The Secret to a Comfortable Retirement
You may think that retirement is something that only old people must worry about, but that’s not true. Retirement is when you stop working and live off your savings and other sources of income. It may seem like a long way off, but the sooner you start planning for it, the better. In fact, if you start saving and investing now, you can be a millionaire by the time you retire.
Sounds too good to be true? Well, it’s not. It’s all thanks to compound interest and various retirement benefits and accounts for you to take advantage of that will help you save for that day.
Compound Interest
When you invest your money, you earn interest. But the magic really happens when the interest you earn also starts earning interest. This is known as compounding.
For example, if you invest $1000 today at a 5% interest rate, then at the end of the year you will have $1050, which is $1000 plus $50 of interest. If you keep your money invested for another year at the same rate, you will have $1102.50 at the end of the second year, which is $1050 plus $52.50 of interest. Notice that you earned more interest in the second year than in the first year, because you earned interest on the interest. This is what compounding means, and it makes your money grow faster and faster over time, which is why starting early pays off.
A common way to think about retirement income is as a three-legged stool. The three legs are Social Security, an employer-sponsored retirement plan such as a 401(k) or pension, and personal savings, including accounts such as IRAs. Relying on several sources of retirement income can provide a stronger foundation than depending on just one.
What are the different sources of retirement income and how can you maximize them?
Compound interest is not the only factor that affects your retirement income. There are also different sources of income that you can rely on when you retire, and each one has its own advantages and disadvantages. The most common types of retirement income sources are defined contribution plans, defined benefit plans, Social Security, and IRAs.
Defined Contribution Plans
A defined contribution plan is a workplace retirement plan that allows employees to contribute part of their income toward retirement. Common examples include 401(k) and 403(b) plans. Depending on the plan, an employer may also contribute money to the employee’s account. The employee generally chooses how the money is invested and takes on the risk of investment gains and losses.
Starting early gives contributions more time to grow through compound interest. Some plans also offer target-date funds, which automatically adjust their mix of investments as an expected retirement date gets closer.
For more information about contributions, employer matching, investment choices, and other plan features, see Understanding 401(k) Plans.
Workplace Retirement Plan Protections
The Employee Retirement Income Security Act (ERISA) establishes federal rules for many workplace retirement plans, including requirements for providing workers with clear information about their plans and protections for plan participants. Some employer contributions may also be subject to vesting, which means the employer’s money becomes fully yours over time.
For more information about vesting and how vesting schedules work, see Understanding 401(k) Plans.
Defined benefit plans
A defined benefit plan is a retirement plan where employees receive a fixed, pre-set benefit when they retire. The company provided retirement benefit payment is determined by your length of service and earnings history. It is not dependent on investment returns or market growth. Defined benefit plans are becoming increasingly rare but are still in place at some companies.
The advantages of defined benefit plans are:
- You have a guaranteed income for life, regardless of market conditions
- You do not have to worry about saving or investing for retirement
- You do not pay any fees or expenses for managing your plan
The disadvantages of defined benefit plans are:
- You have no control over how much you receive or how it is calculated
- You may lose some or all of your benefits if you leave the company before retirement age or if the company goes bankrupt
- You may not receive enough income to meet your retirement needs, especially if inflation or living costs increase
Social Security
Social Security is a federal program that provides retirement income for almost every American worker, paid for by payroll taxes. Employers deduct money from their employees’ paychecks through payroll deductions, match that dollar amount, and send that money to the government. The tax money is used to pay benefits to people who have earned a Social Security benefit as a retiree or to disabled workers and spouses and children of deceased, disabled, or retired workers.
The advantages of Social Security are:
- It provides a basic income for life, regardless of market conditions
- It is adjusted for inflation every year, so your benefit does not lose its purchasing power
- It may provide benefits for your spouse, children, or survivors, depending on your situation
The disadvantages of Social Security are:
- It may not provide enough income to meet your retirement needs, especially if you have a high standard of living
- It may not be available for some workers, such as state and town government employees, who do not pay Social Security taxes
- It may face financial challenges in the future, as the number of retirees increases and the number of workers decreases
To maximize your Social Security, you should:
- Work and pay Social Security taxes for at least 10 years, or 40 quarters, to be eligible for retirement benefits
Your retirement benefit is generally calculated using your 35 highest-earning years. You can choose to claim benefits early, at your full retirement age, or later, with waiting longer generally resulting in a higher monthly benefit.
Traditional IRA Accounts
An Individual Retirement Account (IRA) is an account that allows individuals to save and invest for retirement with certain tax advantages. With a Traditional IRA, eligible contributions may provide a tax benefit now, while taxes are generally paid when money is withdrawn in retirement. In simple terms, a Traditional IRA can be thought of as getting a potential tax benefit now and paying taxes later.
For more information about eligibility, contributions, withdrawals, and investment options, see Understanding Individual Retirement Arrangements (IRA).
Roth IRA Accounts
A Roth IRA also allows individuals to save and invest for retirement, but the tax treatment is different. Contributions are made with money that has already been taxed, so there is no tax deduction for the contribution now, but qualified withdrawals in retirement are generally tax-free. In simple terms, a Roth IRA can be thought of as paying taxes now in exchange for potential tax-free withdrawals later.
For more information about Traditional and Roth IRAs, including eligibility and withdrawal rules, see Understanding Individual Retirement Arrangements (IRA).
Saving for Education
Retirement is not the only long-term goal that may have tax-advantaged savings options. A 529 plan can help families save for qualified education expenses, including certain college and career-training costs. A Coverdell Education Savings Account (ESA) is another type of education savings account with its own eligibility, contribution, and withdrawal rules.
For more information about saving and paying for education, see Financing Your Education.
Activity: Which Accounts for Which Person?
Read each scenario and decide which retirement account or income source would be most important for the person to consider. Explain why.
- Jordan is 17 and works part-time after school. Jordan wants to start saving some earned income for retirement while still young. What type of personal retirement account might Jordan consider?
- Maya just started her first full-time job. Her employer offers a 401(k) and contributes money to employees’ retirement accounts. Which retirement savings option should Maya learn more about, and why?
- Carlos works for an employer that does not offer a pension. He expects Social Security to provide some retirement income but wants to build additional personal savings. Which other sources of retirement income could help strengthen his retirement plan?
How to Create Income in Retirement
Planning for retirement is not only about accumulating a large sum of money, but also about creating a steady stream of income that can support your lifestyle and expenses in retirement. Social Security and defined benefit payments will provide regular income payments but will likely not be enough to cover all your essential expenses. One way to create additional income payments for yourself is to use a portion of your savings to purchase an annuity. An annuity is a contract between you and an insurance company, where you pay money to the insurance company, and in return you will receive regular income payments for the rest of your life or for a specified period. Once you know your essential expenses will be covered, you can use the rest of your savings in your retirement accounts for everything else.
Become a Millionaire Slowly
Saving for retirement is one of the most important financial goals you can have. The sooner you start, the sooner compound interest can start working for you. Regardless of what kind of retirement accounts you choose, pay yourself first by making contributions every year, and work your way up to maxing out the contribution limits, and you’ll be on your way to retiring as a millionaire!
Challenge Questions
- In your own words, explain what the term retirement means.
- What is a 401(k) and how does it work?
- What is Social Security and why do people pay into it?
- Why is it important for you to start saving for retirement early?
- In your own words, explain what a Roth IRA is and what the difference is between a Traditional and a Roth IRA.
- How can you use retirement savings to create income?