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Saving for Retirement: The Basics for Those Getting Started

If you're just starting out in the workforce, it's time to start thinking about saving for retirement. True, you probably have many other financial choices to make which debts to pay off, whether to buy a house, or whether to go back to school. But setting aside some cash for retirement now can pay off handsomely in the long run. (If you need information on setting financial priorities, see Nolo's article  Financial Advice for Young Adults.)

Here are some common retirement saving options, the advantages of each, and an explanation of what they can yield in the long run.

Ways to Save For Retirement

There are many different ways you can save for retirement. If you're just starting out, here are some options you may have.

Most employers offer a 401(k) or 403(b). These are the most common types of plans, largely because they're not very costly for the employer. You designate a certain amount of your salary toward your retirement, and your employer withdraws it from your paycheck. This is a great way to save  you can't spend it and may not even notice it's gone.

While these plans are sponsored by the employer, they're run by investment companies or fund managers. You'll be able to choose from various potential investments with varying levels of risks. (For information on choosing investments, read Nolo's article How to Invest Wisely for Retirement.) There is a maximum amount you can contribute each year. In 2012, that amount is $17,000 for people under 50 and $22,500 for those 50 or older. These amounts change annually.

If your employer doesn't offer a 401(k), fund an IRA. There are several different types of Individual Retirement Accounts (IRAs), some of which may be sponsored by your employer. Even if not, however, you can contribute to an IRA on your own, selecting investments much as you would for a 401(k). Your contributions are limited to $5,000 ($6,000 if you are 50 or older); this amount changes annually.

If your employer doesn't offer a 401(k), your contributions to an IRA are tax-deductible. Even if it does, the contributions can be deducted as long as your income doesn't exceed $66,000 (and phased out starting at $56,000) or $109,000 if married and filing jointly (and phased out starting at $89,000). These are the limits for 2010; they change annually.

Choose a Roth IRA or Roth 401(k). The "Roth" nature of both these plans means that contributions are taxed but withdrawals aren't (see "Tax Advantaged Savings," below, for more on this). 

Your employer may offer a defined benefit plan. With this plan, your employer promises you a certain amount of money, such as a monthly pension, upon retirement. These plans are less common today than they once were, and you may have to work for the employer for a certain length of time before you become eligible.

Benefits of Retirement Plans

Retirement plans offer some important benefits. In addition to giving you financial security when you're no longer able to work, they offer distinct advantages over other types of investments.

Tax Advantaged Savings

Many retirement plans offer big tax advantages  albeit in different ways, depending on the plan.

401(k) and 403(b) plans. Income that you contribute to a 401(k) or 403(b) is not subject to income taxes. The money is taxed much later, when you withdraw it during retirement.

This means that you save more. Here's how it works:  If you put $300 into your 401(k) plan and your tax rate is 25%, your take home pay will be reduced by only $225 (because you would have paid $75 in taxes on that $300). This allows you to save $300 instead of $225.

And investing more cash means greater returns. If you put $225 into post-tax investments each month from age 25, with an 8% annual return, you would have around $523,000 by age 65. On the other hand, if you put $300 into your 401(k) each month with the same return, you would have over $1 million by age 65  and your take home pay would be the same.

Roth IRAs and Roth 401(k)s. So why would you ever choose a Roth IRA or Roth 401(k)? These plans have a different tax advantage: your contributions are taxed now, but you won't be taxed when you make withdrawals. Some experts recommend Roth IRAs for younger investors, because they have longer to see their money grow. This approach also makes sense if you expect to be in a higher tax bracket when you retire.

Employer Matching

Another great advantage to many retirement plans is that some employers will match your contribution, usually up to a certain dollar amount or percentage of your annual salary. This amounts to your employer offering you free money. Don't turn it away unless you're truly destitute and can't contribute anything to your plan. If you can possibly afford it, take the free money.

The one big catch to these matching contributions is that often, the employer's contributions don't "vest" until you have worked for the employer for a certain length of time. For example, you may have to work for the employer for three years before you are entitled to all the cash in the plan. (You always get what you contributed, however just not the employer's share.) If you know you won't be working at a company for very long, make sure you understand how your company's vesting requirements work.

The Power of Compound Interest

Another reason you stand to gain so much when you invest in your retirement is the power of compound interest. When you invest in a retirement account and leave your money there, interest can begin to accrue immediately. Instead of spending the interest, you're adding back into your retirement pot. That means interest begins to accrue on the interest.

For example, if you start with $5,000 and earn 10% interest, one year later you have $5,500. Two years later, you'll have $6,050. And 20 years later, you'll have $30,000 without contributing any more cash. This compound interest is your investment working silently.

This is where youth works in your favor. Your money has longer to grow when you contribute early. That means you can save less and still come out better than someone who started saving more money later in life. Just imagine, if you saved $5,000 at age 25 and didn't withdraw it until age 65, you'd have over $225,000. That's a lot better than starting at age 45  the same investment of $5,000 will only yield approximately $30,000 by the time you're 65.

For more information on saving for retirement, and dealing with other financial issues facing young people and families, get The Busy Family's Guide to Money, by Sandra Block, Kathy Chu, and John Waggoner (Nolo/USA Today).