We have all heard the phrase, “the earlier the better.” This also holds true with retirement savings. It can be tough when you’re just starting a career, adjusting to having your own money, and balancing a budget for expenses and entertainment. “I am young. I am paying off my student loans. I still have 40 years of working until retirement” – I’ve heard it all. But there’s this almost magical thing called “compound interest” that can help you acquire wealth. This is where time is on your side.
The three most popular ways for young professionals to save is through traditional and Roth IRAs and an employee sponsored plan like a 401(k) or 403(b). Traditional and Roth IRAs both offer tax advantages, but there are significant differences.
Before we get into those, let’s talk about how much you should save. There are many schools of thought on this, but it’s most important to do what works for your individual situation. You may not want to survive on a diet of ramen in order to save money for retirement. One thought is to gradually increase your retirement contributions as your income increases. You might want to max out contributions for ten years and then pull back. You might want a steady plan that you can keep up with. Like so many things in life, you’ll likely be happier and more consistent if you plan in a way that reflects and expresses yourself.
Let’s talk about those IRAs. A Traditional IRA may have tax advantages for you NOW. You fund it with after tax money and it grows tax-deferred. Those contributions are generally tax-deductible for most people (there are income limits), and the earnings in the account are taxed at withdrawal. Withdrawals at retirement are generally taxed as ordinary income for that year. There are penalties if you withdraw money before age 59½ . Uncle Sam requires you to take mandatory distributions from your IRA at age 72 ½. The assumption behind a Traditional IRA is that by the time you start taking withdrawals from your account, you will be in a lower tax bracket.
On the other hand, the Roth IRA is attractive because the growth and withdrawals are Tax-Free. Roth IRAs are available to individuals with adjusted gross incomes below specified amounts and contributions are allowed up to specified maximums. These contributions are made on after-tax income and are not tax deductible. Contributions may be withdrawn at any time without tax implications. After the Roth IRA has been in place for at least five tax years, tax-free withdrawals of earnings may be made once the owner reaches age 59 ½ or is disabled. Earlier withdrawals may be taken for first-time homebuyer expenses up to $10,000 (lifetime maximum).
The employee sponsored retirement plan, whether that’s a 401(k), 403(b), 457(b) or Simple IRA, may give you access to FREE money! Many of these plans are designed to provide an employer match as a correlated percentage of your contribution. It’s your employer’s way of saying, ‘Thank You’ for saving for your own retirement!
Everyone’s financial situation is different. We know there’s nothing cookie- cutter in this community and that’s why it’s recommended that you speak with a financial professional to determine which of these, or another plan, may suit your needs. If you are investing through your employer, most HR departments have people who can advise you or direct you to professionals who can.
As noted, these savings do grow over time. It might be useful for you to run some different models to see what you can earn. A financial professional can help with that too! It can be very inspiring, motivating, and eye-opening to see how compounding interest can work in your favor.
Realistically, you still have to live your life. Budget for vacations, experiences, and special things you want to purchase. After all, you’ve earned those too. You’ll want to make sure you have what you need and want today, even as you have your eye toward the future. That’s why putting away a little bit and giving it time is a great practice. Unfortunately, it’s all too rare for people to get financial education. I can’t tell you how many people say to me, “I wish I learned this when I was younger.” Now’s your chance, particularly if you’re in your twenties or thirties, but really, it’s never too late!
Like so much in life, balance plays an essential role. And planning a little today can pay off significantly down the road.
— Michelle Cutrali contributed to this article.