How to save money for the future

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Saving for a house or for retirement can seem daunting. It’s not a new outfit or kitchen appliance we’re talking about here. You’ll need to save significant sums for long-term needs such as retirement, a home purchase or a child’s education costs.

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.

Here are six tips to follow for reaching your long-term savings goals.

1. Take advantage of tax-deferred accounts

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.

Set up automatic deductions from your paycheck to a 401(k) plan at work, if it’s available. 401(k)s often come with matching contributions from your employer. With a 401(k), your contributions are made tax-free, and you’re taxed on your withdrawals in retirement.

If your employer doesn’t offer a 401(k), set up automatic contributions monthly from your bank checking account to a traditional IRA or a Roth IRA. 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.

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 does not cover room and board.

2. 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).

3. Invest more aggressively for long-term savings

A good rule of thumb is to invest conservatively for money you’ll need to access within five years. With longer-term savings goals, you can afford to be more aggressive. A big mistake people 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 per 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 time period, you would end up with $18,289 — nearly $5,000 more.

4. Take advantage of compound returns

Compound returns means your returns are making money, and not just your contributions. This allows your money to grow significantly over time.

An example from Vanguard shows how this works. If you invested a one-time amount of $10,000, and your returns averaged 6 percent per year, but you took the earnings out each year, you would earn $24,000 over 40 years. If you re-invested 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.

5. Dedicate your savings to specific goals

In order to stay on track with your savings, try setting up separate accounts for each goal. You should have a short-term savings account for emergencies such as a car repair, and separate accounts or CDs for each long-term savings goal, such as a retirement account, an account for a down payment on a future house, and a college savings plan.

Estimate how much you will need to save in each category every month to reach your goal. Online calculators make this easy to do. For example, if you need $20,000 for a down payment on a house, you’ll need to save about $255 per month for six years at 3 percent interest compounded monthly.

6. Avoid raiding your retirement accounts

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.”