Set Up Your Retirement Early – Get Your Ducks In A Row

This is Part 3 in the guest series, Get Your Ducks In A Row, which focuses on important financial knowledge to have in your 20s, written by someone in who’s just starting out in the working world. All posts in this series are available here.

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Thinking about retirement during your first job may seem like a juxtaposition. You’re battling student debt from a degree you finished a few years ago, and planning for 40+ years from now is not a priority. Though it seems to make sense, it’s not the smartest move. In your 20s, you have the greatest advantage that stockbrokers and financial advisors alike covet – time and the power of compound interest.

The road to financial independence starts early

The running joke in my family is that the only gift my siblings and I could give my parents is “financial independence”. Growing up, whenever we asked my dad what he wanted for Christmas, Father’s Day, or his birthday, without hesitation he would respond, “financial independence for all my children.” I now realize was code for “I don’t want you living in my basement at age 30” and “please take care of me and your mom when we’re old.”

Now in my first job out of college, the pursuit of financial independence is always on my mind. Talking to my peers, I find there is a delicate balance between constantly feeling broke and embracing the “treat yoself” mentality.

Fear is holding us back

In my first article, I discussed why you shouldn’t use savings accounts for long-term goals. Unfortunately, millennials still prefer keeping the majority of their money in cash. Has growing up through large economic downturns made us second-guess our financial choices? Millennials aren’t very optimistic and 30% think another recession will happen within the next five years. Stocks are viewed as unfavorable investment choices, with only 13% of millennials claiming that they would invest in the stock market.

For those who are hesitant to touch the stock market, the key is to put it in perspective. Short-term, the risk seems daunting but in the long-term, dips rebound. A study from Bankrate revealed that the annual returns from 2007-2016 for the 10-year Treasury was 5%. Stocks surpassed 10-year bonds, reaching an annual return of 8.6%. And cash investments? – Only 0.3%.

Personally, watching my hard-earned money sit and lose value is way more terrifying.

Compound Interest – Looking at the numbers

401(k) investing isn’t sexy. There’s no get-rich-quick scheme and it’s not something most people are impressed by. Even if your 401(k) can make you a millionaire in 30 years, it feels too far away to think about.

Let’s look at the following scenario. Assuming a moderate annual rate of return of 5% and a yearly contribution value of $5,000, what would the value of your retirement portfolio be?

If you start contributing at age 21 for 10 years, your portfolio would reach $175,000.

If you wait to age 31 and contribute for 20 years, your portfolio would reach $173,500.

So, if you start later, you’d have to invest twice as long and still wouldn’t catch up to the other portfolio value.

That is the magic of compound interest!

Building retirement: Traditional 401(k) vs. Roth 401(k)

Investing in retirement is one of the best places to put your money. It’s also fairly easy to do. Many employers offer both traditional and Roth 401(k)s as investment options and will automatically pull your contribution from your paycheck.

Deciding how much you want to invest in your 401(k) can be a little complicated at first. The simple answer is – as much as possible. At the very least, you should contribute the amount of your employer’s match. Otherwise, you’re leaving free money on the table. Start at 8% and see if you can increase it later, depending on your budget.

Choosing between a traditional 401(k) and Roth 401(k) might not matter much, especially as you try to build both a few years down the line. A big difference is taxes: traditional 401(k)s are taxed later when you retire and pull from the account, while Roth 401(k)s are taxed as you put money in. Roth 401(k)s are advantageous to young employees who are in a lower tax bracket. That is, assuming that workers will have higher incomes and therefore higher tax brackets as they age.

Conversely, saving more on taxes by investing in a traditional 401(k) will allow you to start saving more earlier. As long as your annual contributions are maxed out or substantial, your retirement income will compound to be more than you’ll ever use. So, you won’t have to be worried about your tax bracket then.

My approach so far has been to invest only into my Roth 401(k) during my first year of work; I plan to expand into a traditional account later. Additionally, like most college graduates, I started work in the summer. For me, choosing Roth 401(k) has been especially beneficial because I will not have made a full year of my salary by the end of the tax year. Therefore, my tax bracket will be lower for my first year of employment and I expect to get a refund from the taxes I have paid on my contributions.

Betting on whether you’ll be in a higher tax bracket when you retire may be a gamble. But you can hedge your bets by choosing a mix of 401(k) accounts. Get started now and snag that compound interest!

Do you want to retire early?

Early withdrawals from traditional and Roth 401(k)s will be penalized if taken before age 59 ½. IRAs, Individual Retirement Accounts, are investment alternatives that grow tax-deferred with fewer restrictions on withdrawals. IRAs are a great option if your employer does not offer 401(k) plans and like 401(k)s, there are both traditional and Roth IRAs, differentiated by tax breaks.

Under IRS rules, withdrawals from traditional IRAs are still penalized if taken before the age of 59 ½, with exceptions. These include qualified higher education expenses, the purchase of your first home, medical expenses, and insurance premiums. This gives you more flexibility with your money and allows you to take advantage of a greater annual rate of return than savings accounts.

If you want to retire early, explore Roth IRAs. You can withdraw the money you put in at any time and for any reason, without paying penalties. My “financial independence” mentality has taught me to prepare for the flexibility of retiring early. I would rather have the power to choose to work in my 60s because I love my job, rather than needing to.

Contribution Limits

Lastly, be attentive of contribution limits, and the upcoming $500 changes in 2019. Overcontributing can result in fees, so don’t put in too much!

Many people don’t invest enough in their retirement until it’s too late. Hopefully, this knowledge will help you see how it’s possible to set yourself up for financial success.

Cover Photo by Andrew Wulf on Unsplash