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How to save for retirement: Everything you need to know

At a glance:

  • Building a cash cushion

  • Using automatic investment programs

  • How dollar cost averaging works

  • Overcoming your fears about saving for the long term

  • Summary of saving for retirement

  • Practical ideas you can start with today

Saving money for retirement takes discipline, time, and a bit of strategy. Let's take a look at the two strategies of automatic investment plans and dollar cost averaging.

These strategies can be adopted for nearly any investment goal, but we will look at their effects on saving for retirement. Along with that, we look at the importance of having a cash cushion and addressing our fears about saving.

Building a cash cushion

Many people's attempts to put money away for retirement into 401k plans, IRAs, and other plans are sabotaged by the need to divert that money toward emergency expenses — the car breaks down, they lose their job, etc.

A solution to this danger is to set up an emergency fund first, so that one can breathe more easily and tend to the task of funding retirement.

Conventional wisdom says to save for three to six months' worth of your daily expenses, though others suggest more, especially in bad economic times.

Use existing money if you can

Ideally, you want to pay for emergency expenses with existing funds.

Though credit will do the job as well as cash in your savings account, it comes with expensive strings attached. Interest on credit cards, just like the interest on savings accounts, adds up over the months, so you end up paying off a bill higher than what you originally incurred.

An additional advantage of using existing money is that it may earn interest or dividends if sitting in certain types of accounts in a financial institution.

First, track your expenses

You should know your spending and earning habits well enough to decide how large of an emergency fund you're going to need.

If your income is not stable — which is true for many self-employed consumers — you may need a larger fund than someone who gets a steady paycheck does.

Begin by determining how much money you spend in a month, including housing-related expenses, utilities, car payments, gas, insurance, food, and loan payments.

Since a loss of income-earning ability will mean cutting out unnecessary expenses during that time, focus on the necessary ones.

Once you have your total dollar amount, multiply it by the number of months you think you'll need.

With this goal in mind, determine a safe amount to sock away each month or week. At first, it's probably best to set aside a small amount, but be consistent with it.

Liquidity is ideal

Ideally, you want to store your emergency cushion in a liquid, easily accessible account that does not lose its value, so you know how much money you have available in the event of an emergency and you can withdraw money quickly.

Savings accounts offer excellent liquidity. So do money market accounts. Though they hold their value, bank certificates of deposit and savings bonds are not very liquid, though you can take your money out prematurely.

However, you will likely be penalized for early withdrawals and lose some of the earnings you've built up.

Not all accounts are suitable for emergency funds. Existing retirement accounts, for example, should stay put so they can have growth potential over the course of decades. Taking money out prematurely can cost you a huge amount of growth and early withdrawal penalties and taxes over the long term.

Tapping a revolving credit account, such as credit cards, can end up costing you much more in finance charges than you need to cover your emergency expense.

Some people choose stocks or other market-based investments for their emergency funds due to those investments' potential to grow in value over time.

While this can indeed happen, remember that the volatility of the market may put you at a disadvantage when it's time to take your money out. You may end up with less than you put in.

Special accounts for an emergency fund

Many credit unions and banks now offer certificates or savings accounts for specially designated purposes, such as emergency funds. Having an account specially tailored for an emergency can be a psychological boost that motivates saving.

Using automatic investment programs

Retirement plans are very popular choices for automatic investment programs because they can help the retirement savings build up over the course of many years, often decades.

Many investors find that they sleep better at night because the burden of remembering to keep adding to their accounts is taken care of for them through automatic withdrawals.

The potential steady buildup of money, especially if compounded, should provide a noticeable growth in retirement wealth. In addition, many employers provide matching funds for employer-sponsored retirement plans, hopefully increasing the chances that savings grow even faster.

You can build retirement plan funds through automatic investment plans via a sponsored retirement plan such as a 401(k), 403(b), or 457 plan, or on your own with a traditional or Roth individual retirement account (IRA).

Regardless of how you deploy your automatic investment program, remember that they do not assure a profit or protect against loss.

Popular investment vehicles

If your investment strategy involves seeking maximum growth, you may benefit from investments with higher risk profiles, because risk and return are generally correlated (though exceptions do occur).

Over the course of years or decades, the ups and downs in the market can smooth out and may result in a lot of growth. Investments commonly used in retirement accounts include stocks, bonds and mutual funds.

Some investors like to invest in real estate, either in individual properties that they can rent out and receive income from or via real estate investment trusts where a large company invests in many real estate properties and passes on the returns to investors.

Use them in the reverse manner in retirement

Automatic plans are also available for withdrawing money periodically from a retirement account once you retire and need to spend those funds.

In this case, it works in the reverse manner — funds are taken out of the retirement account and automatically deposited into a target account, such as a checking account or money market fund.

How dollar cost averaging works

First, let's define the term.

What is dollar cost averaging?

Dollar cost averaging is the practice of purchasing the same dollar amount of shares of an investment each period of time.

When the price of the investment is up, you buy fewer shares. When the price is down, you buy more shares. To turn this practice into habit, it can be helpful to make the payments on the same day each period.

If you purchased 100 shares of an investment over four months, you would have invested $2,200 and your average price per share would have been $5.50 for 400 shares. If instead you had invested $550 on the 15th of each month, you would have gotten the following:

Overcoming your fears about saving money for the long term

If putting aside money for your retirement scares you, you are not alone.

Financial planners (and psychologists and marriage counselors) see this fear all the time. It's not irrational to fear parting with your hard-earned cash and putting it somewhere you can't touch.

After all, cash is a resource that covers current needs, and we are wired to take care of our current needs. Anything that threatens that need puts us on alert.

But in some ways, we're also wired to delay gratification for better days.

Why be afraid?

What might be at the root of the fear of saving?

Some have a deep-seated fear of being deprived. Others have a sense of entitlement about gratification. Some have a fear of losing their money and becoming destitute. And some fear that it still won't be enough and that it would have been better to spend it when they could.

Yet many have successfully saved money in spite of fear.

The key is to see budgeting not as a threat or a form of denial but as a reward. Indeed, many budgeters report that having a budget actually frees them from feelings of deprivation, vulnerability, or fear. And just knowing that you can have abundance in your later years takes a load of worry off your mind.

Start small

And you don't have to commit to lifelong austerity right up front.

Why not try gradual exposure to saving? Experiment with short-term budgets first, including setting aside a small amount for savings. Try a budget for a single day. Then make one for a whole week and adjust it as needed.

Once you've gotten comfortable with those, you can try a monthly budget. After several months of those, you can try setting down long-term goals. Your budgeting experience will help you find money to set aside for them.

Why set goals?

It is important to have goals because they direct your saving and investing.

When you know what you are sacrificing for, there is less of a feeling of loss, deprivation, or denial. In the case of saving for retirement, just seeing what your money can grow to over the course of years can dampen your fear of losing it.

Though there are ups and downs in the market, historically, saving and investing have always panned out for those who save over the long term.

Summary of Saving for Retirement

For most of us, setting aside money for retirement takes discipline, planning, and effort.

But some things can help us along the way, like an automatic savings or investing plan, an emergency savings plan, and a regular budget that we stick to.

Being sure to "pay yourself first" (that is, diverting a certain part of your paycheck into savings regularly) can help you find the money you need to keep saving for your retirement. If you are investing in stocks or mutual funds as a way to build up a cushion, you may find the practice of dollar cost averaging to be very helpful.

With all this in mind, where does one start?

Practical ideas you can start with today

  • Create an emergency fund of 3 to 6 months' living expenses.

  • Calculate how much I will need to save for retirement.

  • Set up a budget or plan for making contributions to your retirement plan(s).

  • Pay myself first by withholding a chosen amount from each paycheck and putting it into savings.

  • Set up an automatic savings plan(s) at my financial institution.

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

Read more information and tips in our Retirement planning section

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