Here's How You Could Save $40,000 in 5 Years

Saving $40,000 over five years isn't exactly easy, but it's possible. If you're nearing retirement and want to maximize your nest egg, or even if you're just getting started in the workforce, setting aside this much money could be a wise move. 

Here's how to do it with the help of tax-advantaged accounts and the power of compounding returns.  

Step 1: Max out your IRA 

If you earn money, you can contribute to an individual retirement account (IRA). Different IRAs are available, but the two most common types are traditional IRAs and Roth IRAs. 

A traditional IRA allows you to make tax-deductible contributions, meaning you can deduct your contributions from your taxable income, potentially lowering your tax bill. On the other hand, a Roth IRA allows you to make tax-free withdrawals in retirement, meaning you won't owe any taxes on your withdrawals, including the earnings on your contributions. 

Fun fact: You're allowed to have both types of IRAs. My wife and I have a traditional and Roth IRA and have contributed to both over the years.

No matter which IRA you choose, you can contribute $7,000 to it annually, giving you $35,000 by the end of five years. And if you're 50 or older, you can contribute $8,000 annually, boosting your five-year contributions to $40,000.

It's also worth mentioning that the IRS often adjusts IRA contribution limits annually, which means you could potentially reach your savings goal even faster.

Step 2: Let the stock market do its thing

Let's assume you save the current IRA limit of $7,000 and the contribution level doesn't change over the next five years. How can your $35,000 turn into $40,000?

This is where the magic of the stock market comes into play. The historical average annual rate of the S&P 500 is about 10.2%. But when adjusting for inflation, it's about 7%. 

Let's apply the inflation-adjusted rate to the $7,000 annual contributions. If you start with $0 in your retirement account, add $583.33 per month (a total of $6,999.96 in yearly contributions), and earn 7% for five years, you'll end up with just over $41,530.  

Of course, there's no guarantee you'll earn 7% on your investments. The stock market can be unpredictable, and there's always a risk you could lose money, especially over a relatively short investment timeline, like five years. However, the stock market has historically provided higher returns than other investments over the long term.  

Tips for saving more

Don't get discouraged if you can't set aside $40,000 in five years. Maxing out your IRA contributions is excellent if you can do it, but it's not absolutely required for building your retirement savings. 

Instead, come up with a savings plan that works for you. Here are a few tips for getting started. 

1. Set aside raises and extra cash

One of the best ways to set aside more money for retirement is to contribute any extra cash you receive, such as a bonus from work or an annual raise.

Increasing your contributions each time you receive additional money will prevent you from spending it. You won't even miss the money because you won't have time to spend it.

2. Automate your savings

I've been guilty of not doing this enough. It's easy to assume I'll move money into my retirement or savings account and then forget to do it or spend it on something else. But setting up automatic contributions to your IRA or an investment account is the best way to ensure you add to your retirement savings regularly. 

No matter your retirement goals, automating your savings and putting additional cash into your retirement account will help you get there. Just remember that using an IRA can bring you tax advantages, and keeping your money in the stock market is one of the smartest ways to let it grow over time.