Welcome to Lesson 4 of Financial Health 101: Debt and Student Loans, a free short course from Justworks.
Remember the 3-step approach to financial health we introduced back in Lesson 2? (It’s ok if you don’t.) The first step was prioritizing and paying off debt. The next step was setting up a budget to avoid accumulating (more) bad debt.
In this lesson, we’re covering the last step: getting a start on retirement savings.
Before we cover how, we’re going to start with why.
Your 20s are an amazing time to put money toward your future. It’s a time in your life when you can live relatively cheaply. Maybe you have roommates to cut down on expenses. If you don’t yet have children, you may have more wiggle room to invest any extra cash from your “save & repay” bucket towards yourself.
Sure, you have student loan payments, and your salary may not be as high as some of your older coworkers. But time is on your side due to one big reason: compound interest.
Compound interest is the process by which a sum of money grows exponentially due to interest building on itself. Whatever money you put into a retirement savings account now has longer to grow more interest before you retire, netting you more in the future.
Take this example from Business Insider of two friends saving for retirement. One begins saving at the age of 25, and puts $200 per month into a retirement account with a 6% rate of return. The second friend does the same, but waits until age 35 to get started. Both continue to contribute $200 a month until they’re 65 years old.
While the first friend only put about 33% more into their account, they end up with almost twice as much saved: $402,492 versus $203,118. The higher amount is simply because of that extra 10 years of compounding returns. That old saying “time is money”? In this case it’s literally true.
Maybe you’re thinking, “Hold on, I don’t have a spare $200 a month to set aside right now.” That’s totally fine. The point is whatever amount you can put toward your retirement now will pay off bigger in the long run.
Maybe you’re also thinking, “But I don’t even have a retirement account!” No problem. Let’s take a look at the different types of retirement accounts, and how you can get started.
When it comes to retirement savings, you have options. Today, we’ll go through three types of retirement accounts that are fairly easy to manage: 401(k)s and individual retirement accounts (traditional and Roth).
A 401(k) is a retirement savings plan that an employer sets up for their employees. In a standard 401(k), you can automatically deduct a portion of your paycheck, pre-tax, and defer it to your retirement savings plan. Employers can opt to match a percentage of your contribution, helping you to even save more.
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With a 401(k), you are immediately 100% vested in your own contributions (ie you own it). However, employer contributions generally vest over time. In a given year, you vest, or own, a certain percentage of your account that your employer cannot take back. If you quit your job, or don’t work enough hours to be eligible, employer contributions that are not vested would go back to your employer.
Another important thing to know about 401(k)s is that your contributions are tax-deferred. This means you delay paying taxes on your contributions until you “cash out” and take retirement distributions.
Why You Might Like It
Out of sight, out of mind. It’s a lot easier to stick to a savings plan when the money is automatically deducted from your paycheck each month.
Another benefit: you may owe Uncle Sam less. Since your contribution comes out of your paycheck “pre- tax” (before income taxes are deducted), your taxable income is less, so you may pay less in taxes.
If you make a withdrawal before age 59 ½, you may be subject to 10% penalty
If you retire or leave your job any time during the calendar year in which you turn 55 or older, you aren’t subject to the 10% penalty on withdrawals
Many 401(k)s permit loans with special conditions for specific reasons such as the purchase of a primary residence, education or medical expenses, or hardship withdrawals
Tip. It’s not uncommon for companies that offer 401(k) matching to require employees to work at the company for a certain amount of time before the matched funds are fully vested (ie you own the whole enchilada). It’s always a good idea to ask your employer about the vesting schedule when you’re considering contributions to a 401(k). If you want to learn more about vesting, this quick guide from the IRS is pretty helpful.
Individual Retirement Accounts (IRA)
IRAs are similar to 401(k)s in that they’re investment accounts made up of stocks, bonds, mutual funds, and other assets. But unlike 401(k)s, IRAs are accounts you can open on your own. They’re owned and managed by the individual, not the employer.
There are several types of IRAs, and each has eligibility restrictions, as well as caps on how much you can contribute in a year. The most common types are traditional IRAs and Roth IRAs, so let’s explore those in more detail.
Similar to a 401(k), contributions to traditional IRAs are tax-deferred. So you don’t pay taxes on your contributions until you take retirement distributions (ie cash out). The retirement distributions are taxed as ordinary income.
It might be for you if... you are at a salary peak or further along in your career. That’s because, with a traditional IRA you can put off paying taxes until you qualify for a lower rate. The tax advantages can really add up, and in the meantime, you’re building up nice nest egg.
Everyone with an income is eligible to open and contribute to a traditional IRA - there are no income limits
The tax deduction on contributions reduces your adjusted gross income (used to determine how much of your income is taxable), so you might get back more money on your tax return
You don’t pay taxes on any gains until later
You can use traditional IRA money to pay for qualified college expenses, and use up to $10,000 toward buying your first home, without paying an early distribution penalty. (You will pay taxes on the distribution though)
Roth IRAs reverse the tax benefit of a traditional IRA: essentially, you pay taxes now instead of later. That’s because, with Roth IRAs, contributions come out of your after-tax income. Then, later on, distributions in retirement are not taxed.
It might be for you if...you are early on in your career and expect your tax rate to go up in the future (because your earnings are going up - go you!). Roth IRAs can offer such a large tax savings - they aren't even available to high earners. The amount you can contribute begins to dwindle at $120,000 in income for single filers and $189,000 for those married filing jointly. After that, contribution limits slowly shrinks until your ability to contribute is eliminated entirely.
Roth IRAs allow for contributions of up to $5,500 per year, in addition to the 401(k) contribution limits
You contribute after-tax dollars, so you pay at your current tax rate - not the rate you'll be at when you retire
You can withdraw these accounts without tax or penalty before you retire (since you’ve already paid taxes on them). If you withdraw your investment earnings, though, you might be taxed or penalized.
You can use Roth IRA money to pay for qualified college expenses without an early distribution penalty. There are no limitations on how you can use contributions, but distributions of investment earnings might be taxed.
Accounts are not subject to minimum distributions typically required from a traditional IRA and a 401(k) beginning at age 70½, so you can pass money from these accounts onto your heirs
If your company offers a 401(k), sign up and contribute! Based on your personal budget, set up how much you want to put in your account each month and it’s taken right out of your paycheck, pre-tax. Also, ask about whether your company has employee matching or a vesting schedule.
If you don’t have access to a 401(k), you can open an IRA. Contributions to traditional IRAs are taxed later, while contributions to Roth IRAs are taxed now. Roth IRAs are typically more popular with people who are earlier on in their career, but do some digging to discover what’s right for you.
When you’re first starting out on the path to retirement savings, you probably don’t have a ton of money to put into these accounts. That’s ok, especially while you’re still working on paying off student loans and getting started in your career. The important thing at this stage is that you’re doing something rather than nothing!
That said, retirement calculators can be a helpful tool for getting a better idea of what you want to work toward. Keep in mind, these calculators rely on a lot of assumptions. Think of this as simply a good jumping off point to get a picture of how much you have and how much you’ll need, and revisit the calculator as your circumstances change.
Here are a few retirement calculators we like:
Nerd Wallet: Retirement Calculator
Bankrate: Retirement Calculator
New Retirement: Simple Retirement Calculator
Lots of financial services companies offer traditional and Roth IRAs that you can sign up for on your own. Here are some third-party review sites that help you compare these services. Note that many of these sites use affiliate links to earn commissions off of your clicks.
It might seem like a long ways off, but the actions you take now can have a real, positive impact on future, retired you. So get a start on saving. Future you deserves it. And with your budget set up, you can find the right balance that works for you.
That’s it for now. The next lesson is the grand finale. We’re going to close this thing out in style.
This material has been prepared for informational purposes only, and should not be relied on for, legal, tax, or financial advice