Saving for a house or for retirement can seem daunting. You’ll need to save significant sums for long-term goals such as retirement, buying a home or paying for a child’s college education.
The good news is that time is on your side — and so is the IRS. In many cases, saving for long-term needs means you get to save in tax-advantaged accounts such as IRAs, 401(k)s and 529 saving plans. Regardless of which long-term savings account you choose, there are some ways to maximize your savings, so your money works for you.
What are common ways to save for the future?
Retirement may be decades away for you, but you should start saving for it as soon as possible. A good rule of thumb is to save 10 to 15 percent of your gross income per year for retirement.
There are several types of long-term savings accounts that could benefit your financial portfolio.
Set up automatic deductions from your paycheck to a 401(k) plan or other employer-sponsored retirement plan. Companies routinely match employee contributions to 401(k) plans, which can help your savings grow more quickly. Contributions to 401(k) plans are made with pre-tax dollars and taxed only when the money is taken out.
The difference between the two is that you contribute after-tax income to a Roth IRA and withdraw the earnings tax-free in retirement. With a traditional IRA, you contribute pretax income and pay taxes on withdrawals. Consider a SEP IRA if you’re self-employed.
529 Education Savings Plan
A 529 education savings plan is an investment account that allows you to withdraw the earnings tax-free for college, as well as elementary and secondary schools, for qualifying educational expenses, including tuition, books and room and board. The withdrawals can be used at any school.
A prepaid college plan, on the other hand, allows you to buy credits for a beneficiary to attend a specific state public university at today’s tuition dollars, saving money as tuition costs rise. A prepaid college plan doesn’t cover room and board.
To stay on track with your savings, set up separate accounts for each goal. A short-term savings account can help pay for emergencies, such as a car repair, while a certificate of deposit or another savings account can be opened for longer-term savings goals, such as a retirement account, a down payment for a home and a college savings plan.
An online calculator can help you estimate how much is needed to save in each category every month to reach your goals. For a $20,000 down payment on a house, for example, you’ll need to save about $255 a month for six years at 3 percent annual percentage yield (APY) compounded monthly.
What are smart ways to save money?
There are several ways to make saving money easier to make achieving your financial goals less daunting.
Automate your savings
The surest path to success is to automate savings for long-term goals so you don’t even have to think about it.
“Inertia is a powerful thing,” says Greg McBride, CFA, chief financial analyst at Bankrate. “You have to automate your savings, so it happens first. If you wait until the end of the month and save what’s left over, too often, nothing is left over. When there is, there is no consistency to it.”
Set up automatic transfers every month from your bank account to an investment account, from your checking to your savings account, or from your paycheck to a 401(k).
Invest more aggressively for long-term savings
A good rule of thumb is to avoid high risk investments for savings you expect to need within five years. With longer-term savings goals, you can afford to be more aggressive. A big mistake consumers often make with long-term savings is investing too conservatively, McBride says.
“If you are assuming a rate of return of 8 percent, you had better have the bulk of it in equities,’’ he says. “You can’t be stuffing your retirement accounts in bonds and cash.”
Using a savings calculator as an example, if you start with $1,000 and contribute $100 a month to a money market account at a bank that yields 0.5 percent compounded monthly, you’ll end up with $13,359 after 10 years. If you invest the same amount of money into equities earning 6 percent over the same period, you’ll have $18,289 — nearly $5,000 more.
Compound returns means your returns are making money and not just your contributions, allowing your money to grow faster over time.
If you invested a one-time amount of $10,000, and your returns averaged 6 percent a year, but you took the earnings out each year, you’d earn $24,000 over 40 years. If you reinvested those returns each year instead, you would end up with about $93,000 in additional earnings, so your retirement account would be worth $103,000.
“In saving for the long term, time is your greatest ally,” McBride says.
What should I not do with my long-term savings?
At some point, you may be tempted to access your retirement savings before you retire. Don’t. You’re stealing from your future self when you raid your retirement accounts early. You may even have to pay a hefty 10 percent penalty for early withdrawals, in addition to paying taxes on the earnings.
Don’t think of your retirement accounts as sources of cash for current needs. Consider a personal loan, picking up a second job or getting a roommate should the need for extra cash arise.
“If you can’t afford to buy a house without raiding your retirement,” McBride says, “you can’t afford to buy a house.”
–Freelance writer Naomi Snyder contributed to a previous version of this article.