When it comes to savings goals, retirement is probably the largest one you’ll face in terms of how much money you need to save to make it possible.
Experts generally agree that, in order to retire comfortably, you’ll want to work your way up to setting aside 10 to 15 percent of your pre-tax income. That said, everyone’s situation is unique. To help you figure out the right amount for you, consult a retirement calculator.
Once you get in the habit of setting aside a portion of your paycheck for your future, where should you stash your savings? CNBC Make It spoke with Nick Holeman, certified financial planner at Betterment, who breaks down all of your options.
Fund a 401(k)
For most people, contributing to an employer-sponsored 401(k) plan is the simplest way to start saving for retirement. A 401(k) is an effective vehicle for a few reasons:
- It offers large tax advantages: contributions are made pre-tax, so the more you contribute, the more you reduce your taxable income and, in turn, your tax bill
- The money is automatically taken from your paycheck before you have the chance to spend it
- Often, companies offer a match
“401(k)’s are especially great if they have a match,” says Holeman. “That’s something that you won’t be able to get from an IRA (individual retirement account), so if you have that, take advantage of it.”
The way it works is, your company will match whatever contribution you put towards your 401(k) up to a certain amount. For example, if you choose to put four percent of your salary into your account, your employer will put that same amount in as well, in effect doubling your contribution. It’s essentially free money, says Holeman.
Another pro: 401(k)’s have higher contribution limits than IRAs. The contribution limit for 2017 is $18,000 for workers under age 50 and $24,000 for people age 50 or older.
Holeman does note that, “sometimes 401(k)’s have higher fees,” so you’ll want to understand those costs upfront. “The fees tend to be higher because there’s more compliance paperwork associated with 401(k)’s, like anti-discrimination amongst the company. Whereas if you open up an IRA, it’s just your account, so there’s less paperwork, which generally means lower fees.”
Fund a traditional IRA
Not all companies offer a 401(k) plan. If that’s the case for you, there are other accounts designed specifically for retirement, such as a traditional IRA.
Like a 401(k) plan, IRAs also offer tax breaks, says Holeman: “With a traditional IRA, you contribute pre-tax dollars and let that money grow tax-deferred over time. You’ll pay taxes on your contributions and investment gains only when you withdraw the money, which you can do starting at age 59½. If you withdraw before then, you’ll have to pay a penalty fee.”
The maximum yearly contribution is $5,500, or $6,500 for people age 50 or older.
Fund a Roth IRA
With a Roth IRA, contributions are taxed when they’re made, so you can withdraw the contributions and earnings tax-free once you reach age 59½.
Note that in order to contribute to a Roth IRA, there’s an income cap, which the IRS sets each year based on modified adjusted gross income. This year, a single person with a MAGI of $133,000 or more and a married couple making more than $196,000 cannot directly contribute to a Roth.
Like a traditional IRA, there’s also a contribution limit: $5,500 a year, or $6,500 for people age 50 or older.
Should you choose a traditional or a Roth IRA?
“The differences have nothing to do with the risk that you take or the investment choices you have,” says Holeman. “The only difference between a traditional and Roth is from the tax perspective. You get to pick when you pay your taxes.”
Before choosing, look at your tax bracket, he says. Do you think you’re in a higher tax bracket now than you will be when you retire, or do you anticipate jumping a bracket or two by retirement age?
If you’re earning more now, you might want to go with a traditional IRA, since you’ll be paying taxes down the road. If you expect to earn more in the future, a Roth might be the better option, since you pay taxes today.
“You can also do half in a traditional and half in a Roth,” says Holeman. “A lot of people choose to do that because it’s very difficult to guess what taxes will be in the future. Especially if you’re young, you could be trying to predict taxes 20, 30, or 40 years into the future, so a lot of people choose to do half and half to hedge their bets.”
Holeman also notes that, “just like an IRA, a 401(k) can have a traditional and a Roth option. Again, the difference is just when you pay the taxes.”
Fund a health savings account (HSA)
While health savings accounts aren’t designed specifically for retirement, they can be a powerful retirement-savings tool. In fact, depending on your situation, some financial planners advise maximizing contributions to your HSA even before maxing out your 401(k) plan.
With an HSA, you can put pre-tax money towards medical costs to be used whenever you want. There’s no “use-it-or-lose-it” rule: Any unused funds will roll over year to year.
The main requirement for opening an HSA is having a high-deductible health care plan (HDHP), one that offers a lower health insurance premium and a high deductible. This is a good option for those who are generally healthy and don’t have to go to the doctor’s office or hospital that often, Holeman notes: “If you are on medications, have a chronic illness or might be going to the doctor often, then having a high-deductible will probably be very expensive for you.”
The HSA contribution limit is $3,400 per year if you’re single, and $6,750 per year if you have a family, plus an additional $1,000 if you’re over 55 years old.
“It’s less money that you can put in compared to other accounts,” says Holeman, “so this alone is not going to be nearly enough for you to save for your retirement, but it can be a nice addition to your normal savings.”
You don’t have to use a retirement account at all
“These types of accounts mentioned have some nice tax benefits, so they should be where you start,” Holeman says, “but they have some restrictions on them,” such as contribution limits and when you can withdraw the money.
“For someone who wants a little more flexibility or is thinking about retiring early, it might make sense to save money outside of these retirement accounts, in a normal investment account. You don’t get as many tax benefits, but you have a lot more flexibility: There’s no age restrictions on pulling the money out and there’s no contribution limit.”
You can research low-cost index funds, which investing legend Warren Buffett recommends. You can store money in a high-yield savings account or consider robo-advisors. Just be sure to mark these accounts for retirement if that’s what you intend to use them for.
Ultimately, it’s smart to consider more than one retirement savings vehicle, says Holeman: “Having multiple types of accounts, even though it might seem a little scary, in a lot of cases makes a lot of sense and can be extremely beneficial.”
At the end of the day however, what’s more important than choosing what vehicle to use is that you start saving now.
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