At some point during your working life, it’s all but guaranteed that you will need more money than you’re earning. Maybe it will be because you lose your job. Maybe you’ll get sick or injured and face expenses not entirely covered by health insurance. Maybe you’ll have a car accident or a home burglary. And of course, if you're lucky enough to live until you’re old and gray, you will need money to live on in retirement. For all these reasons, you need to save money while you’re earning it.
How much should you save? As much as you can, or at least 10% of your pre-tax income every year. But saving strategies vary depending on your stage of life. Here's how you should be saving:
If You're a Young Adult…
You probably aren’t earning very much, or maybe you are. You might have student loans to pay off. You might be hoping to get married and have children soon, maybe even buy a house. Or you might have no idea how your life is going to play out. Here’s how you might approach saving:
Even if you have oodles of debt to pay off, you should get into the habit of spending less than you earn and putting aside money for a rainy day. Making a budget and sticking to it are a great way to start. And having some cash in reserve will offer both priceless peace of mind, and a way to avoid very high-cost debt if an unexpected need arises. Plus saving now for your longest term needs (i.e. retirement) will make getting to your goal so much easier, due to the remarkable effects of compounding interest (that’s when your principal earns interest, and then your interest also earns interest).
Save at Least 10% of Your Income
If times are flush for you, feel free to save much more! But if your operating budget is modest, try to save at least 10% of your pretax income. Consider automatic direct deposit into an off-limits savings account or an investment fund. If you can do this every single year until you retire, you should have enough to supplement your Social Security check and live comfortably in your golden years. Just remember that you’ll probably have some unanticipated expenses along the way, so save more whenever you can.
401(k) Matches & IRAs
Saving strategically can help you capture some benefits offered by your employer or the federal government. If you have access to a defined contribution retirement account (such as a 401(k) or 403(b)) and your employer matches your contribution, don’t miss out on that match. Here’s why. The immediate return on your savings—whether the match is 50% or 100%—is far higher than you’ll get anywhere else. It’s even higher than any interest rate you’re paying on debt, including high-interest credit cards.
Once you’ve scored the match (it’s usually capped at a percentage of income)—or if you don’t have one—put your savings into a Roth IRA (this is different from a Roth 401(k)), even if you don’t have an emergency fund yet. Your Roth IRA can act as an emergency fund, since you can take out your contributions at any time and for any reason with no tax or penalty due (you already paid the tax before you put the money in). Just don't try to take out the appreciation or earnings, if you can avoid it, since they would be subject to taxes and penalties, unless you qualify for certain exceptions.
This move makes the most sense if your pre-tax earnings are less than $47,000 per year as an individual, or roughly double if you’re married. At that earning level, as of 2015, you’re in the 15% tax bracket—so it’s probably worth paying the government now, since you might well end up in a higher tax bracket as you get older. If your income is very low, you might even get a tax credit on your retirement contributions.
If your income is higher than $47,000 per year (or twice that if you're married), you might still be in the 15% tax bracket if you have a lot of tax deductions, like interest on a mortgage or student loans or certain expenses as a self-employed person. Check your tax return.
However, if your income is significantly higher, and you already have an emergency fund (or equivalent amount in a Roth IRA), you should start thinking about pre-tax contributions again. You can put these in your 401(k) or similar plan; a traditional IRA, or accounts designed for the self-employed. Read on to understand why it may be worth your while to defer the taxes now, even if you’re not middle-aged yet.
Looming Educational Expenses
If you have children, or are planning to, it's never too early to save for their college education. The average-earning U.S. family would have had to save 20% of their pre-tax income, and earned a 6% return on the savings, every year since the child's birth to fully cover today's costs at a 4-year private college. (That's 20% per child; the equivalent of saving $13,000 per child in 2015.)
If you, like most Americans, can't possibly save that much, there are options for less expensive schools, and of course, student and parent loans.
If You’re Middle-Aged…
You're probably hitting your stride in your career; but you also might be running into some major life expenses. Saving should still be a priority.
Assess Your Progress
Hopefully, you’ve managed to build some financial assets, whether that’s equity in your home or savings in various accounts, even if you still have debt to pay off. Use an online retirement calculator to see how you’re faring in your efforts to save for retirement. If you got an early start and your investments have performed well, you can stay the course by continuing to save at least 10% of your income for retirement. If you’ve fallen behind, though, you should increase your contributions now; while there's still time for them to grow a lot.
Find More Money to Save
It may be hard to find extra money when you might still be raising children or putting them through college, or running into other life snafus.
Avoid lifestyle creep when you get raises at work. Instead, put the extra money toward retirement contributions. If raises have been hard to come by in recent years, instead take a look at your budget and see if there are categories you can cut. Focus on legacy costs—do you still have cable? A landline even though everyone in your family has a cell phone? Do you really need a manicure every week?
Think About the Tax Implications of Retirement Accounts
If your earning power has increased over time, you might find yourself in the 25% tax bracket, or even higher. If you think you'll be earning significantly less in retirement (and thus be subject to lower tax rates), it makes sense to put today’s money in pre-tax retirement accounts. Depending on your employment situation, these could be 401(k)s, 403(b)s, SEP-IRAs or other IRAs.
If you’re hesitant about locking all that money away until retirement, remember that in certain circumstances you can get your money back without the 10% penalty on early withdrawals. Many plans allow hardship distributions for things like buying your home and paying for education or medical care or funeral expenses. And even if you do have to pay the penalty, if you’re back in the 15% tax bracket when you take the money out (perhaps because you’ve lost your job or become disabled,) you’re no worse off than if you hadn’t put the money in the deductible account in the first-place.
For example, imagine in a good year, you can save $15,000 of your $80,000 income. You put it in a pre-tax retirement account. If you had instead taken the money as cash, you would have only received $11,250, after paying 25% in federal income tax. The following year, you get laid off, so your income drops precipitously to $20,000. You take the $15,000 out of the retirement account to help you get by, but you’re charged a 10% penalty, and 15% in federal income tax. You end up with $11,250. (We’re ignoring the effect of state taxes, since they vary so much, but the outcome would be the same, unless you happen to move between states.)
You can see how it could be worth the risk of stashing the money in a pre-tax account, even if you might get penalized for pulling it out early.
If You’re an Older Person…
You're approaching your retirement age, so now's the time to make sure your money's on track.
Figure out Your Expected Social Security Benefit
Go to the Social Security website to find out how much you can expect to receive from the federal government after you retire, based on your actual earnings history. This amount is typically about 40% of a median worker’s earnings, which currently translates to a monthly check of nearly $1,300.
Calculate Your Shortfall
Add up your expected living expenses in retirement and see how much money you’ll need to pull from your own savings to supplement your Social Security check and maintain your standard of living. You’ll need about 25 times your annual shortfall (or another way to calculate it is multiply your ending income by 8) to get by. How close are you?
Make the Most of Catch-Up Contributions
If you’re over 50, you can make catch-up contributions to many of your retirement accounts, within limits prescribed by the IRS. For 2015, you could stuff an additional $5,500 in some 401(k), 403(b) or similar accounts. You could potentially add an additional $2,500 to a SIMPLE IRA or SIMPLE 401(k). Traditional and Roth IRAs might be eligible for catch-up contributions of $1,000. These amounts are above and beyond the annual maximums that people of any age are allowed to contribute.
We know it's a daunting proposition to save enough to pay for everything you’ll need over the course of your life. Save early, save often, save extra whenever you can.