Dear Members of the Class of 2016,
You’ve gotten that diploma and landed a job – maybe even your dream job. Now that your career has officially begun, it’s time to think about how it will end.
Even though the ink is barely dry on your new business cards, you need to focus on retirement – specifically, on the need to save for it either through the workplace or on your own. Retirement is decades away but your new best friend, compound interest, is here right now.
Some financial experts say you need $1 million or more for your old age. The median starting salary for the class of 2014 was $45,478, according to the National Association of Colleges and Employers.
Your mileage may vary, of course. If you majored in something like early childhood education, music or communications your paycheck is more likely to be in the $31,500 to $39,800 range. Or maybe you haven’t landed the right job just yet and are making do with retail or other gigs.
Scary, huh? But you have a secret weapon: Time.
Early enrollment in a 401(k) or individual retirement account gives compound interest time to work its magic. Here’s an eye-popping example:
Jane invests $5,000 per year (about $96 per weekly paycheck) between the ages of 25 and 35.
John invests $5,000 per year between the ages of 35 and 65.
Jane gets $1,142,811 upon retirement. John gets $540,741 even though he invested three times as much.
No matter what you earn it’s essential to look at 401(k) plans and/or individual retirement accounts. Although both produce the same result – a comfortable existence for you later on – each has its advantages and drawbacks.
Incidentally, this isn’t just about being secure at 70. Suppose you want to be an at-home parent when you’re 30, or become an entrepreneur at 40? Starting your nest egg early means more options overall.
More than one kind of each account exists. This article will focus on the basics.
On-the-job saving
A traditional 401(k) is sponsored by your employer and offers an average of 19 types of investments, including index funds and actively managed stocks, bonds and money markets. To determine what’s right for you, I recommend you read NerdWallet’s “Investing” page and/or make an appointment with a fee-only financial planner.
Funds come from your paycheck before taxes are calculated. Because you’re paid less the tax burden is lower during your working life. The money gets taxed as it’s withdrawn.
The 401(k) has two clear advantages:
High annual cap. Up to $18,000 each year (more after age 50).
Company contribution. Some employers kick in additional funds (typically up to 3% of your salary).
Contribute at least the maximum match. It’s foolish to leave money on the table (especially someone else’s money). Aim for more, though. Financial experts tend to agree that a minimum of 10 percent (preferably more) of your salary should be set aside. This might not be possible right away, but it should definitely be a goal.
Some employers offer automatic 401(k) enrollment, generally starting at about 3 percent with a gradual increase. Raise it yourself, from the get-go, with an eye toward reaching that 10-percent-or-more goal. Pay attention to investment type, too: Automatic enrollment means a default selection that might not be the best for you.
To keep all your paycheck you have to might have to opt out of the 401(k). Don’t do that unless you have an ironclad alternative. A well-defined budget (more on this below) and a little creativity will let you live on less than you earn, right from the start.
The DIY approach
No 401(k) at your new job? Start an IRA at a financial institution such as a discount brokerage firm or investment company. (NerdWallet can help there, too, with a page called “The Best IRA Providers.”)
The annual cap for an IRA is considerably lower, just $5,500 per year before age 50. Deduct those contributions at tax time; just as with a 401(k), you’re taxed only on the salary you received.
Another important difference: Whereas a 401(k) has an investment menu, with an IRA you choose your own financial vehicles. Again, educate yourself or talk with a planner to get the right mix.
Fees and other costs associated with either retirement plan should amount to 1 percent or less annually. According to The New York Times, many employees go with actively managed mutual funds whose total expenses can reach 2.27 percent each year; by comparison, you might pay only 0.06 percent for a passive index fund.
Generally it’s possible to have both the 401(k) at work and a Roth IRA on your own. But if you’ve got student loans on a starter salary you might have trouble funding even one account. (The average education loan burden is just over $35,000. Yikes!)
When saving feels impossible
Feel like you’re living paycheck to paycheck, with nothing to spare for retirement? Time to get control of your cash. One way to do that is to sign up for a free money-management tool like Mint.com. You need to know where your cash is going right now in order to create a workable budget.
But as my daughter notes in her book “Frugality For Depressives,” budgeting software doesn’t work for everyone. Personally, she found it stressful to use Mint.com so she created her own budget plan, which she calls “One And Done.” (Intrigued? Learn more about the book through the above link.)
You can craft a personal budget as well. One popular framework is the 50/20/30 plan:
50 percent of post-tax income for necessities
20 percent to debt repayment and long-term savings (including retirement)
30 percent for non-necessities (entertainment, hobbies and the like)
Recent grads might have to adjust those numbers somewhat until loans are paid down or until raises/better jobs are obtained. Obviously the “lifestyle choices” category is the one with the most wiggle room, since you don’t have to shop recreationally, eat out every day or party all weekend.
But that doesn’t mean you have to give up fun. A smart consumer will start by looking for the best deals on big-ticket items. A few examples:
Live with a roommate for a while
Twice a year, look for new quotes for insurance, cell plans and Internet service
Seek the best credit card deals
Avoid frequent electronics upgrades
Buying good-quality items that last longer and using price-comparison websites to get the best deals
These and other salary-stretching frugal hacks will create an emergency fund (as little as $500 is a good start, according to personal finance author Liz Weston) and then funnel more dollars into your Someday Fund.
That fund won’t happen unless you make it happen. You can’t opt out of adulthood. Will it be easy? Maybe not at first, especially if you’ve got student loans and a starter salary.
But unless you’re lucky enough to have a defined benefit pension, you can’t afford not to contribute. One day you’ll thank yourself.
Related reading:
Happy graduation! Here’s a toilet brush
I’ve been thinking about retirement
Poor, poor (but not pitiful) me
Nearing retirement? Check your credit
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