If you want to be prepared for retirement, you need savings to supplement your Social Security benefits. Social Security is designed to replace only about 40% of pre-retirement income, when you'll need at least 70% to 80% to maintain your quality of living. What you set aside yourself makes up the difference.
Unfortunately, most people aren't putting enough money toward retirement needs. And even those who do set money aside often put their money in the wrong type of accounts. In fact, a recent survey from Schwab revealed that, outside of a 401(k), a regular bank savings account is the most popular way to save for retirement.
While using a 401(k) is a good start to save for retirement, for most people, there are better options than a bank savings account for putting extra money to work.
You could be missing out on tax breaks
If you use a traditional savings account to save for retirement outside of your 401(k) instead of opting for another tax-advantaged investment account, you're missing out on important tax breaks that make saving easier.
Depending on your income and access to a workplace retirement account, you may be entitled to make deductible IRA contributions of up to $6,000 in 2020 or up to $7,000 if you're 50 or over. For a taxpayer in the 22% tax bracket, a $6,000 contribution to an IRA could result in $1,320 in tax savings.
Unless you make too much to qualify for deductible IRA contributions or you have a specific reason for choosing a savings account instead -- such as wanting full access to your savings before you're 59 1/2 and can make penalty-free withdrawals from IRAs -- you likely shouldn't forgo this tax savings.
You're limiting the return on your investment
Chances are good money in your 401(k) is in stocks. But unless you have a reason for keeping your supplementary savings out of the market, such as an attempt to diversify your assets, it's a good idea to put your money into a brokerage account that allows you to invest.
This makes sense because even the best high-yield savings account typically provides a return on investment of around 2% or less. If you put your money into an investment account and buy a diverse mix of stocks, you could reasonably be expected to earn around a 7% to 8% average annual return.
Of course you don't want to put too much of your money into the market if you're nearing retirement and will be drawing from your investment account soon. But younger investors should have the bulk of their portfolio in stocks and even seniors should have some money invested in equities that provide a reasonable return.
This is important because return on investment makes a huge difference in your retirement readiness. If you invest $5,000 a year starting at age 25, you'd end up with almost $1 million if you earn a 7% return, but just over $302,000 if you earn a 2% return. While $1 million should provide a decent amount of retirement income, $302,000 will likely leave you with a financial shortfall.
Investing in stocks doesn't have to be complicated, either -- even if doing it yourself seems harder than picking investments in your 401(k). Splitting your money among a few different Exchange Traded Funds (ETFs) can enable you to create a well-balanced portfolio even if you have limited investing knowledge. Our model portfolios can help you get started in choosing investments.
Become a retirement investor, not a saver
Schwab's study revealed that 64% of people participating in a 401(k) plan see themselves as savers, not investors. But if you're too focused on the saving part, this could both limit your 401(k) returns and prompt you to put retirement funds outside of your 401(k) in a savings account instead of an investment account.
Saving is just one part of the equation. What you do with your retirement funds can matter almost as much. A simple mindset switch to focus as much on investing as saving can make all the difference in securing your future.