Mid-Layer 1: Building for Your Future
Now that you’ve built a strong foundation the next layer in the personal finance pyramid is building for your future and specifically setting up and automating your tax-advantaged retirement accounts. This layer assumes you have paid off your high interest consumer debt and built an emergency fund so if that isn’t true, I would recommend revisiting the base layer and then coming back here when you are ready.
Managed correctly, your retirement accounts should allow you to retire financially free at the end of your working life. The goal here is to set it up, automate it and (almost) forget it. The magic of a retirement account, especially if you are young, is the compounding of your money over a long period of time.
What are retirement accounts?
Retirement accounts have taken the place of pensions as the main source of income for senior citizens in the United States after social security. This article does a great job at the highlighting the differences between 401ks and pensions, but increasingly 401ks and similar retirement accounts are the only options you have.
There are different types of retirement accounts, but they all have two things in common: (1) they benefit from some kind of tax advantages and (2) in most cases, money you contribute into the account is not accessible to you until you reach a certain age (in most cases 59 and a half). To be extra clear – money you put into these accounts will be locked up until you reach retirement age. For that “lock up” you will save a considerable amount of money on taxes which typically far outweighs the disadvantages of locking up your money. There are several circumstances where you can access your tax accounts, but you typically are charged a fee if you access the money earlier than retirement age.
A few common types of retirement accounts are a 401k, 403b, IRA and Roth IRA. There may be some other types, but these are the most common. Most medium and large employers have a 401k. A 403b is similar to a 401k, but offered by public schools and some nonprofits. IRA stands for Individual Retirement Account and as expected it’s managed by individuals and not through an employer. A retirement account is an account, but you will still need to select investments within that account. Most companies do this work for you and offer a select number of investments that are geared toward retirement accounts.
Some companies offer matching as an incentive for their employees to invest in their 401k. There are multiple ways a company can set up their matching policy so it’s best to contact your Human Resources team and ask for your company’s specific policy, but the important thing to know is that THIS IS FREE MONEY! If your company has a matching policy you absolutely need to be investing as much as it takes to take advantage of the match.
How much should you invest?
There are several methodologies for calculating how much you should save for retirement, but the simplest method is to save 15% of your annual salary for retirement which most accounts let you automate (more in the next section). Fidelity’s article does a nice job at outlining some of the other considerations (e.g. age, spending habits, etc.), but the most important part of starting to save for retirement is starting and the earlier you start the better because of the magic of compounding.
Automating Your Account
My number 1 tip for your retirement account is to automate it. You can automate your investments to be taken directly from your paycheck so you never see the money hit your bank account. It usually takes 10-20 minutes to set up and then you (almost) forget it until retirement. As an example, when I joined my current job I set my 401k up to auto-withdrawl 10% from my paycheck and invest into my 401k sponsored funds. It increases as my salary increases, but I never touch it. The only way I’d need to adjust it is if I leave my current employer and join a new one, but we’ll leave that to another post.
That’s it. There are many rabbit holes you can go into with retirement accounts but we kept this short and simple because the most important thing about saving for retirement is to start and the earlier the better. We’ll address the complexities in the future, but the main takeaways for now are to (1) identify what options your employer has for retirement accounts which you can do by talking to your human resources team. (1) determine how much you should invest if it’s something different than the recommended 15% and (3) set it up so it automatically deducts from your paycheck and invests into your 401k.
