Updated: Apr 13, 2019
Hello Money Talkers! Today’s blog is about the fourth step to financial freedom, planning for retirement.
I know, we are young, why should we be thinking about retirement? We are just now trying to save, begin careers, buy homes and start families. How can we add planning for retirement on top of that pile of concerns? The sad truth is that when our generation hits retirement age, there is a chance that social security will not cover our retirement needs, and it might not even exist at all. We cannot rely on the money being there if it might not be, so we need to plan for our futures ourselves. That is why we must think about retirement now.
What happens when you get to an age where you can’t work anymore? Or your health declines? Or you get laid off with no money saved for retirement? You will be royally f*cked, that’s what!
So basically, the reason it’s smart to begin planning for retirement early is interest. Interest works against you when your in debt, but interest works for you when your saving. That’s because the sooner you start saving the longer your money has to grow. For example, if you start at age 25, and save $3,000 a year in a tax advantaged retirement account for 10 years only. By the time you reach 65, your $30,000 investment will have grown to more than $338,000, (assuming a 7% annual return). If you didn’t start saving until 35, and then you saved $3,000 a year for 30 years. By the time you reach 65, your $90,000 will grow to only about $303,000. That's a huge difference!
When saving for retirement you should always save in a tax advantaged account. A tax advantaged account is an account that is either exempt from taxation, tax-deferred, or offers other types of tax benefits. The most common tax advantaged accounts used for retirement saving are 401(K), 403(b), and IRA. So let’s look at these types of accounts more closely.
401(K): This is the most common form of retirement savings. A 401(K) is a retirement plan that is offered by an employer to eligible employees to save and invest for retirement on a tax deferred basis. You decide how much money you want deducted from your paycheck and deposited to the plan. It is up to you to choose to participate in the 401(K), so if you are not already enrolled in your companies 401(K) plan, ask your employer right now if they offer one and if you are eligible and get started. The amount you choose to contribute each pay period is also up to you. If you earn $1,000 each pay period and decide to set aside 4% of your pay, $40 is taken out of your pay and placed in the 401(K) plan. The way that a 401(K) is tax deferred is that the contributions are deducted from your salary on a pre-tax basis. This means that by contributing to a 401(K), you actually lower the amount you pay in current income taxes. So instead of being taxed on the full $1000 per pay period, you are only taxed on $960. You don't owe income taxes on the money contributed until you withdraw it from the plan. The idea is that the value of the stocks and bonds you invest in (your company automatically chooses these for you, so don’t worry if you don’t know anything about the stock market), will go up over time and your money will earn more money.
Here is the icing on this already delicious cake: your employer may also choose to make contributions to the plan in the form of what is called a “match”. Typically, employers match a percentage of employee contributions, up to a certain portion of total salary. So, using the same numbers from the earlier example, if you earn $1000 each pay period and choose to set aside 4% of your pay and your employer matches your contributions up to 4%, then your employer is essentially giving you $40 every pay period. Matches are really FREE MONEY! So anytime that your employer offers a match, always at least contribute up to that amount. I find this form of retirement savings to be the easiest because you literally do not have to think about it. The money automatically comes out of your account each paycheck before it hits your account, so you don’t even miss it. It is tax deferred and grows tax free. It accrues interest through the stocks and bonds that your employer chooses to invest in. Plus, you get free money with the employer match. If your company offers a 401(K) you should always participate.
403(b): This plan works the same as a 401(K) in the way that you choose to deduct your contributions from your pay, they are tax deferred, and they can grow through investments. The basic difference between a 401(K) and a 403(b) is that a 403(b) is used by nonprofit companies, religious groups, school districts, and governmental organizations. The law allows these organizations to be exempt from certain administrative processes that apply to 401(K) plans. This allows the administrative costs for a 403(b) to be lower. So depending on where you work is whether your company will offer the 401(K) or the 403(b), if they offer a retirement plan at all.
Now, what if you are like me and your company doesn’t offer a retirement plan? Or what if you are self employed? Well folks, you are not off the retirement planning hook that easily, there is still a retirement plan for you.
IRA: If a 401(K) or 403(b) is not available to you then you can choose an Individual Retirement Account (IRA). Or you could even use an IRA to supplement your other retirement plans. An IRA is an account you set up at a financial institution that allows you to save for retirement with tax-free growth or on a tax-deferred basis. You can either pay someone to handle your account or you can choose where to invest this money yourself. I do my own investments and I simply put it all into index funds, but if you are new to investing then you might want to pay the extra fee to have a professional manage your account. You should always try to contribute the maximum amount to your IRA each year to get the most out of these savings. Be sure to monitor your investments and make adjustments as needed if you are managing your investments yourself. There are two types of IRA’s:
Traditional IRA: In this type of IRA you make contributions before you pay taxes on them (pre-tax) or you can claim your contributions on your taxes to add to your refund. Your contribution and any earnings grow tax-deferred until you withdraw them in retirement. This is good if you think you will be in a lower tax bracket when you retire because the tax-deferral means the money may be taxed at a lower rate.
Roth IRA - You make contributions with money you've already paid taxes on (after-tax) and your money grows tax-free, with tax-free withdrawals in retirement. This is good if you think you will be in a higher tax bracket when you retire, because the money will be taxed at a lower rate.
Now that you are familiar with why young people should be concerned with planning for retirement and the most common types of retirement plans I am going to introduce to you all to the FIRE movement. FIRE is an acronym for Financial Independence, Retire Early. Essentially, the premise behind the FIRE movement is that if you maximize your income and minimize your spending to create extreme savings and optimize your investments then you can accumulate more than enough money for retirement. If your retirement savings can sustain you for longer then you can choose to retire earlier. How awesome is that!? Now you have the freedom to do whatever you want!
Basically, saving for retirement is essential to becoming financially fit. Pick which retirement savings plan works best for you, 401(K), 403(b), or IRA and get to saving. If you save for retirement with enough ferocity than you could even afford to retire early and pursue… well whatever you feel like.