The new year has brought a sense of optimism that the challenges of 2020 will soon be behind us. If you were among those fortunate enough to have remained employed and safe through it all, you may have noticed your savings account grew. Perhaps your discretionary spending fell sharply as you dined out less and postponed big travel plans. You may have even received a few rounds of direct payments from the government for your family.
Indeed, the personal savings rate in the U.S. exploded to a record 33 percent during the pandemic — nearly doubling the previous high of 17.5 percent set in 1975. This presents an excellent opportunity to start 2021 off on firm financial footing and put some of that mini windfall into an IRA to fund your future. In the U.S., in a country where 1 in 5 Americans have less than $5,000 saved for retirement, you’re ahead of the game if you’ve already started. If you haven’t, don’t sweat it; it’s never too late and this could be a perfect time to start.
An IRA is an effective savings tool because it allows you to access financial markets in a tax-advantaged way. Traditional IRA contributions are tax deductible today, but you’ll pay income tax when you withdraw that money in retirement. With a Roth IRA, you pay taxes on contributions today, but that income won’t be taxed later — so long as you adhere to withdrawal rules. When you have savings in both types of accounts, it’s a little easier to manage the amount of income tax you pay in retirement.
But how much should you contribute to an IRA, and how often should you do it?
HOW MUCH SHOULD I CONTRIBUTE TO AN IRA?
Know yourself. What kind of life do you want to live in retirement? Some people want to travel, some plan to golf daily while others plan to downsize and live closer to the grandkids. These decisions will impact how much you will need to save to support your lifestyle. A simple, back-of-napkin way to estimate your financial need in retirement is the “Multiply by 25 Rule.” Start with an annual income you’ll be comfortable with in retirement, say, $60,000, and multiply it by 25. That comes out to $1.5 million you’ll need to save to support your desired annual income for 25 years (the average length of retirement in the U.S. is 18 years, according to the U.S. Census Bureau).
Now, this is hardly an exact figure and you wouldn’t build a financial plan around it alone. The rule doesn’t factor in tax law changes, inflation, market performance or the fact that retirement can last longer than 25 years. However, it does provide a ballpark figure to see if you’re on the right track.
Know your limits. The IRS, as of 2021, caps the maximum amount you can contribute to a traditional IRA or Roth IRA (or combination of both) at $6,000. Viewed another way, that’s $500 a month you can contribute throughout the year. If you’re age 50 or over, the IRS allows you to contribute up to $7,000 annually (about $584 a month).
If you can afford to contribute $500 a month without neglecting bills or yourself, go for it! Otherwise, you can set yourself up for success by aiming to set aside about 20 percent of your income for long-term saving and investment goals like retirement.
Prioritize high-interest debt, but don’t ignore other goals. Indeed, an IRA is an excellent way to save for retirement, but if you have a lot of high-interest credit card debt you’ll want to expedite paying that. Federal Reserve data show credit card interest rates on balances hover around 14 to 19 percent, while long-term, the stock market has generated average annual returns of roughly 10 percent (7 to 8 percent accounting for inflation), according to the U.S. Securities and Exchange Commission. Clearly, there’s a pretty good chance interest costs will outpace your potential for gains.
Prioritizing high-interest debt doesn’t mean neglecting your retirement savings, paying student loans, building your emergency fund or saving for a big trip. However, you want that bad debt off the books as soon as you can manage (without impacting other goals) so your growth isn’t hampered by pesky interest costs. Maybe instead of contributing $500 a month to an IRA, you bring it down to $250 while using the difference to accelerate payments on debt. With the right plan, you can balance current priorities while setting yourself up well for the future.
WHEN SHOULD I CONTRIBUTE TO AN IRA?
The earlier the better. With investing, time is your greatest asset. That means the sooner you start saving the longer it can grow. If you invest $10,000 and generate the average 7 percent, inflation-adjusted market return, it would be worth $19,000 after 10 years, $54,000 in 25 years, $149,000 in 40 years! Keep in mind the market may return more, or even yield negative returns, in a given year. But over long periods of time, as you can see, time in the market has a pretty big impact on growth.
Again, if you haven’t started saving for retirement don’t worry. It’s never too late to start.
Get that match. If you have a 401(k), you can still contribute the maximum allowed to an IRA, Roth IRA (within income restrictions) or combination of both. But some employers offer matching contributions in their 401(k) plans. If your employer matches contributions, dollar-for-dollar, up to 6 percent of your salary, make sure you’re contributing at least 6 percent from each paycheck first. It’s free money, so don’t leave it on the table!
Once you’ve at least hit your match, you can keep funneling up to $19,500 annually into a 401(k) per 2021 IRS rules, or you can divert funds above and beyond your employer match into your Roth IRA or traditional IRA – whichever works best for your plan. And if you’ve maxed out your 401(k), an IRA is a great way to capitalize on additional tax-advantaged retirement savings, depending on your income and tax filing status.
HOW OFTEN SHOULD I CONTRIBUTE TO AN IRA?
Make it consistent. The other key is to make consistent contributions — even better to automate the process altogether (contact your HR department to set up automatic paycheck contributions or schedule automatic transfers from your bank). For one, this ensures you’re making saving a habit. But there’s an additional benefit, known as dollar-cost-averaging.
It works like this: If you want to max out your IRA in a given year, you could invest $6,000 all at once and hope you caught the market at a good time, or you could invest $500 in each month and get 12 shots at hitting a bullseye. This is one way to dull the impact of market volatility, because you’ll pay a higher price for fewer shares of your investment when the market rises, but you’ll get more shares with the same contribution when the market is low. Over the long run, odds are you average into a better price than if you attempted to time the market. Regardless, investing is always risky and strategies like dollar-cost averaging won’t necessarily prevent losses, but investing strategically within a broader financial plan can give you confidence to weather economic ups and downs through retirement.
NEED A LITTLE HELP?
We get it. Maybe you have student loans, or credit card balances to pay. Maybe you want to travel while you’re still young or you’re planning to put money into a new business venture. Heck, for many people, the idea of monitoring all these accounts sounds worse than nails on a chalkboard. Fortunately, you don’t need to do this on your own.
If you feel like you could use a little help managing today while building for tomorrow, a financial professional can help you build a plan that can help you live the life you want to – not only today, but decades from now.