Unless you are independently wealthy, setting aside money today to see that you have enough for the years down the road by starting a retirement fund is not an option—it’s mandatory.
Unfortunately, inertia can be a powerful force, and going from not saving to saving can be daunting to most people. So much investment and financial advice are designed for people who have already begun saving and investing for the future. Below are some strategies for those looking to start the process.
- The most important step to take in saving for your future is to start saving.
- The government and many businesses offer incentives to save, such as IRA or 401(k) accounts, which allow account holders to accumulate savings tax-free for many years.
- An employer’s contribution to a retirement account amounts to free money, and the benefit should be maximized.
Starting a Retirement Fund
If you earn money, you pay Social Security taxes, but the funds used to pay Social Security benefits are expected to become depleted. According to the Social Security Administration (SSA), the 2022 annual report containing financial projections shows that the Social Security fund will be able to pay the full scheduled benefits until 2034. After that point, the trust fund will be depleted and only 77% of the scheduled benefits will be able to be paid with continuing tax income.
Thus, it is unclear how well its benefits will cover the actual cost of living. Simply consider the debate today over chained CPI, a newer way of measuring the pace of rising prices called inflation, and what that could mean to the value of future benefits.
It is also important to note that the government (and many businesses) offers incentives to save. Putting aside money into an appropriate qualified retirement plan, such as an individual retirement account (IRA) or a 401(k), lowers a tax bill in the year that the money was saved and can accumulate tax-free for decades.
Similarly, many companies will also contribute funds if an employee contributes to a retirement account. An employer’s contribution amounts to free money, and most financial advisors would encourage their clients to maximize this opportunity.
Challenges at the Start
Most people who are not already saving believe they do not have enough money to meet day-to-day expenses, let alone have any left over to save. However, paying yourself should be every bit as much of a priority as paying other people. Of course, it is unwise to default on loans or allow bills to go past due, but if you don’t take care of yourself, who will?
There will be months when you come up short and have little to save. You will also find that your investment choices may be limited. It is important not to become discouraged, but to save as much as you can, as often as you can.
The personal-finance industry is set up to cater to those who have considerable wealth—virtually every bank and brokerage would rather deal with 10 millionaires than 10,000 people with $1,000 each. Nevertheless, your savings and retirement plans should be based on what meets your needs, not those of the financiers.
To that end, even $250 or $500 in retirement savings is a worthwhile start. Any savings establishes a habit and a process. There are multiple brokers now that offer no-minimum, no-fee retirement accounts. The key to saving for retirement is to be consistent. It should be a continuous, lifelong habit.
Thus, it helps to set yourself up for success. For example, don’t attempt to scrape together the cash for a last-minute contribution to an IRA in April right before you file your tax return. Instead, save a little each month, ideally using an online savings account, and only tap into it in extreme emergencies.
Most of these online accounts will allow you to automatically deduct a set amount every month from your regular account. If your employer offers a 401(k) program, you can have deductions made automatically from every paycheck.
Brokerage firms should be selected based on the fees charged and their range of ETFs and mutual funds.
Selecting a Brokerage Firm
An increasing number of large, national, well-known (they advertise on TV) brokerage and mutual fund firms are willing to open small accounts without fees or minimums. Opening accounts with these larger firms can be a good idea. They often have a wide selection of investment options (mutual funds, exchange-traded funds, or ETFs) and the most transparent and reasonable fees.
Also, these large firms have the infrastructure to offer you additional services (including personal investment advisors) as your needs change over time.
It is important to take the time to make a good selection. Most, if not all, firms charge fees for transferring accounts, and switching firms repeatedly will reduce your savings. Focus on fees and the range of ETFs and mutual funds that they offer. Don’t be too concerned with the trading tools and services they provide, because trading is not wise when you are saving and have limited funds.
Be Realistic About Risk
Those who are just starting to save for retirement also need to consider investment risk. While academics and investment professionals struggle to define and measure risk, most ordinary people have a pretty clear understanding of it: What’s the likelihood that I’m going to lose a substantial portion of my money (with “substantial” varying from person to person)?
Novice savers and investors should be realistic about risk. While any amount of savings is a good start, small amounts of money are not going to produce livable amounts of income in the future. This means that it makes very little sense to invest in fixed-income or other conservative investments at the beginning. Similarly, you don’t want to invest that initial savings in the riskiest areas of the market, so avoid the riskiest areas of the market—no biotech, no bitcoin, no gold, no leveraged funds, and so on.
A basic index fund (a fund that matches a popular index such as the Dow Jones Industrials or S&P 500) is a good place to start. There is certainly a risk that the price will fall, but the odds of a total wipeout are nearly zero and favor a reasonable amount of growth.
The best first investments are in mutual funds and ETFs, which are low cost and require little effort.
Your First Investments
As a new saver/investor, your first investments will most likely be in ETFs or mutual funds. ETFs and mutual funds allow you to invest almost any amount of money (from a little to a lot) with little hassle and cost. With a mutual fund or an ETF, you can take $500 and essentially buy tiny stakes in dozens (if not hundreds or thousands) of stocks all at once, giving you a greater likelihood of seeing positive returns and fewer major losses.
Index ETFs have become popular in recent years. For a minimal cost (an initial commission and a small annual fee that is paid or deducted automatically from the shares themselves), an investor can effectively buy the entire S&P 500 or other popular indexes. A growing number of ETFs allow investors to invest in broad categories such as “growth” or “value,” which is something that has been available to mutual fund investors for decades.
Mutual funds, however, still have their place. They often give investors the benefits of active management from a fund manager, who makes decisions on a day-to-day basis to try to earn higher returns for investors. By comparison, most ETFs run on autopilot—holding a specified list of stocks (usually matching an index) and only changing when the index changes.
When looking for mutual funds, determine the fees and expenses (lower is better) and also look at the performance. Ideally, you want a fund that has not only performed well overall compared to its peers but has also lost less money in the bad times.
What to Choose
Regarding first investments, consider two or three ETFs. Most mutual funds have minimum investment amounts of $1,000 or more, so they may not be an option yet. Consider buying one or two of the following ETFs:
- Vanguard Total Stock Market (VTI)
- SPDR S&P 500 (SPY)
- Vanguard Dividend Appreciation (VIG)
- Vanguard Value (VTV)
- Vanguard Growth (VUG)
- Vanguard FTSE All-World ex-US (VEU)
- Invesco Dynamic Large Cap Value (PWV)
- SPDR Dow Jones Industrial Average (DIA)
- SPDR S&P Dividend (SDY)
- Invesco S&P 500 Pure Growth (RPG)
If you can afford to own two or three, try to get a good mix. For example, one large market fund (VTI, SPY), an international fund (VEU), and either a growth (VUG, RPG) or value (VTV, PWV) fund, based on your personal preferences.
The suggested amount to have in retirement savings before investing in stocks.
Over time, the habit of saving will hopefully take hold. Moreover, you may find that your earnings increase, and you can save more. As you do that, and your initial investments grow in value, you will find that you have an increasing number of investment options.
With more money to invest, mutual fund investment minimums may be less restricting, and you may be able to own more funds and ETFs. You may also find that you can afford to take more risks (investing more in growth stocks or more aggressive growth equities) or target particular types of investments (investing in specific sectors or geographical areas). If this becomes the case, be careful not to diversify excessively. It is much better to have five great ideas than 15 mediocre ones.
Some readers may be wondering by now when they can start buying individual stocks. There is no hard-and-fast rule here, but I would suggest that $5,000 in total savings is a good number to use as a minimum. There is nothing wrong with investing $1,000 in an individual stock or two and keeping the rest in funds or, if you are comfortable, increasing the allocation to individual stocks.
Investing in individual stocks is quite different from investing in funds or ETFs. It requires assuming more responsibility for your investment decisions, which requires the investment of considerable time and research. The rewards can be greater, but without the ability to invest the necessary time on an ongoing basis, it is wiser to choose funds and ETFs for the long term.
As your earnings increase and you have more money left at the end of the month, try to max out your annual contributions to your 401(k), IRA, SEP IRA, or whatever savings options are available to you. Contribute up to the annual maximum allowed by law.
Types of Retirement Plans
The 401(k) plan is a popular defined-contribution retirement plan offered by many employers. The 401(k) features many investment options that employees can contribute using pre-tax dollars, some of which may be matched by the employer (subject to a vesting period).
The money in a 401(k) grows tax-deferred, meaning that you won't have to pay taxes on the contributions or the gains until you start to make withdrawals in retirement, presumably at a lower tax bracket.
For tax year 2022, workers under age 50 can contribute a maximum of $20,500 to a 401(k). This increases to $22,500 for tax year 2023. Those 50 and older can also include an additional $6,500 in catch-up contributions, which increases to $7,500 for 2023. These limits are indexed to inflation, and are updated annually.
The 403(b) plan is similar in many ways to the 401(k) but is only offered by non-profits, governments, or government-agency employers such as public schools or public hospitals. There are some small differences between a 403(b) and 401(k), but for most employees these wouldn't matter.
Employees of state and local governments may instead be offered a very similar 457(b) plan.
A traditional IRA is an individual retirement account that you self-direct using pre-tax dollars that then grow tax-deferred. An IRA can be opened with a brokerage firm and you can buy and sell securities like stocks, ETFs, bonds, and mutual funds, although there are some restricted asset classes like precious metals and real estate that cannot go into an IRA.
Contribution limits for 2022 are $6,000 per year ($6,500 for 2023), with savers age 50 and older able to make an additional $1,000 in catch-up contributions. These limits are indexed to inflation and adjusted annually.
A Roth IRA uses after-tax dollars instead of pre-tax dollars. Investments then grow tax-exempt rather than tax-deferred. Roth IRAs have the same annual contribution limits as a traditional IRA, but are subject to income limits.
The income phase-out range for Roth contributions for married couples filing jointly for 2022 is $204,000 to $214,000; for single filers and heads of household, it's $129,000 to $144,000. For tax year 2023, the income phase-out range for Roth contributions for married couples filing jointly is $218,000 to $228,000; for single filers and heads of household, it's $138,000 to $153,000. If you earn above those amounts, you cannot contribute to a Roth at all.
SEP and SIMPLE IRA
If you are self-employed or the owner of a small business, there are additional retirement plan options.
A SEP IRA (which stands for simplified employee pension) allows employers of any size to contribute pre-tax dollars toward employees' and their own retirement. Only employers, including the self-employed, can contribute to a SEP IRA. In 2022, employers can contribute up to $61,000 or 25% of the employee's compensation, whichever is less. This limit increases to $66,000 for tax year 2023.
SIMPLE stands for "Savings Incentive Match Plan for Employees." Only businesses with less than 100 employees can set one up. A SIMPLE IRA has two contribution formulas that can be used. An employer can either:
- Match up to 3% of the employee's annual contribution, or
- Set up a non-elective 2% contribution of each employee's salary without requiring employee contributions.1
In 2022, the contribution limit for employees is $14,000. Employees aged 50 years and older can make additional catch-up contributions of up to $3,000. For tax year 2023, the contribution limit for employees is $15,500, and employees aged 50 years and older can make additional catch-up contributions of up to $3,500.
Defined-Benefit (DB) Pensions
Some, though a dwindling number of employers still offer defined-benefit (DB) pensions. These are essentially guaranteed lifetime annuities that pay a steady income stream to retirees until their deaths. Employers are responsible for the pensions along with any investment decisions that go into them.
Saving in organized retirement accounts is just one type of saving, but there are many more options. The government has specific rules and limits on how much you can save each year in tax-sheltered accounts. However, there are no limits on the savings you can put into ordinary taxable brokerage accounts. Although the dividends can be subject to taxation, and you will pay taxes on capital gains, you are still saving and building wealth.
Retirement Saving Tips
In addition to the information provided above, there are some general tips that you can use to maximize your retirement savings potential. Some of these include:
- Invest with the appropriate risk profile: even if you usually avoid risk, the longer you have until retirement, the more aggressive your retirement portfolio should be. Then as retirement approaches, shift into more conservative allocations. Target-date funds are easy set-it-and-forget it mutual funds that automatically make these risk adjustments for you over time.
- Diversify: don't put all of your eggs in one basket. Diversification is the key to maximizing expected return while minimizing risk. One retirement savings mistake is to allocate too much to your company's stock in your 401(k). While having a small amount of company stock is fine, too much can create unnecessary risk.
- Employer match: If your employer matches contributions, it is essentially free money. Maximize this benefit if you have it. This may mean increasing your own contribution level to get there.
- Automate savings: Have your retirement contributions automatically taken out every month or week so you don't have to worry about forgetting. Automating also keeps your emotions in check when markets become volatile, since investing when stocks are down can mean buying at deep discounts when they bounce back.
- Start early: There's no time like the present. The earlier you start funding a retirement account, the longer it has to grow and compound. That said, even if you're older it is worthwhile to begin saving for retirement instead of putting it off indefinitely.
How Much Do I Need to Save for Retirement?
How much you need to save for retirement depends on your current age, income, and the lifestyle you want when you retire. There are several rules and heuristics you can use to estimate what's needed, although none of these are foolproof:
- 15% of gross salary: Save 15% of your gross salary for as long as you can
- 4% rule: Divide your desired annual retirement income by 4%, So, if you make $50,000 per year, you would need 50,000/0.04 = $1,250,000.
- Age rules: By age 30 you should have 1x your annual income saved, 3x by age 40, 6x by age 50, 8x by age 60, and 10x by age 67.
What Type of Retirement Fund Is the Best?
All qualified retirement plans have their pros and cons. Some have different tax advantages but may be limited in the amount you can contribute or are subject to income caps. Others may only be available to small business owners and their employees. Yet others may offer employer matching contributions. In the end, any retirement account is better than none at all.
Is a 401k a Retirement Fund?
Yes, a 401(k) plan is a common type of employer-sponsored defined-contribution retirement fund.
How Do I Start a Retirement Fund?
You can open an IRA with your brokerage and sometimes even your bank. If you work for a company, you will also often have access to a 401(k) plan (or similar). All you have to do is sign up and start funding it.
The Bottom Line
The most important part of any savings or retirement plan is simply to start. There is no one right way to save money, nor one right way to invest. You will make mistakes along the way, and sooner or later you will see the value of some (if not all) of your holdings decline. While this is not desirable, it is normal. What is important is that you keep saving, learning, and looking to build wealth for the future. If you establish the habit of saving money every month, take the time to place your money wisely, and patiently allow your wealth to build, you will be taking huge steps forward in making your financial future more secure.