We all know that we should be saving more money for retirement, but how do you make that happen? How do you go from nothing to maxing out all our tax-advantaged savings options like your employer sponsored retirement plan or individual retirement account (IRA)?
As I’ve mentioned in previous posts, my wife and I have been on this path for sometime. I’m proud to say that we currently have reached the maximum amount allowed for my 401k and for our Roth IRA’s. It wasn’t easy, but looking back I’m sure glad we did it!
So what steps did we take along the way to get to this point? Here is the strategy we used:
1. Maxing out your employer’s contribution.
When I first signed up for my 401(k) at work, I was very fortunate to receive some great advice – Contribute at least 8% because that’s the maximum contribution amount for our employer match.
If your employer kicks in any extra money on top of what you contribute, make sure you’re taking full advantage of it! Why? Because to not do so would be like leaving money on the table. Why pass up free money?
Where to look:
• If you’re starting a new job, sign up for it right away.
• If you’ve been working for a while, then go to work tomorrow and raise your rate. Don’t wait.
I still remember the PAIN I felt when my newly earned paycheck came back less than I was use to because of my new contribution. But as time went on, my spending and budgeting adjusted. You learn to live without it and don’t know any different.
Once you hit the contribution rate you need to get your employer’s maximum match, feel free to move on to the next step.
2. The Freedom of the IRA.
Beyond that 8% contribution, my next move was to contribute to an IRA. Why did I not just keep contributing to the 401k? Two reasons:
Employer plans like 401k’s and 403b’s are often criticized for being too limited on choices and for having higher than average fees. With an IRA, the terms are far different. You are free to choose almost anything and anyone you’d like to invest in: Mutual funds, stocks, ETF’s, CD’s, etc.
The other reason is because I feel as though you can do better with a Roth IRA than a traditional 401k. In my opinion, the Roth IRA was the better choice over the Traditional (). As I’ve shown through example previously, your “effective” savings rate is much higher with a Roth. But don’t get too hung up. Investing in a Traditional IRA is still good. The point is to do it!
Where to look:
• Start with raises at your job. Each time you or your spouse gets a raise, take half of the percentage and apply it towards the IRA.
• Have you reviewed your budget lately? Could you be spending less on some of your expenses or credit cards? Are one of your major expenses about to expire? For example, my IRA savings got a big boost after our children started going to grade school and our daycare expenses dramatically decreased.
• What are doing this year with your income tax refund?
3. Turn Back to Your Employer Sponsored Plan.
So after a few years of pay raises and a few changes in our budget, we were each able to hit that $5,000 maximum contribution to the IRA. Where did we look next to stash money? Back to where we started.
After you take advantage of the IRA, go back to your employer retirement plan and work towards getting it to be fully funded. Why? Because your employer retirement plan is tax-sheltered and still has a big advantage over putting your money in the bank or using a normal brokerage account. Why pay 25% (or more) on taxes if you don’t have to!
Where to look:
• Again, look at your raises or review your budget. Each time your paycheck grows or your expenses decreases, this is an excellent opportunity to redirect that money to a sensible place. This may be slow, but it does work!
• Not getting that raise or is your budget already cutting to the bone? Find alternative methods for supplementing your income. See about part time work. Feeling really ambitious? Look at developing some form of passive income to bring in another revenue stream.
4. Above and Beyond
This is the point my wife and I are still trying to reach. Our plan is that once all our tax-advantaged savings accounts are all maxed out, we’ll turn to traditional investing in low cost mutual funds and stocks.
Now just because these aren’t “tax free” accounts doesn’t mean we’ll stop paying attention to the tax situation altogether. There are significant differences between short-term and long-term tax rates. In general, holding mutual funds and stocks for the long-term (over one year) has better tax advantages than holding them less than that. Want better? Dividends from dividend paying stocks are taxed at an even lower rate.
Please note that we haven’t fully exhausted all our tax-advantaged alternatives yet. For example, you could still invest in an annuity or life insurance policy. However, I will tell you that in my opinion the jury is still out on these two. Both are highly criticized for having extremely high fees and complicated rules. I will need to do more research before I can endorse either.
The Moral of the Story:
As the old saying goes, Rome wasn’t built in a day. And your retirement savings account certainly won’t be either.
You’re not going to save one million dollars in the first 10 years. In fact, it will probably take several years. Don’t get discouraged! Little by little, you will slowly build a fortune as long as you remember your priorities and stay disciplined.
Are you happy with your retirement savings rate? How do you boost your retirement savings and what strategies have you heard to max out these accounts? Please feel free to share.
Photo credit: Microsoft Clip Art