By: Robert Vogel, CFP
To millennials, retirement seems a lifetime away. And, it is! However, now is the best time to start saving for retirement, says our guest blogger, Robert M. Vogel, CFP®, Director of Financial Planning for JFS Wealth Advisors in Doylestown, PA. In today’s post, Robert gives millennials—or anyone new to the workforce—an overview of understanding and maximizing company-sponsored retirement plans like a 401(k) or IRA, in plain and simple terms.
“A part of all you own is yours to keep.” This is the secret of wealth revealed by the wealthy man in the 1926 book The Richest Man in Babylon, by George Samuel Clason. Written as a series of financial education pamphlets, which were later compiled into a book, this simple statement contains the foundation for financial prosperity. But, you say, isn’t everything I earn mine to keep? No. You must pay taxes, buy food and clothing, pay rent or mortgage, insurance, the occasional Starbucks, and the list goes on and on. The brilliance of this statement is that it identifies savings as a habit borne of discipline; a habit best formed early.
Many try to put off saving until they reach some unspecified level of abundance. But like a chased rainbow, it always seems to recede into the distance. As your income increases, so do your expenses, making adjusting your lifestyle to accommodate saving can be just as painful. Delaying also incurs a hefty cost: If you saved $18,000 for 10 years, between age 25 and 35, that $180,000 would grow to $1.4 million at age 65 assuming a 6% annual rate of return. If you miss those 10 years, you must save a similar amount for the next 30 years to end with the same amount. Missing $180,000 in the first 10 years cost you almost $350,000 in additional savings to arrive at the same place. This is the power of compounding returns.
Thanks to the power of compounding, we know we should save early and often. But, what is the best way to save for the long-term? For many of us, the first and best option is through a plan offered through our employer. There are many plans, but the most common is the 401(k).
Named for the section of the tax code from which it hails, the 401(k) is an employer-sponsored retirement plan that allows you to set aside money directly from your paycheck to save for retirement (withdrawals before retirement are limited and may incur penalties). In 2017, you can contribute up to $18,000, if you are under age 50. Many plans offer the additional benefit of an employer contribution, which could be in a lump sum profit sharing contribution or a match. For example, your company adds $0.50 for every $1 you contribute up to 5%. Understand if your company has a match and how it works, since contributing less than the amount to maximize the match is essentially giving up free money!
Once money goes into the 401(k), the assets can be invested, often in a limited menu of investment options chosen by the plan administrator or advisor. The investments will range from aggressive (for younger investors) to conservative (for investors approaching retirement). Most plan websites have tools to help identify which investments are best for you. Once your investment strategy is set, don’t look at it more than once per year! One of the worst things investors do to damage their own returns is constantly follow the ups and downs of their investments.
Many 401(k) plans offer two options: Roth and Traditional. What is the difference? Taxes. One pays taxes now and the other pays later. The Roth 401(k) allows you to make contributions with after-tax dollars, and when withdrawn in retirement they are tax-free. The Traditional 401(k) allows you to make contributions on a pre-federal tax (pre-state and local based on your taxing authority), and when the money is withdrawn in retirement it is taxable as income. Because of this you can generally contribute more to a Traditional 401(k), up to the max, without affecting your take-home pay. For example, if you contribute $10,000 to a Roth 401(k) while in the 25% marginal income tax bracket, you could contribute up to $12,500 to a Traditional 401(k) and have the same amount of take home pay. The extra $2,500 is the tax due from including the $10,000 contributed to the Roth 401(k) in your income.
So how do you decide which is right for you? It all hinges on whether the amount of tax you would pay today on the contribution to the Roth is less than the tax you project you would pay at distribution on the larger balance in the Traditional. For a younger person, this is almost an impossible question to answer given so many unknown variables. A good starting point is to use a Roth 401(k) while any portion of your contribution falls into the 15% marginal income tax bracket, which peaks out at $37,950 for a single taxpayer and $75,900 for married filing joint. Above that it probably makes sense to have a discussion with a seasoned financial advisor who can help project what your retirement might look like.
If your company does not offer a 401(k), fear not! There is still a good savings option for you (beyond putting money into a brokerage account) albeit not quite as generous. Anyone under age 70 ½, with taxable earned income, can contribute to an Individual Retirement Account (IRA) each year. Opened with the custodian of your choosing, but often a brokerage or mutual fund company, the IRA allows you to make an annual contribution up to $5,500 (2017) or 100% of income, whichever is less, for those under 50.
Like the 401(k) there are two options, Roth and Traditional, but with a slight difference. Like the 401(k), Traditional IRA contributions are deductible for those not covered by an employer-sponsored retirement plan and taxable when withdrawn, and a Roth IRA contribution is not deductible, but the proceeds are tax-free when withdrawn if certain criteria are met. The difference from a 401(k) is that the ability to make a Roth IRA contribution is phased out as your income increases. For single taxpayers, the ability to make Roth IRA contributions phases out between $118,000 and $133,000 of income; for married taxpayers filing jointly, it phases out between $186,000 and $196,000.
So, remember: A portion of all you own is yours to keep: start saving early. Increase your savings as your salary increases. Make the most of your company retirement plans. Take advantage of tax-free growth while in a lower tax bracket. Set your strategy and forget it for a year.
With more than 17 years in financial services, Robert helps clients plan for retirement and focuses on multi-generational investment planning for high-net-worth individuals, families, successful professionals, business owners and retirees. He can be reached at firstname.lastname@example.org or 215.497.5050.