Does this sound like you?? You’re in your late 20’s or early 30’s. You have a job with a work retirement plan. You have a positive cash flow, but aren’t quite sure how to prioritize your savings. If so, here are some simple steps you can follow to ensure you set yourself up for a successfully funded retirement.
Be aware that these are general recommendations- of course, there will be exceptions given an individual’s specific circumstances. For example, if you are still working to pay off student debt or a car loan, you may prioritize differently than someone without any liabilities.
Step 1: Be sure you start saving for an emergency fund.
An emergency fund is at least 4 to 6 months of expenses kept in a savings account. This insures that the money is readily available should you need it in a sudden emergency situation such as losing your job. Begin saving towards this goal as soon as possible!
Step 2: Set up and start monthly savings for larger expenses.
Consider larger expenses that aren’t a part of your yearly budget such as larger trips, buying a new car or purchasing bigger home furnishings. Set up separate savings account buckets for any of these items that apply to you. Determine a monthly contribution you can make for each bucket and set up your savings account to automatically withdraw that amount from your checking account.
This will help you to be prepared with easily liquid funds for larger items, so you avoid having to pull money prematurely from your retirement or brokerage accounts.
Once you have started to set up your liquid savings program in Steps 1 and 2, you can focus on your retirement savings program. However, don’t think that you must complete these steps fully before moving on. You will get the most benefit from starting both your liquid and retirement savings at the same time. Ideally you should work to build up your retirement savings contributions to total 15% of your wage amount.
Step 3: Take advantage of your company’s 401k or similar retirement account program.
Many companies will match some percentage of your contributions to a 401k. For example, Blue Corporation offers a 100% match on the first 6% of contributions, which means that the company will match all employee contributions up to 6% of their salary.
Most companies also include a vesting schedule for the employer matching contributions. This schedule delays the employee’s ownership of the company match for a specified number of years. For example, the 6% match from Blue Corporation is vested 50% after 1 year and 100% after 2 years. If an employee leaves Blue Corporation after working there for 1.5 years, she will only benefit from 50% of the company’s contribution to her 401k.
Learn about your company’s match and vesting policy. Be sure you are at least contributing to your 401k up to your company’s match percentage and are aware of the vesting schedule. This helps you to grow your retirement account value much faster.
Step 4: After maximizing your work 401k match, contribute to your Roth IRA each year.
Currently, you can contribute up to $5,500 each year into a Roth account ($6,500 if you were age 50 or older). This limit is increased every few years for inflation. If your adjusted gross income will fall between $117,000 and $132,000 as a single taxpayer or between $184,000 and $194,000 as a married filing jointly taxpayer, your contribution amount will be proportionally phased out until you reach the upper AGI limit at which point you cannot contribute to a Roth IRA.
A Roth IRA is unique. It is the only retirement account for which you will never pay income taxes on amounts you withdraw in retirement (assuming that is, that you follow the withdrawal rules). A Roth IRA is funded with post-tax dollars and all future growth is never taxed. Say, Mary has both a regular IRA account and a Roth IRA. Over the years, she contributes $100,000 to each account. Both accounts grow to $500,000 over 30 years. Mary has a 30% tax rate in retirement. The regular IRA growth of $400,000 will generate taxes of 30% X $400,000 = $120,000. So the real value of regular IRA is $500,000 less $120,000 taxes or net of $380,000. The Roth IRA value retains its $500,000
Step 5: Next, maximize work 401k pretax retirement account contributions.
Once you have maximized your Roth contributions, increase your 401k contributions up to the maximum amount which is currently $18,000/year ($24,000/year of age 50 or older). Your work pretax contributions allow you to defer paying taxes until you make retirement withdrawals. In doing so, you are effectively earning investment growth on the tax deferral amount.
Step 6: Contribute any remaining funds into a brokerage account as part of your overall retirement savings program.
Since you are investing after tax amounts, the brokerage account represents a source of retirement funds which will generate much less taxes when withdrawn than your pretax work 401k or regular pretax IRA accounts.