3 Retirement Planning Habits to Start in Your 20s
Entering the real world as a career driven adult fresh out of college is one of the scariest steps I have ever taken. I attended school, earned good grades, graduated from college—now what? I’d spent my whole life knowing exactly what my next steps were until I suddenly found myself leaping into the real world with the hope that 22 years of preparation would keep my head placed squarely on my shoulders. After several years, I’m happy to report that my head remains in its rightful position, but my journey has not been without learning curves along the way. Primarily, understanding the importance of early retirement planning and how to maximize my savings and contributions.
Because you’re likely receiving the most income you’ve earned on your own, it can be easy to become distracted by your earning potential after college; but it’s important to prioritize saving at least 15% of your income. The entire amount does not need to go into a traditional savings account, it could (and should) be spread out among several short- and long-term accounts—including an emergency fund, savings account, 401k or other employer retirement fund, and a Roth IRA.
Short-term accounts include traditional savings accounts and emergency funds. Monies saved in these accounts are easily accessible and can be used for emergencies, unforeseen expenses, or during job transitions. A common metric used to estimate the amount you should have saved in these accounts is a minimum equivalent of three months’ expenses. Your expenses can include rent, utilities, loan payments, phone and internet bills, and anything else that you pay on a monthly basis. The COVID-19 pandemic that has overcome our community has reminded everyone the importance of having these funds readily available.
Although savings accounts are pertinent to any successful financial plan, we do not want to rely on them as our only savings vehicle. The average interest rate for savings accounts is 0.09%, but the average rate of inflation is 2-3%. This means that your savings account will not keep up with the pace of inflation and will lose value in time as the cost of goods increases. You should also regularly monitor your monthly expenses to ensure that you have the appropriate amount saved.
Long-term savings accounts can include employer sponsored retirement plans and Roth IRAs. Monies saved in these accounts are expected to remain there until later in life when they will be used to support your daily lifestyle in retirement. The most popular type of retirement account offered by employers is a 401(k). A 401(k) is an account that allows employees to contribute a portion of their income to be invested into stocks and bonds, thereby earning a rate of return greater than inflation. Depending on your allocation, one could expect to earn a 5-6% average return on investment over a 10-year period. With this return you will outpace inflation, grow your portfolio, and earn income to spend during retirement.
In addition to the employee’s contribution, most employers will also offer a contribution match. For example, when an employer offers a 5% match for participants, they will match your contribution up to 5% in addition to your regular salary. At a minimum, we recommend that you contribute enough to your 401(k) to earn the employer match, and to start contributing as early as you can in your career. For every year your money is invested in the market, your potential for additional earnings increases exponentially.
401(k)s are considered a tax deferred account. In this type of account, contributions you make reduce your gross income when filing your annual taxes with the IRS, ultimately saving you money in the current year. However, withdrawals made once you’ve entered retirement will be subject to income tax.
Alternatively, a Roth IRA is another type of commonly used retirement account for individuals. Unlike 401(k) contributions, income taxes are paid in the current year on the funds contributed to a Roth, making withdrawals from the account during retirement tax-free to the individual. It is common for individuals to fund Roth IRAs at an age when they are in a lower tax bracket and a Roth IRA is more advantageous.
The key takeaway is the importance of saving any way you can and, when possible, diversifying your savings among short- and long-term accounts. Consider allocating 5% of your income to a savings account, 5% (or to more to earn the employer match) to a 401(K), and 5% to a Roth IRA.
As always, contact your Certified Financial Planner™ to ensure you are on track or to discuss a savings plan that best suits your goals.