Individual Retirement Account, or IRA

The individual retirement account, or IRA, is a special kind of investment account that anyone can open. An IRA is important because it provides tax savings. There are two kinds of taxes that apply to retirement savings. The first is the standard set of income taxes that get taken out of your salary as you earn it. When you take the money you earn and put it into investments to let it grow over time, which is called making a contribution, eventually you need to sell your investments and cash out to pay for your retirement expenses. That is called taking a distribution. When you do that, the money is taxed again, so you face double taxation on it.

With an IRA, you can choose to protect your savings from one of these types of taxes. In a traditional IRA, you do not need to pay taxes for the contributions up front, although the balance will still be taxed when you take a distribution at the end. In a Roth IRA, you do pay taxes on contributions but not on the distributions. You can pick one type and start adding money to it and investing that money in mutual funds, stocks, bonds, or anything else you want. It is even possible to open one of each kind and contribute some money to each one.

However, every individual has an annual maximum amount that they can legally contribute to all of their IRAs, and you can’t contribute any more if you have multiple accounts. The max can change from year to year to account for inflation and other factors. Getting an IRA up and running and making regular contributions is a good goal to set because the investments will grow over time and provide money to use when you retire.

Employer-Sponsored Retirement Plan, Usually 401k

Another tool that some people have is an employer-sponsored retirement plan. For most companies, this is called a 401k. For non-profit organizations like colleges or government jobs, this will be called a 403b. These work exactly the same way as an IRA in terms of their tax benefits. However, they also have an extra benefit– employers often make matching contributions.

If their match is, for example, 3 percent, that means that if you contribute 3 percent of your salary to the 401k, then your company will add that same amount of money into the account for you out of their own pocket, so that you really get 6 percent of your salary in contributions. On top of that, employer-sponsored plans have a separate maximum from IRAs. So you can max out your IRA contributions and still be allowed to add money to your 401k.

Other extra benefits are a lot less common but still might be of use. For example, some employers have a separate plan that works like a 401k but can only be used for medical care and medical expenses in retirement. These usually have lower contributions but are still handy. For people who make high salaries, their employer might have an overflow plan, which is an extra savings plan to benefit people who have maxed out the legal level of contributions to their 401k.

Social Security Benefits

Aside from these plans, it is important to consider benefits like Social Security. Right now, Social Security is in an uncertain place. To ensure that the program has enough money to pay retirees, there are going to have to be reforms of some kind. Those reforms might involve lowering benefit levels, increasing taxes, a combination of both, or some other approach. It is difficult to predict what will happen, but Social Security is not going to disappear or go away entirely.

Calculating Retirement Savings

If you want to try to predict how much money you will have when you retire, consider using a compound interest calculator. These can help you forecast your accumulated savings under different conditions. Start with a compound interest calculator and add in how much you have saved now as the principal. Then you can add how much you plan to contribute across all of your plans, like an IRA and 401k.

For the interest rate, put down how much of a return you plan to get from your investments. Then for the timeline, enter how many years until you plan to retire and see what results you get. Experiment with it. For example, if you hope to get a 5 percent return, you will get one number. But then see what would happen if you only get a 3 percent return. Try seeing what would happen if you were to retire at 65 vs. if you were to retire at 70. These small changes can make a huge difference in your accumulation.

Many people don’t think too much about their retirement, especially when they are young. But starting to make contributions early, even if they start out small, will lead to a lot more accumulations because they grow at a compounding rate. It is very hard to catch up on this kind of saving late in life because there will not be many years of time for the money to grow before you need to withdraw it and use it to pay for the month to month expenses of living in retirement, whatever those might be for you.

Start Contributing as Early as Possible

The best place to start with retirement savings is to start contributing to some sort of retirement account as early on as possible. Even if the amount is small, being able to start early means that the savings can spend more time growing. In addition, as your salary increases from year to year, it will become easier to contribute and save more.

Everyone has Access to the IRA

Everyone has access to at least one form of retirement savings account. This is the Individual Retirement Account, or IRA. An IRA is an investment account that has a tax advantage. Most investments are subject to two kinds of taxes– first, the money is taxed under regular payroll tax once you earn it as a salary. Then you invest that money, and later, you sell the investments and withdraw the profit. That withdrawal is also taxed.

If you put the money into an IRA and invest within that, you can avoid one or the other of the taxes depending on whether it is a traditional or Roth IRA. The specific type does not matter too much, but the benefit of being able to reduce the taxes on savings is a major advantage. In addition, it allows for the investments to grow faster and more easily.

Understanding the Annual Limit

These accounts have an annual limit, and contributing to that limit will lead to a good amount of retirement savings. In the account, you can choose what to invest the money in. Ideally, this is a set of assets that will grow in value over time. The combination of contributions from you and the growth of the assets should create the overall stock of money that will provide the funding for retirement. Investing earlier means that the assets and the money have more time to grow with compound interest.

The first and most important choice to make is how much to put into these accounts. As mentioned above, everyone has access to an IRA, and some people will also be able to use a 401k, 403b, or similar employer-based plan. These work the same way as IRAs in terms of tax savings. They have a separate limit and may come with employer contributions that can help you save more. Getting as much as possible out of these accounts and getting as many contributions as possible is a good goal to have.

Choosing Where to Invest

Beyond just contributing money to the account, there is also the question about how to invest it. Generally speaking, there are two forms of assets where most people invest– stocks and bonds. Stocks are pieces of a company’s ownership, and they tend to be more volatile. They can grow at a higher rate, but they also come with more risk of losing their value. On the other hand, bonds are steadier in value and do not grow as fast, but they also come with less risk. The best choice is one that makes you feel the most comfortable about the combination of risk and the rate of return, which will involve a blend of both stocks and bonds.

This is something that can change over time. For example, younger people have more time ahead of them, and they want their assets to grow as fast as they can. That means they will benefit more from stocks and might want to have a higher ratio of stocks to bonds in their portfolio. On the other hand, older people who are approaching retirement have accumulated a lot of value in their assets. Instead of trying to grow, they generally want to preserve the value they already have. That means they might want to have more bonds than stocks.

Calculating the Best Ratio for You

There are lots of different rules of thumb and other approaches to decide which ratio is the best fit for you. A conversation with a financial planner or advisor is a good place to get started. For learning how a set of assets will grow over time, you can do all of that with an online compound interest calculator. Enter the starting point as the principal, along with the additional monthly amount that you will contribute to the account. Then put the rate of return on the investments as the interest rate, and you will be able to calculate out what the assets might be worth at any point in the future based on your assumptions.

This calculator does not provide a guaranteed prediction of your specific outcome, but it can guide you. If you want to reach a certain goal, you can see what kind of monthly or yearly contributions you need to make in order to reach that goal. This is an important step in framing your plans from a financial perspective. As a worker, you need to balance saving for retirement with other financial priorities like child care, a car, and housing.

Start Planning for Retirement Early

The earlier you start thinking about retirement savings, the easier it will be to make a plan and save in accordance with your goals. This is something that can seem distant and abstract, but the earlier the action takes place, the easier it will be to feel satisfied with the retirement plan. Retirement can be complex to understand at first, but learning about the power of early contributions and how they grow through compound interest over time. It is that growth that makes retirement possible, and committing to the plan early on is a key way to build up that momentum that will carry through to the goal.

There is nothing like feeling secure in the retirement plan you have and knowing what adjustments to make and when to make sure that you stay on track as the years go by, and knowing how that will benefit you in the end.