You probably know that the sooner you start investing, the better off you’ll be in your golden years. But what if you don’t start saving until you’re in your 50s? Is all hope lost?
Understand your savings
When you prioritize saving for retirement, the first thing to do is determine where your income will come from to create a plan that works best for you.
Unlike employment, retirement income is usually pieced together from many different sources, and each type of account has its own rules and requirements.
It can quickly get confusing, so make a list of the different retirement accounts you have, then include the current balances and any income you might expect to receive from other sources.
It can be helpful to think about your accounts in broad terms so you can apply structure to your investment plan. Generally, your income will fall into one of three categories:
Traditional individual retirement account (IRA)
Pension plan set up through your employer
Simplified employee pension (SEP IRA) set up by you as a self-employed business owner
Savings incentive match plan (SIMPLE) IRA
If your tax-deferred accounts are employer-sponsored, you fund them with pre-tax dollars from your paycheck. If you have a traditional IRA, you deduct your contributions on your tax return, so you’ll have to pay federal and potentially state taxes when you withdraw funds.
You may also need to take the required minimum distributions when you reach age 72.
Tax-free accounts are advantageous because you fund them with money you’ve already paid taxes on, and if you meet the qualified distribution requirements, you generally don’t pay taxes on your earnings.
If you need to make an early withdrawal from your Roth accounts, you can pull out your contributions without a penalty or taxes, but if you pull out any of your earnings, you may be subject to a 10% early withdrawal fee plus taxes.
HSAs withdrawal rules are a bit different. You can withdraw funds from your HSA prior to the minimum account age of 65, but if they aren’t qualified medical expenses, you may have to pay a 20% fee, as well as taxes.
If you withdraw money from an HSA for unqualified medical expenses, but you’re 65 or older, you will still pay taxes on those funds, but not the 20% penalty.
Other sources of income
This is the broadest category, which makes it hard to accurately project what you may receive from these potential income streams. Visit the Social Security Administration to calculate your estimated payment based on what you’ve paid in social security taxes. A retirement or tax professional may also be able to help you determine other forms of applicable income.
Increase your contributions
Once you determine what types of accounts and potential income you have, it’s time to think about how much you can contribute now toward your future retirement.
Create a budget (or review your existing budget) to know where your money is going and consider cutting back on some categories to make room for additional retirement contributions.
If you haven’t prioritized your retirement savings until now, consistently increasing your investment contributions, even by just a few dollars a month, can bump up your retirement savings and allow you to take advantage of as much compound interest as possible.
Note that the IRS has rules about how much you can contribute every year, and getting as close as possible to those contribution limits is one of the best ways to make up some ground if you’re behind in your retirement savings.
In 2021, the standard 401(k) contribution limit is $19,500, and $6,000 for a Roth or traditional IRA.
If you’re aged 50 or older, you can also take advantage of catch-up contributions, which let you save even more every year.
The 401(k) catch-up contribution allows you to save an additional $6,500 for a total of $26,000 every year.
Roth IRA catch-up contributions allow you to save an extra $1,000 for an annual total of $7,000.
It’s usually best to maximize contributions to tax-deferred or tax-free accounts first, and if you still have money to invest, use a brokerage account for anything above the yearly contribution caps. Review the best brokerage accounts to help you choose the right one for your situation.
Consider your risk tolerance
Financial advisors generally recommend that as you get older, you take less risk by moving money from potentially volatile assets, such as stocks, to safer bets, such as bonds.
Although it’s potentially true that you could make more by staying invested in the stock market, there is risk involved whenever you’re investing money, and it’s important to know how much you can tolerate before you put your eggs into one particular basket.
The S&P; 500 has historically returned about 10% annually, which means you could make $5,000 a year on a $50,000 investment, but it’s important to remember that you could also lose your initial $50,000 in a single day, as many people learned in the 2008 financial crisis.
The financial markets can be volatile in the short term, so it’s important to consider your own personal risk tolerance and how close you are to retirement before using a risky investment strategy.
Avoid early withdrawals
When you hit a financial rough patch, it can be tempting to look at your retirement accounts and think they’re the answer to your immediate financial problems. But don’t touch that money.
Both tax-deferred and tax-free accounts are set up to save specifically for retirement, and accessing the money before you reach retirement age can be both difficult and expensive. The IRS is strict about when and how you withdraw money, especially if you try to take money out before you reach age 59 1/2, or if you’ve been contributing to the account for fewer than five years.
If you need to make an early withdrawal from your 401(k), you may have to pay a 10% penalty, as well as any taxes on the funds you take out. That could take a huge chunk out of your nest egg, so it’s best to leave that money where it is and let it grow.
If you’re withdrawing from a Roth IRA or other after-tax account, the rules are a little different. If you withdraw your contributions only — the money you have already paid taxes on — you can take it out without penalty or paying additional taxes. However, if you withdraw any of your earned interest before retirement age, you may be subject to both taxes and a penalty.
Even though you can take your contributions out of a Roth IRA, you probably shouldn’t. You miss out on all the potential gains and compound interest by withdrawing funds early, so don’t take early withdrawals lightly.
Keep tax planning in mind
For many people, planning for taxes after you retire is an afterthought, and that first tax bill in retirement can be shockingly painful.
Remember, when you pull money from your tax-deferred accounts — 401(k), 403(b), etc. — you’re required to pay taxes on your contributions and earnings, any pensions or annuities you receive, and possibly even your Social Security payments.
Taxes on a Roth IRA or Roth 401(k) are different because you’ve already paid taxes on the contributions, and if you meet the distribution requirements, you generally don’t have to pay taxes on your earnings.
Because of this, Roth IRAs are a good option to add to your retirement portfolio. In addition, they can help you reduce the amount of taxes you pay in retirement when your income is usually lower and you don’t have to take the required minimum distributions.
Be aware that Roth IRAs have income limits and not everyone can take advantage of this tool.
If you make more than $125,000 a year as a single person or more than $198,000 as a married couple filing jointly, the amount you can contribute to a Roth account is reduced. If you make more than $140,000 as a single person or $208,000 as a married couple, you are not eligible to contribute to a Roth IRA account.
Pay off your debts
As retirement approaches, most people want to simplify their lives as much as possible, and that should include paying off debt. Retirement income is usually less than when you’re employed, so anything you can do to get out of debt before you withdraw from retirement accounts is a good idea.
Focus on getting rid of the high-interest debt you have first, such as credit cards or car loans, and then work to pay down your mortgage or any other low-interest debt you may have.
Because you don’t have to spend that money on consumer debt, this will stretch your retirement accounts further and allow you more room to spend on budget lines that increase in retirement, such as health care expenses, which usually go up as you age.
Knowing the difference between a 401(k) and a Roth IRA is a good place to start your retirement planning. Increase your contributions as much as possible and know how much you can expect to receive from all of your accounts by using online retirement and benefit calculators. If you don’t yet have retirement accounts, you can open one on your own using an investment app. Pay attention to any taxes or fees you may owe, and focus on paying down as much debt as possible before you retire so you don’t have to spend retirement resources unnecessarily.
Although making sure you’re ready to retire can feel overwhelming, pat yourself on the back for facing this situation head-on and starting today with your savings goals. By taking small steps now, you’re setting yourself up for success in your future retirement.
More from FinanceBuzz: