Saving for retirement can sound like a complicated and overwhelming task to start putting money aside for, but you can (and should) actually begin right now. 

Alex Chalekian, our Learn mentor, shares how to start saving for your golden years with the four common types of retirement savings accounts.

Part 1: 401(k) Retirement Savings Account

Let’s start with a tax-advantaged, retirement account. This is usually offered by many employers and is commonly known as a 401(k) plan. If you work for a public school or a non-profit organization, your version of this tax-advantaged retirement account would be called a 403(b).

If your company offers a 401(k) or 403(b) plan and you are eligible, you can contribute pre-taxed earnings. Meaning, your contribution comes directly out of your paycheck before federal income taxes are assessed. This contribution lowers your taxable income on that paycheck and your money will grow tax-deferred in the retirement account. You can decide on a specific percentage of your paycheck to go into the 401(k) or 403(b) and put your retirement savings on autopilot.

Additionally, many employers offer some sort of a match on your contributions. For example, as a benefit to its employees, your company might offer to match your contributions, dollar for dollar, up to 7%. This means that for every dollar you contribute, up to 7% of your paycheck, they will make the same contribution into your account. It’s highly suggested that you try to contribute to your 401(k) or 403(b) plan at least up to the percentage that they will match. After all, it’s free money, so make sure you take advantage of it.

A good habit that will help increase your success in reaching your retirement goal, is to increase your contribution any time you get a raise or bonus. This is an easy and effective way to add more money to your nest egg. Calculate the amount of your raise or bonus as a percentage of your income and increase your contribution percentage accordingly.

Part 2: Traditional IRA

A traditional individual retirement account (IRA) is an account that allows you to make contributions that can be tax-deductible and your investments grow tax-deferred. 

What does this mean? This means you don’t pay any taxes on the dividends, interests, or gains while the money remains inside the IRA. 

Similar to a 401(k), withdrawals are considered as taxable income and there may be an additional 10% penalty if you draw money before the age of 59 and a half. 

There are also contribution limits that change yearly. In 2020, the max contribution for the year is $6,000 for those under the age of 50. If you are over the age of 50, the max contribution jumps to $7,000. These numbers change annually, so it’s important to check with your financial planner when you’re ready to start an IRA.

Your contributions may be deductible, therefore reducing your taxable income. But this deduction may be phased out based on your income or if you're covered by a retirement plan at work. It’s a good idea to check with a tax professional if your contributions are deductible.

If your company doesn't offer a 401(k) plan, you might want to consider setting up a traditional IRA to save for retirement. But what if your company does offer a 401(k) plan? Should you contribute to that plan or into a traditional IRA? 

If your company offers a match on your contributions, then a 401(k) makes more sense. Additionally, if you plan on contributing more than the max contribution limit of $6,000 or $7,000 in 2020, a 401(k) would be more suitable since it has higher contribution limits. 

If you don't plan to contribute more than the annual limit and your 401(k) doesn't offer a match, you might want to set up an IRA where you can have a large investment selection as opposed to limited options in your company’s 401(k) plan. 

It’s also important to note that a 401(k) plan doesn't come along with you when you leave the company, while a traditional IRA is portable. This means the IRA is yours and you can control where it's held. 

When should I start saving for retirement?

It’s never too early to start setting aside money for retirement, but why is it important to save while you’re young? Simply stated: Compounding interest. 

Let’s say you’re 22 years old when you start putting $5,000 a year into a traditional IRA with a 6% annual return until you reach the retirement age of 67. At that point, your IRA would hit a little over a million dollars.

In this same example, let’s say you wait until you’re 32 years old to start saving in the same traditional IRA. That same $5,000 a year with the same return of 6% means your account would have about $557,000 when you’re 67 years old.

In this scenario, waiting 10 years to start saving towards retirement actually costs you about half a million dollars. So to help increase your success in reaching your financial retirement goal, try to start saving as soon as possible.