Now that you know what a retirement plan is and how compound interest works, let’s talk about some strategies to save for retirement effectively.
1. Start early
The earlier you start saving for retirement, the better. As we just saw, compound interest can significantly affect how much money you accumulate over time. All else equal (the contribution to your account and growth rate), starting in your 20s instead of your 30s can potentially triple how much money you have available in retirement.
2. Build an emergency fund
Before you start saving for retirement, make sure you have an emergency fund that can cover at least three to six months of living expenses. An emergency fund is a savings account that you can use for unexpected expenses or emergencies, like medical bills, car repairs, or job loss. An emergency fund can help you avoid dipping into your retirement savings or taking on debt when things go wrong.
3. Consider which type of retirement account to set up
As we mentioned earlier, there are different types of retirement accounts, like traditional and Roth 401(k)s and IRAs. Each type of account has its own pros and cons, depending on your income level, tax bracket, and retirement goals.
Generally speaking, a pre-tax account like a traditional 401(k) or IRA is better if you expect to be in a lower tax bracket in retirement than you are now. This way, you can save money on taxes now and pay less taxes when you withdraw the money in retirement.
On the other hand, an after-tax account like a Roth 401(k) or Roth IRA is better if you expect to be in a higher tax bracket in retirement than you are now. This way, you can pay taxes now at a lower rate and enjoy tax-free withdrawals in retirement.
With that in mind, let’s look at the features and limits of the most popular retirement plans you can choose when you’re in your 20s or 30s.
401(k)s, 403(b)s, and 457(b)s
These are the most common employer-sponsored retirement plans. These plans allow you to contribute a percentage of your income to a designated account before paying taxes on it. If you’re in your 20s or 30s, the annual contribution limit for these three types of accounts is $22,500 for the 2023 calendar year.1
In a 401(k), 403(b), or 457(b), your money grows tax-deferred, which means you’ll only pay income tax on the saved amount once you start making withdrawals in retirement.
Some employers also offer contribution matching, which means they will add a certain amount of money to your account for every dollar you contribute, up to a limit. This is essentially free money to increase your savings.
Roth 401(k)
This type of account is similar to the traditional 401(k), except that you fund the account with after-tax dollars. That means that your money grows tax-free instead of tax-deferred, so you won’t pay income tax on retirement.1
IRAs
An IRA is an Individual Retirement Account. This is another type of retirement plan you can set up on your own, regardless of whether you have an employer-sponsored plan. Similar to the 401(k), there are two types of IRAs: traditional and Roth, with the only difference being that you fund a traditional IRA with pre-tax dollars while the Roth IRA is funded with after-tax dollars. You can save a maximum of $6,500 annually in an IRA in 2023.1
High-yield savings accounts
High-yield savings accounts are good alternatives to retirement accounts like the ones mentioned above. They generate returns on your savings without you moving a finger, although rates are usually lower, and these accounts don’t have tax benefits. However, they’re a smart choice if you’ve already maxed out your other retirement accounts.
4. Max out your 401(k) or IRA
If your employer offers a 401(k) plan, take advantage of it, especially if they match your contributions. If this is the case, you should contribute at least enough to get the full employer match to avoid leaving free money on the table.
It won’t be easy to max out the 401(k) annual contribution limit of $22,500 when you’re in your 20s since it means saving $1,875 every month. However, if you do, and your money grows at a very conservative rate of 8%, by the time you reach age 65, you’ll have a nest egg of $6.5 million.
Of course, with student loan payments averaging $503 per month,2 setting aside another $1,800 for retirement may not be realistic. But you try to max out the amount your employer will match if you can afford it.
The average employer in the U.S. matches contributions up to 3.5% of a worker’s salary.3 So, if your salary is $50,000, you should try to save at least $146 every month. That way, your employer puts up the maximum of $146, and you get $292 deposited monthly into your 401(k). By retirement, you’ll have over a million dollars saved if you start saving when you’re 25, or a little over $435,000 if you wait until you’re 35 to start saving.
If your employer doesn’t offer a retirement plan, you can always open an IRA. In this case, you’ll have to put the full $292 per month yourself to reach the same goal as in the previous example. But if you max it out at the full $6,500 per year, you’ll have almost $2 million by the time you retire.
