The Benefits of Saving Money for Retirement
Retirement accounts are among those schemes that require long-term commitment, and, hopefully, continuous contributions. Retirement accounts are where you need to invest now for your future self to spend.
However, the fact that you owe it to yourself to have a decent retirement doesn’t make things easier. Rather, it introduces psychological barriers that manifest into devastating retirement stats: a large majority of Americans are behind on their retirement savings goals by a fair margin.
The younger you are when you start saving for retirement, the better. At the same time, paradoxically, the younger you are, the less you care about retiring.
This doesn’t mean you can’t start growing your retirement account in your 40’s, 50’s, or 60’s. It simply means that you’d be better off if you start as early as possible.
The case for saving for retirement
In essence, there are two big reasons to start transferring contributions to your retirement plan as early as possible:
- The perks of retirement accounts;
- Not having to rely on the government (or your children) during your golden years.
Tax deferral and compound interest are two of the most important financial benefits of retirement accounts (compared to other accounts). When you start saving early, you simply put them to work in your favor.
Also, having a hefty retirement account will allow you to be a self-sufficient retiree. For some, this can prove to be more relevant than the financial advantages (in the strict sense). The future of Social Security retirement benefits is uncertain, and your kids, well, they’ll have their own life.
Let’s delve deeper into retirement accounts.
Retirement and advantageous taxation
Tax-deferred retirement accounts are unique in the world of saving and investments. In plain terms, they allow the account holder to postpone paying taxes on the income (interest for the deposit) until retirement. Since the tax bracket for retirees is lower, you end up paying less tax. Of course, you can do this only after you retire.
Tax deduction is attractive for everyone, so certain limits on yearly contributions to retirement accounts are put in place to avoid abuses. These annual limits vary because there are different retirement plans and accounts. Let’s check them out.
As many of you already know, this is a company-sponsored retirement account. This means that another entity (your employer) is also transferring money to your account – and there’s nothing like it in savings and investment. With a 401(k), not only do employers match your contributions (to a varying degree) but the account is also tax-deferred. The limit on annual contributions for 401(k) is $19.500.
Individual retirement account (IRA)
This is the retirement option for business owners and self-employed workers. There are two main types of IRAs: traditional IRA and Roth IRA. The traditional IRA allows you to put your pre-tax income in a tax-deferred account (where it can grow as an investment). This is pretty much the same as 401(k), but without employer contributions.
On the other hand, Roth IRAs enable you to put post-tax income into the retirement account. This means that you pay taxes on the money before you put it into the account, so when you withdraw the money, as a retiree, no taxes are due. Also, the income from your account through the years is tax-free. Not having to pay taxes on earnings from an investment is another rare perk that only retirement accounts, like Roth IRA, can offer you. The annual limit for IRAs is $6,000 (or $7,000 for those at the age of 50 and above).
The favorable taxation of retirement income is one of the greatest benefits of saving for retirement.
Potential growth of investment
The compound effect of investing in a retirement account is also very attractive. “Compounding” simply means to mix your earnings with the amount that is already in the account. So, those accounts that collect returns on investment in the form of interest allow you to reinvest potential earnings and grow the account (interest + interest on the reinvested earnings).
In theory, compound interest has a substantial impact on your savings over a long period of time. Let’s compare two workers: Jim, who started saving for retirement at the age of 25, and Wendy, who started saving at the age of 40. If the return on investment is fixed at 7% (for the sake of calculation), Jim would need to invest circa $180,000, in order to have a $ 1,000,000 portfolio at the age of 65. Wendy, on the other hand, would need to invest circa $370 000 to reach the same value.
And not only that, but Jim’s required monthly savings (to reach a million-dollar portfolio) are around $400, while Wendy’s monthly contributions are more than $1,200. You can do your own math to see how this translates for your personal finances.
This is a hypothetical scenario in which your investments experience steady growth. In reality, all investments include some level of risk, though the risk of buying stocks is far greater than the risks associated with retirement accounts.
Unreliable social security
Saving for retirement will allow you not to depend on Social Security benefits. As a general rule, retirement benefits are much lower than the income you were used to spending during your working years (as low as 50%). So, if there’s no retirement plan in place, you will need to adopt a frugal lifestyle to make ends meet.
Retirees have a lot of expenses, be it health care costs or financial emergencies. Government programs like Medicare come and go, and inflation will continue to erode the purchasing power of Social Security retirement benefits.
As Congress is mulling over cuts in Social Security in the future, and pension plans become rare, you want to avoid relying on benefits when you retire. While most of these circumstances are out of your control, saving isn’t – you can start doing it today.
Avoid being a burden to your children
The prominence of multigenerational living in the US changes through the decades, but still, most Americans would prefer to keep their privacy. Moving in with your children’s family once you become a retiree is always an option, but the worst scenario is when you simply have to do it because you can’t afford to live independently. This can cause a lot of aggravation.
In the past, we had what was known as “the sandwich generation”, or middle-aged generations who had to take care of their children and their parents at the same time. This creates a burden and can contribute to conflicts. For some families, it’s difficult to support two generations, on top of supporting themselves. Sometimes, children can’t afford to support their aging parents even if they want to.
Growing your retirement savings will allow you to be independent and not impose upon your children. That way, everyone will be happy when you do spend time with your children and grandchildren.
Money management habits you will adopt by saving for retirement
Although retirement accounts are focused on securing your future, some benefits of saving for retirement are immediately apparent. When you save, you inevitably adopt money management habits that will improve your financial prospects on many levels. They, too, can be a reason to start saving for retirement.
Let’s review them.
Curb wasteful spending
Saving is centered around making the most of the money you have on your hands. Yes, additional income is always welcome, but learning not to waste money is probably the greatest lesson in personal finances. Planning your retirement will prompt you to develop a monthly budget, and this can help you track and eliminate excessive expenses on an ongoing basis.
Living within your means
The need to grow your retirement account will teach you to live within your means. Some even choose to live below their means to reach specific financial goals faster. Such a lifestyle can help you increase all of your savings, not only your retirement funds. It can free up cash for investment, but most importantly – it will prepare you for life with less income, which will be handy once you do retire.
Make the most of opportunities
Having your retirement settled and on track will provide greater versatility in every other aspect of your life. This newfound financial freedom will make it easier for you to switch careers, improve your education, invest in the market, or move across the continent. Good budgeting (developed to satisfy the need of growing a retirement account) will introduce flexibility to your life, and as a result, you can materialize life goals and take opportunities.
Better handling of financial emergencies
The budgeting habits you learn when you save for retirement will make it easier for you to weather life crises. Unfortunately, these things do happen, and if you have financial security, then you have one less thing to worry about. And this goes beyond having an emergency fund, but is also reflected in your saving and lifestyle habits.
There are a number of differences between retirement accounts, savings accounts, and other financial instruments you should be aware of. For instance, retirement accounts are considered investments, and as such, they are not FDIC insured, like other accounts up to $250,000 are.
Also, the money in your retirement account is up against inflation, and additional bank fees and investment fees can create dents in your returns. Meanwhile, your choice of retirement plan will play a great role in the taxes that are due when you retire. No one has escaped taxation yet, and even Social Security retirement benefits are taxable in some cases.
The turmoil of the financial markets can significantly affect your retirement savings. So, those projections of compound interest over time are hypothetical. That doesn’t mean you should act as soon as markets face a downward trend and withdraw your money from the account. Panic caused by short-term losses can jeopardize long-term gains (we are talking decades here).
As always, the best risk mitigation strategy for financial assets is – diversification. Apart from saving for retirement, have cash on hand and savings in multiple accounts (some invested in assets).
Let’s talk about death
People are not comfortable discussing their own death (or the death of a loved one); however, this issue is relevant when we consider lifelong saving. We can save for retirement, but will we ever live long enough to spend it?
Some find it comforting to know that even if they lose their life, the savings in the retirement account can be transferred to beneficiaries. But that is as far as protection of the funds can go. Studies on end-of-life finances show how difficult it is to develop a single retirement policy that would work for all of us.
The flip side
Generally speaking, new generations have a longer life expectancy than their parents. Increased lifespan can also contribute to creating a large number of retirees who are practically outliving their savings. What will they spend after that? In view of this, it’s best to get on top of your retirement savings as soon as possible.
Your future self will thank you for it.