From living the good life to loving the nightlife, we college students suck up scads of cash to fuel our consumer needs. However, our drive to seize the day leaves little consideration for tomorrow.
I understand that for a readership with an average age of twenty it might seem out of place to be discussing retirement, but there are several investment strategies you can take advantage of today that will help ensure a comfortable retirement later on.
Save Early
We should all have a healthy respect for the power of compound interest. The earlier you start saving, the more rapidly you can amass long-term wealth. A single dollar invested today at 9% interest (annually) will be $31.40 by the time you retire (assuming a 40-year time horizon).
If you delay even ten years to begin saving, that number drops to $13.26 for every dollar invested. Those early dollars are the ones that will enrich your retirement the most, so squirrel them away as soon as it becomes an option.
Take Risks
Savings accounts and CD's are polite forms of robbery (the former more than the latter). Large banking institutions take your money, offering you laughable rates of interest, only to turn around and invest it themselves in a number of higher-yielding alternatives. To get the returns you'll want, you will have to go to the market. That 9% interest is very much attainable over the long term with a properly diversified stock portfolio - stock market returns historically average over 11% annually.
Buying into the high-yield investments offered by the market means you will be subject to considerable volatility. For people nearing retirement, exposure to volatility is a luxury that often cannot be afforded.
However, with our retirements forty or more years ahead of us, the younger generation can afford to weather the periodic turbulence of the market and reap the consequent profits. The closer to retirement you begin to invest, the less risk you will be able to afford and the larger the portion of your savings that will be anchored in secure, low-yield bonds - cutting your overall gains.
Know Your Retirement Vehicles (and max them out!)
With the government grubbing at your hard-earned dollars, it can be difficult for your portfolio to grow. Investment gains are often taxed at both the state and federal level. From your state's marginal tax rate to federal capital gains, these taxes can be prohibitive, keeping down your portfolio's growth rate. Fortunately, several vehicles exist for ferreting away funds while keeping Uncle Sam's fingers out of your pie.
The Individual Retirement Account (IRA)
The traditional IRA is the bread and butter of your long-term investments. Every dollar you contribute (up to the annual contribution limit of $5,000) can be deducted from your gross income. This means that any monies you contribute to an IRA don't cost you a cent in income tax. Let me repeat this: money you contribute to an IRA doesn\'t cost you in income tax!
Moreover, your gains in an IRA are tax-deferred, meaning that your capital gains are not taxed until you pull money out of the account. This allows your profit to be fully absorbed into your portfolio, to grow exponentially along with the principal.
Essentially, an IRA shields a portion of your income from taxes and allows your investments to grow rapidly, free from the hindrance of taxation on capital gains. If you start an IRA today with $5,000 (you'll have to do it before filing your taxes for the previous calendar year) and contribute the maximum $5,000 per year to the account, after 40 years you will have built a nest-egg of just over $2,050,000 (assuming a 9% annual rate of interest, compounded monthly).
Alternatively, were you to invest the exact same amount of money without the benefit of tax-deferment, you will have saved barely more than $1,000,000. This radical disparity throws into stark relief the necessity of taking advantage of tax-deferral.
Tax Deferred (IRA)* Taxed Normally (28% marginal rate)
| Initial balance: | $5,000 | Initial balance: | $5,000 |
| Total deposits: | $200,000 | Total deposits: | $200,000 |
| Total interest earned: | $1,846,942 | Total interest earned: | $1,111,581 |
| Total taxes paid: | $0 | Total taxes paid: | $311,243 |
| Total Saved: | $2,051,942 | Total Saved: | $1,005,338 |
*Note that this amount is subject to your marginal tax rate upon withdrawal
So what's the catch? An individual retirement account is, you guessed it, for retirement. Withdrawing the money you invest is inadvisable before the age of 59.5, as you will be subject to a 10% penalty.
There is special recourse for withdrawals in the event of an emergency, but you will be required, over time, to pay back what you took out. Additionally, all withdrawals (early or otherwise) are subject to taxation at your marginal (income tax) rate. As such, withdrawals from an IRA should be measured to prevent your taxable income from spilling over into higher tax brackets that would take a larger bite out of your gains. Fortunately, given that your savings are meant to last you throughout the whole of your retirement, the latter is not much of a downside. As well, the 10% penalty is good incentive to leave those retirement dollars undisturbed.
The Roth IRA
Both traditional IRAs and Roth IRAs offer tax advantages for retirement savings. However, they do so in entirely different ways. While a traditional IRA offers tax deferment, a Roth IRA has you pay all of your taxes up front (your contributions to a Roth are NOT deductible from your gross income, meaning they are taxed normally).
The benefit of this IRA variant is that when you withdraw funds from the account you may do so without being subject to taxation. Every dollar you save is yours, tax-free, including any capital gains you realize (money you gain in interest is never taxed).
The maximum IRA contribution is capped at $5,000 among all variants, so you will have to choose which one is best for you. For those of you whose careers land you in the well-heeled segment of society, a traditional IRA may be most advantageous, as your income both before and during retirement will put you into the higher tax brackets, making payment of your taxes up front less beneficial and large withdrawals during retirement less impactful (from a tax standpoint).
However, for those of us whose base income will sort us into lower tax brackets, a Roth IRA may be the way to go. By paying your taxes up front, you effectively pay at the lowest possible marginal rate. Over time, as your base pay increases and you are taxed at a progressively higher rate, your initial investments will have grown, tax-free. When you retire, you are subject to zero taxation on your withdrawals.
Similar rules for withdrawal apply. As with an IRA, you must be 59.5 years of age to withdraw from your Roth. Additionally, you are not eligible to withdraw from your Roth IRA until five years have passed from the date it was initially established.
The 401(k)
As soon-to-be entrants into the job market, this retirement vehicle deserves your special attention. A 401(k) is an employer-sponsored retirement plan that is very much like a traditional IRA, though with several notable distinctions.
401(k)s have higher contribution limits than a traditional IRA. You can shield as much as $15,500 of your income (per year) from taxation via your 401(k). Gains on these tax-deductible savings are, as with an IRA, tax deferred, allowing your money to grow at the same rapid pace.
Moreover, most employers will match a portion of your 401(k) contributions, up to a dollar-for-dollar match. Matching funds from your employer are, essentially, free money, and may exceed the annual contribution limit of $15,500.
When sitting down with your employer in salary negotiations, I advise you to extract as generous a 401(k) match as you possibly can. Max out your 401(k), with or without matching funds, and (with disciplined investment) you can retire a multimillionaire.
As with an IRA, early withdrawals will set you back 10%, plus your marginal tax rate. Also, qualified withdrawals may begin after the age of 59.5 and are taxed normally as income. However, an interesting benefit of having a 401(k) is the ability to take out a loan against the principal (up to $50,000 or 50% of the account balance, whichever is smaller).
A loan taken out in this manner must be repaid to the account, with interest. The good news here is that the interest goes straight back into the 401(k), meaning you're paying interest to yourself!
Be Disciplined
Now is the time to start forming sound financial habits. Throw together a basic budget and try to get a sense of the influx and outflow of your capital. Look for the potential to save (even if you don't actually put the money away just yet) and practice cutting back in various areas of your spending. Spending a little bit less won't stop you from enjoying life, while materially improving your retirement and affording some peace of mind along the way.
With some very mild accounting and a modicum of financial discipline, you'll be prepared to max out those retirement vehicles from your first day on the job. Youth is a fleeting, yet profitable advantage. Capitalize while you can.
