Between their meager paychecks and a heap of bills, young people don't have much cash left for retirement savings. Many 20- and 30-somethings must contend with student loan debt, credit card debt, cell phone bills, and car loans, in addition to necessities like food, housing, and healthcare. Often, there isn’t much money left over to devote to retirement. According to the Employee Benefit Research Institute, half of all workers between the ages of 25 and 34 have less than $10,000 in savings or investments. That's unfortunate because young people are in the best position to begin saving for retirement. Here are 8 tips for getting going:
Put compound interest to work. Compounding interest can yield impressive results. For example, an investor who contributes $5,000 to an IRA every year beginning at age 25 could potentially accrue $1.6 million by age 70, according to Fidelity calculations that assume a 7 percent annual rate of return. “If you want to retire with something resembling your pre-retirement life, you will have to save substantial amounts on your own through a 401(k) or IRA,” says Dallas Salisbury, President and CEO of the Employee Benefit Research Institute. To be able to sustain a do-it-yourself income--without the help of Social Security--of $40,000 a year in retirement spread over 30 years, you will likely have to accrue approximately $1 million.
Avoid fees. Over time, investing expenses eat away at your nest egg. Even one percent in fees will significantly reduce your retirement account balance over your working life and beyond. For example, if you left $20,000 in a 401(k) account with a 0.5 percent in annual expenses for 20 years without adding any additional contributions, it would grow to $70,500 (assuming a 7 percent rate of return). If the fees were instead 1.5 percent annually, the average return would be reduced to 5.5 percent, and the $20,000 will grow to only about $58,400. “Ask your employer to find what the expense ratio is,” says Manisha Thakor, co-author of On My Own Two Feet: A Modern Girl's Guide to Personal Finance. “Typically you want mutual funds to have an expense ratio of less than one percent.” Since large employers can often negotiate institutionally priced investment options, fees are often lower in your employer’s 401(k) plan than in an IRA you can get on your own. But if your employer doesn't offer a match and the fees are too high, consider shopping around on your own. Ann Dryden Witte, a Wellesley economics professor, recommends index funds as a low-cost way to invest in stocks.
Get your match and take it with you. Contributing enough to your 401(k) to get the full match is a great way to boost your retirement savings. The most common employer match is 50 cents per dollar on up to 6 percent of your pre-tax pay, according to the Profit Sharing/401(k) Council of America. Find out how soon you become vested to get the full match. About 44 percent of 401(k) plans have immediate vesting, which means you get to keep your employer’s matching 401(k) contribution as soon as it is deposited. If you're not immediately vested, it might be worth sticking with your current employer until you can take the full match with you.
Minimize taxes and penalties. One of the biggest advantages of 401(k)'s and IRAs is they allow you to defer taxes on deposits and accruals until the funds are withdrawn. Only then do you have to pay income tax on the amount taken out. But if you take the money out before age 50 1/2, you'll face a hefty 10 percent penalty on that withdrawal. Also, consider Roth 401(k) and Roth IRA accounts, which allow you to pay income tax on the amount you deposit now and take tax-free withdrawals in retirement. To decide whether a traditional or Roth retirement account is better for you, weigh your current tax rate against what you estimate your tax rate will be in the future. If you expect to be in a higher tax bracket in retirement, it's better to go with a Roth 401(k). But if your tax rate is currently higher than you think it will be in retirement, you'll be better off delaying taxation by choosing a traditional 401(k). You can also hedge your bets by contributing to both types of retirement accounts.