Lesson 6: Saving for Retirement – Napkin Finance

Lesson 6: Saving for Retirement

Just as with taxes, it’s up to you to create your own retirement savings plan when you work for yourself. That means you need to set up your own plan, decide how much to save, and choose your own investments.

The basics: pretax vs. after-tax

Before we look at account types, it’s important to know the difference between pretax and after-tax retirement accounts

With pretax accounts, like 401(k)s and traditional IRAs, you contribute “pretax” dollars today (by taking a deduction for your contributions) and pay income taxes on your withdrawals in retirement. With after-tax accounts, you take no deduction for your contributions today, but you don’t owe any taxes on your withdrawals in retirement.

Bottom line: If you’re in a low tax bracket now (i.e., because you’re early in your career), it may make sense to save in an after-tax account, like a Roth IRA, so that you can get those taxes out of the way.

Types of accounts

You have several options when it comes to account types. But don’t be intimidated by all the options—chances are you’ll be fine with just one:

Account type Features
Traditional IRA Pretax; contribute up to $6,000 a year
Roth IRA  After-tax; contribute up to $6,000 per year (maximum allowed for Roth and traditional IRA accounts combined) 
SEP IRA Pretax; unique to self-employed workers; contribute up to $56,000 a year. If you have employees, you may have to set up and contribute on their behalf as well.
Solo 401(k) Pretax; an option if you’re self-employed with no employees; contribute up to $56,000 a year 

How much to save

Unlike many employees, you won’t get the benefit of any employer match in your retirement account. That means you’ll have to save even more in order to stay on track.

How much does that really work out to? You want to have enough money to comfortably cover your living expenses once you stop working. If you plan to travel or take up new hobbies in retirement, you’ll want to have a buffer for those costs as well.

Everyone’s retirement needs are different, but here’s a way to estimate how much you might need:

  • Decide when you’d like to retire.
    • The normal retirement age for people born after 1960 is 67, which is when you can receive full Social Security benefits. But many people choose a different age.
  • Estimate your expenses in retirement.
    • Though your circumstances may change, try to anticipate how your obligations might shift as you get older. Do you expect to pay off your mortgage well before retirement? Are you planning to move somewhere with a low cost of living?
  • Multiply your expenses by 25.
    • If you plan to withdraw 4% of your savings each year in retirement (a common rule of thumb), then you’ll need 25 times your expected expenses to live comfortably off those earnings.

Besides investment earnings, you’ll also receive Social Security benefits. Some people will also be eligible for other government benefits or a pension.

Investment choices

Once you’ve chosen an account type and started funding it with some savings, you’ll need to choose investments. The main issue you need to decide when choosing investments for your retirement accounts is your stock/bond mix. (This is also known as your asset allocation.)

When you’re young, it probably makes sense to mainly hold stocks. That’s because stocks provide pretty reliable long-term growth (even though they can perform erratically in the short run or even lose money in a single year). As you near retirement, you’ll likely want to start shifting your portfolio toward bonds, which don’t usually return as much as stocks but also don’t take such extreme price swings.

An easy rule of thumb to follow for choosing your mix is called the rule of 120. Just subtract your age from 120 and use that figure as your percentage allocation to stocks. Invest the rest of your money in bonds.

Increase your savings

Here are a few ways to reach your retirement goals:

  • Start as soon as possible: Even if you don’t have much cash available, invest whatever you can. The sooner you start earning, on any amount, the more you’ll have available when you retire.
  • Increase your contributions annually. Schedule a yearly income review to figure out how much more you can put into your savings and investments. Better yet, do this quarterly as an incentive to grow your business and seek out new clients.
  • Challenge yourself to a self-match. Since you don’t have an employer, no one will match your 401(k) contributions. But that doesn’t mean you can’t retire on your terms. Set up your own “employer match” program, and challenge yourself to double your monthly contributions.

If you’re unsure where to invest, you might consider speaking with a financial advisor who can walk you through the process and help you build your portfolio.

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