Betty Xiong: Ask GFC 012 – Retirement Planning on Your First Job

Sunday, September 25, 2016

Ask GFC 012 – Retirement Planning on Your First Job

When people who are just starting out in their careers recognize the importance of getting their retirement savings under way, they’re heading in the right direction.

But how to do it mechanically is where the questions come into play.

ask GFC - Retirement Planning on Your First Job

Daniil asks:

“Hi Jeff,

I am a recent college graduate and am starting a new job next week. This will be my first real full-time job. The company offers a 6% match on a 401k. My question is: what would you recommend for me to really jump-start my savings for retirement?

Thanks,
Daniil S.”

Good for you in deciding to initiate your retirement savings immediately Daniil! Congratulations – you’ve already taken that all important first step by deciding to make it happen now.

Trust me, one of the biggest mistakes with retirement planning is when young adults put off retirement savings for a someday that never arrives – or arrives too late in the game.

Daniil is asking specifically what would really jump-start her retirement savings? I have some suggestions, Daniil, and they go in a few different directions. I’m going to make recommendations that take a holistic view of your financial situation, rather than limiting it to retirement savings alone. And believe it or not, it’s all related! But then, that’s what financial planning is all about.

Take a Retirement Detour – Create a Financial Buffer

“Life is what happens to you while you’re busy making other plans.” – John Lennon

This applies to your finances as much as it does to life in general. While you’re saving money for retirement, other situations will arise that will require funding. By anticipating these future needs, you will enable yourself to continue funding your retirement, as well as removing the need to tap your retirement savings early.

In addition to contributing to your 401(k) in a sufficient amount to max out your employer matching contribution, you should also do the following:

Set up an emergency fund. You should have enough money in liquid savings to cover cash emergencies or even a temporary job loss. This should generally be an amount equal to at least three months of living expenses. Your emergency fund will provide you with ready cash so that you don’t have to dip into retirement money early.

Get out of debt. The debt treadmill often starts early in life! People start borrowing money when they’re young, and it gradually becomes a lifestyle. For that reason, you should work to reduce your debts while you’re saving for retirement. This is especially true if you have credit card debt. Not only do they charge very high interest rates, but by eliminating them you’ll have more money for everything else, including more retirement savings.

Save up for major purchases. When you’re young, there’s usually a long list of major purchases in front of you. Those purchases could include vacations, a car, furniture for an apartment, the down payment on a house, or even an upcoming wedding. You should start saving for any of these as soon as you see them on the horizon. That will keep you from either borrowing or taking money out of retirement to pay for them.

Why am I recommending that you take the steps? As money begins to accumulate in retirement savings, people sometimes raid those savings early to cover any of the contingencies above. That’s an almost natural outcome when most or all of your money is in retirement savings alone.

The problem with that strategy is that it is very expensive! You not only have to pay regular income tax on the withdrawals, but you’re also subject to an early withdrawal penalty tax equal to 10% of the distribution. That means that early withdrawals from retirement can cost you 30%, 40%, or even 50% in taxes.

The purpose of setting up these additional strategies is to prevent that from happening. Think of it as part of your overall retirement plan.

Set Up a Roth IRA

With all of the above covered, the next best step is to set up a Roth IRA. Unlike your 401(k) contributions, your contributions into the Roth will not be tax-deductible. But the investment earnings within the account will be tax-deferred. And when you begin taking withdrawals from the account the money will be fully tax-free.

That alone should be sufficient reason to add a Roth IRA to your retirement mix. But there’s even more.

The contributions that you make the plan can be withdrawn tax-free for just about any purpose. In this way, a Roth IRA can also function as a backdoor emergency savings account (though I don’t recommend it for that purpose!). But equally important is the fact that Roth IRAs, being self-directed, typically have more investment options than the average 401(k) plan.

You can contribute up to $5,500 per year to a Roth IRA. I strongly recommend that you work this into your overall financial plan – especially once you have an emergency fund fully stocked, and your credit card debts paid off.

Invest Up to the 401(k) Maximum Allowed

If all of the above steps have been completed, any extra savings that you have should be directed into your 401(k) plan, up to the maximum amount allowed.

The IRS allows you to contribute up to $18,000 to your 401(k) plan each year. In combination with your employer matching contribution, this is a powerful way to accumulate a large retirement plan very early on.

For example, let’s say that over the next 10 years your average income is $75,000. You contribute the maximum of $18,000 each year. In doing so, you also get the maximum employer matching contribution of $4,500 ($75,000 X 6%). That means that $22,500 is going into your plan each year, on average, for a total contribution of $225,000 over the decade.

Assuming an average annual rate of return on your investment of 7%, the account would grow to $344,000 after 10 years. At that point, you could even stop making contributions to the plan. And in another 30 years – still assuming a 7% average annual rate of return on the plan – the balance would grow to over $2.6 million! You’d be able to retire comfortably even if you don’t make any additional contributions.

If Daniil is say, 25 right now, that would be an awesome position to be in at age 35!

I hope this helps you to reach your financial goals Daniil, and anyone else who’s right out of school and taking their first job. How well you start has a lot to do with how well you finish, so now is the time to ask questions and take action. So ask away, and I’ll try to answer as many questions as possible.