5 Things All College Graduates Should Know About Saving for Retirement
While investment planning isn’t top of mind for many college graduates, it’s something I’ve had numerous friends ask me about, with the questions most often centering around the topic of 401(k) planning. One friend who graduated alongside me (albeit with a degree in computer science), for example, is now beginning to think about 401(k) contributions.
How much is a healthy amount to invest? What exactly is an employer-match? Which investments should he choose if he decides not to opt-in to the companies default options?
Why You Should Save For Retirement
Thinking about the future can be worrisome. Whether you’re age 20 and just entering the workforce or well-established at age 60, retirement will likely be a radical change of pace. Do you want to continue some form of part-time employment? Maybe focus on a hobby that has been neglected or start traveling like you’ve always wanted?
We want the freedom to choose when we stop working, and that freedom is achieved through retirement planning.
I enjoy this quote from Warren Buffet: “If you don’t find a way to make money while you sleep, you will work until you die.”
This quote offers a very blunt lesson. Not many of us want to spend our twilight years doing the same work we did 40 years prior. Even if you genuinely enjoy what you do, it’s nice to decide for yourself when it’s time to stop. However, that decision is one that’s made for you when you fail to plan.
What is a 401(k)?
A 401(k) plan a company-sponsored retirement plan that allows employees to contribute funds to tax-advantaged accounts that give preferential tax treatment compared to regular investment accounts. Employees can choose to invest in pre-selected funds, and employers may make matching contributions of a flat amount or up to a percentage of the employee contribution.
When To Start Contributing
Many plans allow employees to start making contributions once they reach 21 years of age and after they’ve been employed for a year, but these requirements are up to the employer’s discretion (your employer should have a fact sheet indicating the parameters for eligibility).
Regarding when you should start contributing—the sooner you begin, the better.
Let’s look at an example:
Client A is age 21, earning an annual salary of $50k, contributing 10% of their income to retirement, and seeing average annual returns of 7%. Remaining consistent with their savings plan, they enter retirement at age 67 with just over $2 million.
Now, let’s assume that same client waited 10 years to begin investing. They enter retirement at age 67 with just over $1.1 million. Had they started investing 10 years earlier, they would have seen an 80% increase in their retirement savings. The advantages of investing early is undeniable.
How Much To Contribute:
When thinking of contributing to retirement, the rule of thumb is to invest 10% of your current income. While people may have different expectations of retirement, and 10% of one person’s income might look different from another’s, the 10% rule is a good baseline. I recommend contributing enough to receive your employer match (if one is offered).
If your employer offers to match 50% of the first 4% that you contribute, for example, your investment effectively increases by 50% in an instant. This is the equivalent of at least four years of economic growth!
Roth or Traditional, which is better for you:
More companies are offering Roth 401(k) options in addition to the traditional (or pre-tax) 401(k) choice many of us are familiar with. Which do you choose to invest in? Well, it all revolves around when the retirement funds are taxed, so you should ask yourself, “When do I want to pay taxes on this money?” Traditional 401(k) plans are funded with pre-tax money, and that money grows as it’s invested. Those funds are not taxed until you begin taking money out of the account.
On the other hand, Roth 401(k) funds are taxed first, then invested. However, when you choose to take the money out, all of it is withdrawn tax-free, including any growth that it incurs.
If you anticipate your earnings to only increase as you age, a Roth 401(k) could be the better option now. This would allow you to pay taxes on your contributions while you’re in a lower tax-bracket. However, if you are in a higher tax bracket now and plan to retire into a lower bracket, it may be more beneficial to pay the taxes later in retirement.
The Bottom Line
Invest heavily in your 401(k) accounts and start early.