One of the most important question young people should ask themselves when they get their first job is, “How much should I put away for retirement?” At the age of twenty-two with your first real job, retirement is probably one of the last things on your mind. Paying off student loans, paying rent, maybe even paying a mortgage can take precedence in a person’s twenties and thirties, but time flies and before you know it retirement is just around the corner. It’s never too soon to start thinking about retirement planning or too soon to start saving. Moreover, the sooner you start the less you must put away from each paycheck.
Some important questions to be asked are: When do I want to retire? What kind of retirement lifestyle do I want? How much do I need to save? How much can I afford to put away? Let’s take a look at Roberto’s data and see how much he will need to save for retirement.
Current age: 22
Retirement age: 65
Years until retirement: 43
Dollar amount wanted to live on after retirement: $100,000 per year
Life expectancy after retirement: 25 years (90 years old)
Dollar amount needed to save for retirement: $2,500,000 ($100,000 x 25 years)
Present value of $2,500,000= ---------------------- = $593,686 (1 + .034) 43
$593,686/ 43 years = $13,807 per year
$13,807/12 = $1,150 per month
$1,150/$4,583(1) = 25% of monthly paycheck
25% of Roberto’s monthly paycheck is a lot, especially considering he just graduated, is paying off student loans and getting set up in his life. He could consider putting away a smaller proportion of his paycheck now and slowly increase his contribution in the future when his salary is higher. While this is a tempting thought, Roberto’s financial obligations will most likely increase, not decrease. He might get married, buy a house, have children, and, given current statistics, get divorced. Given these probable future financial obligations it is better that he start saving as much as he can at an early age. Also, the accrual rate decreases with age. Interest on money put away in an a person’s twenties accrues at a much higher rate than that same amount put away if that person is closer to retirement age.
So what are Roberto’s options? Three major options for retirement saving are a 401(k) provided by his employer, an IRA or a Roth IRA, and a mutual fund. These will be discussed in further detail below.
A 401(k) is an employer provided defined-contribution pension account. A designated amount of money is deducted from an employee’s paycheck before tax and contributed to the fund. Three major positive attributes of a 401(k) are that often the employer will proportionately match the employee’s contribution up to 25%; money is contributed before tax and the tax is deferred until the money is withdrawn after retirement; and the money contributed is not included from taxable wages at the time of contribution, which reduces taxable income. Limitations of the 401(k) are that there is a 10% excise tax on any distribution made before age 59 ½ or if he is still employed by the company (unless withdrawn due to “hardship” as define by the Internal Revenue Code) The yearly contribution amount is limited to $18,000 as of 2015. As of 2006, employees also have the option of a Roth 401(k) where the contribution included in wages and taxed at time of contribution but is tax free when withdrawn. With a yearly limitation of $18,000, Roberto could put all of his $13,807 retirement savings in a 401(k).
IRAs or Individual Retirement Accounts are retirement savings are similar to employer-provided plans, but are established by and funded solely by the taxpayer. Contributions to a traditional IRA are tax-free at the time of contribution and tax is deferred until the money is withdrawn after retirement. With a Roth IRA, the contribution is taxed at the time of contribution,