Last Updated Apr 25, 2011 8:04 AM EDT
How well you handle this "do-it-yourself" retirement saving system and avoid the common pitfalls will mean the difference to being prepared for retirement or not. But the good advice for saving and investing for retirement isn't universal to everyone. What you should be doing can vary based on your age and the number of years to save that are ahead of you.
A Milestone to Reach by your 30's
According to a number of studies, assuming you are looking to retire at age 65 and earn an average income, by the time you are age 30 you should have accumulated 1 to 2 times your annual pay in retirement savings be saving 10 percent or more of your income in your 401(k).
Here is another eye opener. According to the National Savings Rate Guidelines for Individuals, this study concluded that in almost every typical scenario (with some existing savings, Social Security, pensions, etc.) , most workers would need save at least 10 percent or more of their gross income during their entire working lives to accumulate sufficient savings to pay for their needs in retirement.
So here are some guidelines for folks in their 20's and 30's to get to this milestone.
Join 401(k) as soon as eligible
So you finally land a "real job" and have a life of working and earning ahead of you. Saving for retirement is probably the last thing on your mind. The most common reason given by younger workers for not saving for retirement is the inability to come up with the extra dollars to save. You may have college loans and credit card debt to pay. For this reason, only about 30 percent of younger workers who are eligible to join their employer provided 401(k) plan do so.
Most companies will require you to be employed for at least six months to a year to join the 401(k) plan, but a rising number allow you to join right away. You need to know when your employer's plan allows you to participate and join as soon as you are eligible to do so. Also find out how much you need to contribute in order for you to receive the maximum contributions from your employer. Most employers will require you to contribute at least six percent of your pre-tax pay to get a three percent employer matching contribution.
Although more employees are eligible to participate in a 401(k) type plan, some workers are not. But if you are not eligible to participate in a 401(k) plan, you do have options. If you are self employed, you can establish and contribute to a self-employed 401(k) plan, where you can make contributions to your own account as both the employer and employee for a total pre-tax contribution of $49,000 per year. If you are not self employed and earn $5000 or more, you can contribute up to $5000 to an Individual Retirement Account. The point is that you have options and having access to a 401(k) is not necessarily a requirement to being able to save for retirement in a tax-advantaged retirement account.
Contribute 10 Percent
Most Employer 401(k) plans will provide a matching contribution on up to six percent of employee contributions. Don't let this fool you into a false sense of security that this matching formula is some implied message for what you should be contributing. This study concluded that for the average worker, you'll need to contribute 13 to 15 percent of your pay each and every year into your 401(k) plan account to have a reasonable chance of having enough money to pay for your retirement. So, if your employer contributes three percent, and you contribute ten percent, the total contribution would be 13 percent.
For some younger workers, they may think that a small amount saved won't amount to much at retirement. If you are age 25, earn $30,000 per year and save 10 percent, or $3,000 in one year consider this: if that $3000 grew at a rate of 10 percent, you could have over $160,000 at age 65. Of course, inflation would increase the cost of your living expenses, and $160,000 won't buy as much in 40 years as it would today. But taking a 3.5 percent rate of inflation into account, that would provide the purchasing power of about $40,000 at today's cost of living, which is still no small chunk of change.
Juggling debt payments and retirement savings can also be a struggle. If you have student loans, do not sacrifice 401(k) plan savings to make extra principal payments on these loans. The reason is that through loan consolidation, you should be able to lock in low fixed-interest rates on these loans and therefore these may be less costly to service.
But if you have credit card debt (most college seniors have credit card balances of $3000 to $7000), the advice is different. Contribute an amount to the 401(k) plan to get the maximum employers matching contributions (typically six percent) and then use any extra income to pay down your credit card balances as quickly as possible. That is because while the return on the "matched-contributions" is hard to beat, the return on the unmatched contributions is not likely to exceed the 18 to 29 percent interest rate you could be charged on the credit card debt. If you lack the discipline to go back and increase your 401(k) contributions after you pay down your credit card debt, then just start right out at 10 percent.
Consider Roth 401(k) Contributions
Some plans will also allow a newer feature called Roth 401(k) contributions - these are deducted from your after-tax pay, but all of the growth on these contributions is tax-free at retirement when the money is withdrawn. This can be a significant benefit to younger workers who will be investing for a long time and thus will have larger amount of growth on their retirement savings. If your plan offers this feature - and more will be doing so - strongly consider make some or all of your contributions in the form of a Roth 401(k) contribution.
If you absolutely cannot afford to save 10 percent of your pay right now, then begin with at least the minimum required to receive the maximum employer matching contributions and automatically increase your contributions each year coinciding with an annual increase in your pay. Most workers will get a pay increase each year and the historical real wage increase in the US is about 1.5 percent per year. Many 401(k) plans include an automated feature - called a contribution escalator - which you can set up to automatically increase your contributions by a defined amount on a pre-set date in the future.
Invest for Maximum Growth
According to major 401(k) plan service providers, younger employees invest the retirement accounts more conservatively than their parents - allocating some 35 percent of their accounts in lower risk bond and stable value funds. Studies show that some 19 percent of workers in their 20's have no stock investments in their 401(k) accounts. One reason for this could be that most of their experience with stock funds included the period of 2007 through 2008, when the stock market losses negatively impacted their accounts. But the younger you are, the more time you have to save and invest and the majority of your retirement account and future contributions should be allocated to stock funds. If you look at the performance of the financial markets between the periods of 1956 through 2005, a 100 percent stock allocation generated an average annual return of 10.4 percent, but a 60 percent stock and 40 percent bond allocation generated a return of 9.1 percent. While this may not sound like a lot, over time this can make a huge difference in the amount of money a younger person could have at retirement.