Your 2018 Retirement Guide

To retire is to start a completely different phase of your life, and you need to plan for it extensively. It's never too soon to start thinking about the future and saving money for your golden years. Here, we'll review everything you need to know about saving for retirement this year, including the different types of accounts you can put your money into, the rules on using them, and some tips on investing your money so it grows enough to support you throughout your golden years.

Why save for retirement now?

If you're relatively new to the workforce, you may assume that retirement isn't something you need to worry about at present. Not so. The sooner you start saving for retirement, the greater your chances of amassing a sizable nest egg. That's because the more time you give yourself to build wealth, the more you allow compound interest to work its magic.

Compound interest, in the simplest terms, is the money earned by your previous earnings. In other words, over time, you can not only make money on the funds you invest, but also reinvest your gains and make money off of those, too. Thanks to compound interest, your investments can grow exponentially, as the table below will illustrate.

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Now, back to compounding. The following table shows how much your retirement plan might grow to depending on when you first start funding it, assuming you invest $400 each month and earn an average of 7% per year on your investments:

TABLE AND CALCULATIONS BY AUTHOR.

Note how much a longer investment window can boost your results. In this example, you stand to accumulate $1.37 million if you give yourself a 45-year savings window. But your total out-of-pocket cost for that $1.37 million will be just $216,000, which means you're looking at a lifetime gain of well over $1 million. You can thank compound interest for that.

The more time you give yourself to save, the more money you stand to accumulate -- even if you can only make modest monthly contributions over time.

How much should you save for retirement?

There's no magic savings number that guarantees you'll never run out of money in retirement. That said, retiring with about 10 times your end-of-career salary is a reasonable goal to strive for (though as you'll see in a minute, it always pays to do even better). This formula isn't perfect, but because you'll typically need 70% to 80% of your pre-retirement income to live comfortably as a senior, and Social Security will only provide about half of that for an average retiree, aiming for 10 times your ending salary will likely bring you closer to that goal.

Imagine you're earning $60,000 a year before you enter retirement. You'll want about $42,000 to $48,000 in annual income during retirement to cover your bills without stress. The average Social Security recipient collects about $17,000 a year at present, so if we assume your retirement benefit is the average, then you'll need to get $25,000 to $31,000 annually from other sources, like savings. If you manage to amass 10 times your ending salary, or $600,000, and withdraw your savings at an average rate of 4% per year -- which financial experts have long recommended -- that translates into $24,000, which just about gets you to the low (but perfectly acceptable) end of that range.

So how do you get there? You'll need to set aside money consistently throughout your career and invest your savings wisely. The more you save each month, the better, but as a general rule, you should aim to sock away 15% or more of each paycheck for the future.

Let's say you earn $60,000 a year throughout your career and manage to sock away 15% of your salary over a 30-year period. If your investments generate a 7% annualized return during that period, you'll end up with $850,000. Withdraw from that total at 4% annually, and you'll have $34,000 a year to work with in retirement.

Of course, if you don't have 30 years to save before retirement, you'll wind up with less. Case in point: If your savings window is only 25 years long, your total will be about $569,000. Given 20 years, you'd wind up with just $369,000. So if you're behind schedule, dig deep and save as much of your income as possible.

And if you can't hit that 15% threshold right away, however, don't worry. It's hard to part with 15% of your earnings when you're first starting your career and have limited earnings and student debt. Simply do the best you can and try to ramp up your retirement savings over time.

Once you get on board with the idea of saving for retirement, the question becomes: What's the best retirement plan for you? Thankfully, you have a number of options to choose from depending on your income level and employment status.

The traditional IRA

Short for individual retirement account, an IRA is a great way to set aside funds for the future. You can open an IRA at most banks or financial institutions. Anyone who earns income can contribute to a traditional IRA, although eligibility stops at age 70 1/2 -- but then, you'll likely be retired by then anyway.

Traditional IRAs work as follows: Your contributions go in tax-free, which means that if you're not saving in a workplace retirement plan, you can generally deduct the full amount you put into your IRA from your taxable income for that year. Traditional IRA contributions also get to grow on a tax-deferred basis, which means you're not paying taxes on your account's gains year after year. And if you hold dividend-paying stocks in your retirement plan, you're not liable for taxes on the dividends you collect. However, once you start taking withdrawals in retirement, they're taxed as ordinary income.

Currently, workers under age 50 are allowed to contribute up to $5,500 per year to a traditional IRA, while workers aged 50 and up can contribute $6,500. Once that money is in your account, you can't take it out until you reach age 59 1/2. If you take a withdrawal before then, you'll pay a 10% early-withdrawal penalty on the withdrawn amount, plus income taxes (though, to be fair, you'd have to pay income taxes even if you made the withdrawal after age 59 1/2).

There are, however, a few exceptions to that penalty. If you withdraw money from an IRA to pay for college or your first home, you can generally avoid that 10% hit (though the penalty-free amount will be capped). Keep in mind, however, that when you make early withdrawals from your IRA, you'll miss out on the withdrawn amount -- and any gains it may have earned -- when you're retired. It's generally best to leave your retirement savings alone until you're actually retired.

Another thing you should know about traditional IRAs is that they impose required minimum distributions, or RMDs, once you turn 70 1/2. Because any distribution from a traditional IRA will trigger taxes, RMDs are something you need to consider when deciding where to stash your retirement savings. On the other hand, odds are that by the time you're liable for RMDs, you'll be ready to start withdrawing from your retirement savings anyway.

Keep in mind that if you're covered by a retirement plan through work, or you're married to someone who is, your ability to deduct your IRA contributions will depend on your income. You can max out your traditional IRA regardless of what you earn, but you may not get the full up-front tax break. 

The Roth IRA

Roth IRAs differ from traditional IRAs in that contributions are made with after-tax dollars. The amount you put into a Roth account isn't deductible on your tax return, which means there's no immediate tax break for contributing. However, the money you put into your Roth IRA gets to grow tax-free, as it would in a traditional IRA. And best of all, once you start taking withdrawals in retirement, they're yours to collect free and clear of income taxes.

Furthermore, unlike traditional IRAs, Roth IRAs don't come with RMDs, which means you can leave your money to sit and grow tax-free for as long as you live. You can also leave your Roth IRA to your heirs if you choose to go that route, at which point they'll benefit from tax-free withdrawals as well.

Another thing you should know about Roth IRAs is that you're technically allowed to withdraw your principal contributions (but not any gains) at any time without penalty. The reason is that because those contributions have already been taxed, the IRS doesn't care what you do with them afterward. That said, any money you remove ahead of your golden years is income you won't have available in retirement, and that's reason enough to leave your savings alone.

Roth IRAs do come with income limits that prevent higher earners from contributing to them directly. At present, you can't directly fund a Roth IRA if your income exceeds $135,000 as a single tax filer or $199,000 if you're married filing jointly. You can, however, contribute to a traditional IRA and convert that account to a Roth down the line. As far as annual contribution limits go, they're the same as a traditional IRA's: $5,500 for workers under 50 and $6,500 for those 50 and over.

The traditional 401(k)

Many employers sponsor 401(k)s, and if yours does, you have a great opportunity to sock away a nice sum for the future. Traditional 401(k)s work like traditional IRAs: Your money (which is automatically deducted from your paychecks) goes in tax-free and gets to grow on a tax-deferred basis, but withdrawals are taxed in retirement. You'll be penalized for removing funds from your 401(k) prior to age 59 1/2 unless you qualify for an exception, and you'll be on the hook for RMDs upon reaching 70 1/2.

There are, however, a couple of key differences between a 401(k) and an IRA. First, the annual contribution limit is higher for a 401(k) than an IRA. You can currently put up to $18,500 a year in a 401(k) if you're under age 50, or $24,500 a year if you're 50 or older. And because most companies that sponsor 401(k)s also match employee contributions to varying degrees, you might snag some extra cash in the process. Furthermore, if you're at least age 55 when you separate from the employer sponsoring your 401(k), you can remove funds from that account without incurring a penalty.

While many workers find it easy to save in a 401(k), one drawback you should know about is that your investment choices will be limited. An IRA will typically allow you to choose from thousands of different stocks, funds, bonds, and much more. That flexibility can not only help you minimize your investment fees, but also help ensure that your investments align with your strategy and tolerance for risk. Employer-sponsored 401(k)s may also come with hefty administrative fees, which are then passed on to you, the saver. 

The Roth 401(k)

Roth 401(k)s are similar to Roth IRAs in that contributions are made with after-tax dollars, but the money gets to grow tax-free and isn't taxed when withdrawn (assuming you don't withdraw funds before age 59 1.2). One major difference, however, is that there are no income limits associated with Roth 401(k)s, so even higher earners can open one. As is the case with a traditional 401(k), you can contribute up to $18,500 annually if you're under age 50, or $24,500 if you're 50 or older. However, you should be aware that you will be on the hook for RMDs once you turn 70 1/2, which means you can't leave your money in a Roth 401(k) to sit and grow indefinitely.

The SEP IRA

Short for simplified employee pension, a SEP IRA is a retirement plan designed for independent workers and small-business owners that allows for higher annual contributions than a traditional or Roth account. Currently, you can contribute up to 25% of your net business earnings (your earnings minus your business expenses, SEP contribution, and half of your self-employment taxes) for a maximum of $55,000.

One thing you should know about opening a SEP IRA is that if you employ others, you're required to make the same contributions, percentage-wise, to their accounts as you make to your own. This means if you set aside 10% of your own earnings in a SEP, you need to contribute 10% of your workers' earnings to their accounts, which could get expensive. If you're a solo freelancer, however, this won't come into play.

SEP IRA contributions go in tax-free, so you get an immediate tax break for funding your account. Once you retire, however, your withdrawals will be taxed.

The SIMPLE IRA

Short for savings incentive match plan for employees, a SIMPLE IRA is another retirement account designed for independent workers. The benefit of opening a SIMPLE IRA is that you can contribute more than you can to an IRA. The current annual limits are $12,500 if you're under 50, or $15,500 if you're 50 or older.

If you employ other people, you must offer them matching contributions. You can either match their contributions directly up to a maximum of 3% of their compensation, or contribute a fixed 2% of their compensation -- the choice is yours. Furthermore, if you're self-employed, you get to contribute as both employer and employee. This means you can contribute any amount you like as per the above limits, but also match your contributions dollar-for-dollar on up to 3% of your earnings. So if you earn $50,000 a year and are 40 years old, you can contribute $12,500 plus another $1,500. 

As with a SEP IRA, SIMPLE IRA contributions give you an up-front tax break. Withdrawals, however, are taxed in retirement.

The Solo 401(k)

Though 401(k)s are usually associated with the companies that sponsor them, if you're self-employed, you have the option to open a Solo 401(k). Solo 401(k)s work just like traditional 401(k)s, but their annual contribution limits are substantially higher. For 2018, you can contribute up to 25% of your self-employment income (minus your business expenses, plan contribution, and half of your self-employment taxes) for a maximum of $55,000 if you're under 50, or $61,000 if you're 50 or older. Your contributions will go in tax-free, but withdrawals will be taxed in retirement.

How to invest your retirement savings

Once you decide which type of retirement plan to fund and get some money into that account, you'll need to figure out how to invest your savings. Your goal should be to invest in a manner that maximizes growth without taking on needless risk. To that end, it pays to go heavy on stocks. The 7% average annual return we applied in our table above is actually a couple of percentage points below the stock market's average, which means that if you put a large chunk of your retirement plan into stocks, you could do that well or even better.

As you get older, you'll want to shift more of your investments into safer options, like bonds. But if you're relatively young, loading up on stocks most certainly makes sense.

To figure out how much of your portfolio should be in stocks versus bonds, a good rule of thumb is to take your age and subtract it from 110. This means that if you're 30 years old, you should have about 80% of your retirement investments in stocks and the rest in bonds (or you might leave a small percentage in cash). As is the case with most financial formulas, this one has some wiggle room. If you have a higher tolerance for risk, you might put 90% of your investments in stocks at age 30, and if you're extremely risk-averse, you might allocate 70% to stocks. But this should give you a general sense of where to start.

Depending on the type of account you open, your investment choices may be somewhat limited -- especially if you're working with a 401(k) plan. When you're evaluating different investments, one of your first considerations should be the fees they charge. Fees will come into play when you invest in funds -- namely, mutual funds and exchange-traded funds.

Investment funds can be either actively managed or passively managed. Actively managed funds rely on expert fund managers to choose their investments, and they charge investors higher fees for that expertise and hands-on approach. Meanwhile, most passively managed funds simply mimic existing indexes such as the S&P 500, which is why they're known as index funds. They don't need high-paid stock-pickers, thus they tend to charge very low fees. Not only do index funds charge lower fees, but in recent years they've managed to match or beat the performance of actively managed funds.

The good news is that all funds are required to disclose their fees in their respective descriptions, so there shouldn't be any major surprises provided you do your research. Because fees eat away at your returns over time, keeping them to a minimum will help you amass the greatest level of wealth.

In addition to minimizing your fees, you need to diversify your investments so you get access to different areas of the market. Diversification not only broadens your opportunities for gains, but reduces your exposure to losses. Imagine you have the bulk of your savings invested in a specific industry -- say, biotech. If that sector takes a hit, you stand to lose a large amount of money. However, if your money is evenly spread across 10 industries, then your portfolio might take a relatively small hit if the biotech sector tanks, but your remaining investments may hold steady or even gain in value. 

Loading up on index funds is a good way to instantly diversify your holdings without paying high fees or trying to hand-pick single investments. If you're looking for a piece of the stock market action, you might consider the Vanguard S&P 500 ETF (VOO 1.20%), which will grant you instant exposure to most of the U.S. stock market. If you're older and want to move more money into bonds, the Vanguard Total Bond Market ETF (BND 0.11%) is a solid bet. You can easily diversify outside of index funds as well -- just make sure the investments you choose cover a wide range of industries and sizes (in other words, you'll want large-cap and small-cap stocks or funds).

Setting yourself up for the future

Whether you decide to keep your retirement savings in an IRA, a 401(k), or both at the same time (which you're allowed to do), the key is to start setting money aside as early as possible and continue doing so throughout your career. That commitment, combined with a smart investment strategy, should allow you to retire with enough money to live in comfort and security. And really, that's the dream.