Being a millennial, I realize that retirement sounds like a foreign, future concept to most people my age. Retirement? I’m only in my 20s/30s; I’ve got at least 30-40 more years of working left before I can retire. Why would I worry about that now? I want to use my money to enjoy my life now. Why bother working if I’m just going to save all my money and not do anything with it. These are all VERY common thoughts about retirement at this age. The thing is it’s scary that many people think this way. First of all, there’s no one forcing you to work until you’re 60 something. It is possible to retire early if you save enough to do so. However, the more important thing to note here is that while 30-40 years may seem incredibly far away, you should start saving for your retirement as early as you possibly can.
As this is YourAverageDough’s first retirement post, I wanted to start simple with basic concepts and tips on retirement planning.
Employer-sponsored retirement plans
Many jobs offer employee-sponsored retirement plans as a benefit to their employees. Generally, these come in the form of a “defined benefit” plan or a “defined contribution” plan. A defined benefit plan means that the employee is not expected to provide any of his/her own money towards this retirement plan, but rather it is fully funded by the employer. A good example of this is a pension plan. Pensions guarantee a specific amount of monthly income in retirement and the risk lies with the employee. A defined contribution plan, on the other hand, requires contributions from both the employer AND the employee. Two of the most common examples of these are a 401(k) and 403(b).
What’s the difference between a 401(k) and a 403(b)?
“A 401(k) plan is a qualified employer-established plan to which eligible employees may make salary deferral (salary reduction) contributions on a post-tax and/or pretax basis. Employers offering a 401(k) plan may make matching or non-elective contributions to the plan on behalf of eligible employees and may also add a profit-sharing feature to the plan. Earnings in a 401(k) plan accrue on a tax-deferred basis” (Investopedia-401(k) Plan).
A 403(b) is the 401(k) equivalent for public schools and 501(c)(3), or non-profit, organizations. These plans can invest in either annuities or mutual funds (Investopedia-403(b) Plan).
How much should I contribute to my 401(k)/403(b)?
At a minimum, you should contribute whatever your employer will match. Employer match refers to how much your employee will contribute to your retirement plan on your behalf. For example, your employer may match contributions up to 5% of your salary. In this case, you should be contributing at least 5% of your salary to your retirement plan in order to take full advantage of this “free” money from your employer. If you feel comfortable contributing even more than the 5%, that’s even better! There are, however, limitations on how much you can contribute. For 2017, the IRS set a maximum contribution amount of $18,000 into employer-sponsored retirement plans annually.
All this being said, if you do not feel that you in a financial position that allows you to contribute the full employer-match for some reason, then do the maximum amount you are comfortable with. I understand that some people have extenuating circumstances causing them to be unable to contribute to certain things and everyone’s financial (and life) situations are totally different. That’s okay.
So this means I can only contribute $18,000 per year towards my retirement?
Nope. Along with employer-sponsored retirement plans, individuals are allowed to open their own retirement accounts, typically in the form of an Individual Retirement Account, otherwise known as an IRA. There are two types of IRAs: traditional IRA and Roth IRA (see below for definitions). The IRS allows individuals to contribute up to another $5,500 (or $6,500 if you’re 50 or older) to your IRA each year, in addition to the $18,000 allowed towards employer-sponsored plans.
A traditional IRA is a retirement savings account that provides tax-deferred growth and potentially tax-deductible contributions. With a traditional IRA account, your gains grow tax free, which includes both capital appreciation gains and dividends received. The biggest benefit of a traditional IRA, though, is that your contributions are tax deductible if your income is below the threshold determined by the IRS (see table below for 2016 thresholds).The downfall to the traditional IRA is that funds are taxable when withdrawn, after the individual reaches age 59 ½. For most people, though, your tax rate will be lower in retirement than it is while you are working because you are likely to have a lower income stream.
A Roth IRA is a retirement savings account that is not tax-deductible and is not taxable if withdrawn after the individual reaches the age of 59 ½. A Roth IRA is similar to a traditional IRA in that gains grow tax free; however, unlike a traditional IRA, the withdrawals are also tax free with a Roth IRA. So, while you may not receive a taxable deduction as you do with a traditional IRA, you are able to withdraw the funds tax-free once you are over the age of 59 ½.
If you withdraw funds from either IRA, you will be slapped with a 10% penalty, with ONE exception. If you qualify as a first-time homebuyer (which means you haven’t owned a home for at least 2 years, even if you have previously owned a home), then you can withdraw up to $10,000 to be used towards the purchase of that home. Remember, though, with a traditional IRA your funds are taxable when withdrawn, no matter what. So, while you won’t receive the 10% penalty, you will be taxed on your withdrawal. With a Roth IRA, you can withdraw $10,000 to be used to help cover cost associated with buying your home both tax-free and penalty-free. I do want to note that this is not encouraged, as the funds in your IRA should be used for your retirement, so try to save for your house elsewhere
If I’m allowed to contribute $23,500 per year towards retirement, why would I need to start so early?
Have you read my The Power of Compounding post yet? If not, go do it! Compounding interest, in finance terms, is defined as the ability of an asset to generate earnings (interest, dividends, income), which are then reinvested in order to generate their own earnings. In other words, if you contribute $1,000 today into your retirement plan, which generates an annual return of 5%, you will have $1,050 in one year. With all factors the same and no additional contributions, in just 5 years that $1,000 turns into $1,276. In 10 years that same $1,000 becomes $1,629. In 20 years that same $1,000 will be $2,653. And in 30 years that $1,000 will become $4,322. Incredible right!?
The point is that the earlier you invest, the more money you will have in the future. Compounding is basically multiplying your money by simply letting it sit in one place for years without doing anything to it (obviously this is in the most basic form). Why wouldn’t you want to make as much money off of your money as possible??
Okay, so how much do I need to retire?
This number is different for every single person. There is no magic retirement number that works for everyone. Instead, think about what you want your retirement to look like. What do you plan to do with your time? Do you plan to travel? Where do you plan to live? What would you like to be doing with your money? What kind of lifestyle do you need to support? Are you expecting to have any large purchases in retirement? Are there any goals you want to achieve? Sure, your thoughts on these things may change as you get older, but you should contribute to your retirement based on your current goals and thoughts. You can always adjust your numbers with time. The most important thing to consider is how to retire comfortably, without financial stress and not NEEDING to work if you don’t want to.