In previous articles, I explained how to estimate the amount you’ll spend each year once you stop working and the size of the nest egg required to support that spending.
The next step is to calculate how much you’ll need to save each year to reach that goal. There are many interactive tools available to help you arrive at this savings number, including one accessible through the U.S. Securities and Exchange Commission website. Find the one that you are most comfortable using.
Reaching your retirement goal, however, depends not only on how much you save, but also how you save. The challenge is determining which combination of options will yield the greatest benefit. Here are a few suggestions:
Start now. Leverage the power of compounding. Compounding occurs when investment earnings generate their own earnings. To work it requires saving, re-investing the earnings and time. The more you save and the more time your money has to grow, the better.
Make use of tax-advantaged accounts. Employer retirement plans — e.g. 401(k,) 403(b) — and IRAs are powerful wealth-building tools because of the special tax treatment they receive. Contributions and earnings grow tax-deferred or even tax-free for years, increasing your chances of building a substantial retirement nest egg. These accounts come in two versions, traditional and Roth. Typically, contributions to traditional accounts can reduce taxable income and, therefore, your tax bill. Furthermore, investment earnings are tax-deferred until withdrawn. Roth contributions, on the other hand, are not tax deductible, but earnings and withdrawals during retirement are tax-free, provided you meet some basic requirements.
Prioritize how you use your savings. If your employer plan offers a matching contribution, save at least the amount your employer will match. This is “free” money and it will grow tax-deferred. You will not get a better deal anywhere. If you do not get an employer match or have already taken full advantage of one and still have additional savings, pay down any high interest debt next. Unpaid interest and finance charges are continuously added to your balance, so the power of compounding works against you, creating a snowball effect. After an employer match, eliminating this debt will provide a great return on your investment.