,000 a year, that’s $6,000 a year invested–which is $500 a month.
Using this investment calculator we can project an amount of $1.7M at retirement.
But, will that be enough?
And here’s why.
If we are comfortable living on $40,000 a year, then $1.7M at retirement will be plenty.
In fact, if we invest properly–earning 12% on average–we will likely never run out of money because we would be able to live on the interest alone. That’s with inflation factored in, too.
Inflation has averaged around 4% per year, and if we are getting 12% returns on our investments, we could live on 8% and break even with inflation, allowing us to never touch the principal amount.
This will not only pay us through retirement, but it might also be a legacy we leave our children (or whomever).
That’s why 15% is so magical. It’s the perfect goal and makes everything else possible.
Do a Roth and a 401(k)
Since the Roth and the 401(k) both have tax advantages, why not capitalize on both?
There are two reasons for doing that:
(1) employers will generally give you a match for a 401(k), and
(2) you will likely need to invest more to reach your 15% goal.
Once again, you don’t want to miss out on free money. If you work for a company that offers a 401(k) match, contribute up to at least the match, so you don’t miss out on that money.
Since most employers won’t match much more than 3-6%, chances are you will need another retirement account to make up the rest of the 15%–that’s where your Roth comes in.
Sure, you could do a Traditional IRA instead, but remember–the savings on a Roth are way better! If you qualify for a Roth, that’s definitely the way to go.
If you contribute 5% to a 401(k), you’ll want to contribute 10% to a Roth. This allows you to take full advantage of all the benefits: the company match, the tax-deferred savings, and the tax-free savings. That’s huge!
In the odd event that you are contributing up to the company match in your 401(k) and have maxed out a Roth, and still aren’t saving 15%, you could up the 401(k) amount until you reach it.
If you don’t qualify for a Roth because you make too much and you have maxed out your company 401(k) and still haven’t reached 15%, then you’ll want to look at some taxable account options. These will have the same kind of investment options available–without the tax advantages or retirement accounts. But I suppose some people have to go that route.
The best way to save for retirement is to take advantage of retirement savings accounts if you can. I would do this before looking into other options, for sure.
But the most important thing–whichever options you have–is to invest 15% of your income towards retirement. That way you have enough when you retire, you have enough to pay living expenses now, and you’ll have enough to live like you do today through retirement.