Workers in Their 20s Are at a Clear Advantage in Saving for Retirement.
Defined-contribution plans — i.e., 401(k)s — are the primary source of retirement savings for most. They can seem complicated at first, but they don’t have to be. Management really comes down to a few basic decisions:
No. 1 — Traditional 401(k) Versus Roth 401(k)
Roths are becoming a more common option on retirement platforms. The appeal with the Roth versus the traditional plan is the potential tax savings when distributions are made in retirement years. Money that goes into the Roth today is taxed today, but all earnings and future qualified distributions are free of tax. Contrast that with the traditional plan, where money goes in tax-free and all future growth is free from tax, but qualified distributions are taxed at ordinary income rates. Odds are, when saving in your early 20s, your marginal tax bracket will be lower than when you eventually take distributions in the future.
No. 2 — Contributing
This boils down to two primary questions: How much? and When? The answer to the first question is: as much as you can afford. Saving 10%–20% of salary is a great start. You can always adjust the percentage of salary as you home in on your budget. The key is always making sure you’re taking advantage of the full company match offered. Not doing so is like leaving free money on the table! The answer to “When?” is also simple and straightforward: As soon as possible. The following examples show the benefits of starting to compound your saving early:
Starting at 22, you save $10,000 annually in your retirement plan for 10 years, or until you’re 32. Over that period you’ll have contributed $100,000. Assuming 7% annual returns you’d have $138,164. If, for the next 30 years (or between the ages 33 and 62) you never contributed another dime but still had 7% annual returns, your account at 62 would be worth $1,051,743.
Forgo saving in the 401(k) between 22 and 32 but instead save $10,000 annually between 33 and 62. You’ll have contributed $300,000, but assuming the same 7% annual returns, your account would be worth $944,607 when you turn 62.
No. 3 — Allocation
Determining the allocation of your retirement account has a lot to do with risk tolerance. Risk tolerance, in its
most basic form, is the amount of ups and downs (mostly downs) in your account’s market value that you’re willing to stomach. In general, the more risk you’re willing to take, the more long-term return you should be compensated with as a result. Certain types of risks can be decreased through diversification. This is a big reason most investors preach the benefits of diversified portfolios. Company retirement platforms generally offer a menu of mutual funds to create a portfolio; making sure the allocation matches your risk tolerance and time horizon is crucial to long-term success. Target-date funds can also be a great alternative if creating your own allocation is daunting. Be sure to match the approximate year of your expected retirement, and the fund will automatically reallocate based on your time horizon to retirement.
No. 4 — Beneficiaries
Be sure you have selected primary and contingent beneficiaries for your retirement account. Ultimately these instructions will be used to determine who the account will go to in the event of the owner’s death. It’s very important to annually review the selected beneficiaries. Circumstances change (e.g., marriage, kids, estate planning, etc.) so confirming accurate and up-to-date beneficiaries gives peace of mind.
No. 5 — Be Aware of Fees
The mutual funds that are available for investment within the retirement plan can have a wide range of fees. Some index funds have low fees, perhaps less than 1/10 of 1%. Other managed mutual funds can have internal expense ratios over 1%. It’s important to understand the total all-in cost you’re paying when building a portfolio from limited investment options. Furthermore, be aware of services that offer to manage your 401(k) for a fee. You may have to opt out of such programs, and if they are not driving value, it’s likely better to forgo that service altogether.
This article was originally published in the November 2019 issue of BetterInvesting Magazine.
Matt Mondoux sits on the BetterInvesting investment committee and is an adviser at Blue Chip Partners, Inc., a privately owned, registered investment advisory firm based in Farmington Hills, Michigan.