I’m going to preface this article by saying that I am not an expert in retirement plans. I am self-taught, with a lot of help from both of my parents, some books, and the internet. Before you open any account, I highly recommend speaking to an expert and exploring all of your options. I also advise reading How to Be Richer, Smarter, and Better-Looking than Your Parents by Zac Bissonnette, which offers financial advice to students and young people in a fun and understandable way. (Thanks for getting it for me, Dad!)
“When should I start saving for retirement?” has a very simple answer: as soon as you possibly can. For most people, this happens in their early- to mid-twenties, but others may wait until they’re 30 or older depending on their financial situation. Simply speaking, the younger you begin saving for retirement, the more of a return on your investment you’ll see when it comes time to actually retire. The reasoning for this is that your money has more time to grow and if you invest young enough, the money you’ve earned through interest, dividends, and market changes also has time to grow.
Think of it this way: If you invest $5,000 each year starting at age 25 and stopping at age 30 (for a total investment of $30,000) and earn 7% annual returns on investment, you’ll have over $408,000 by the time you’re 65. If you wait until you’re 35 years old to start saving for retirement, invest $5,000 each year from ages 35 to 40 (for a total investment of $30,000), and earn 7% annual returns on investment, you’ll have just under $208,000 by the time you’re 65. Even though you’ve invested the same amount of money, waiting 10 years to do so significantly lowers your growth. (Of course, the above scenarios are barring any recessions and market fluctuations. These do happen, but the longer you invest, the more likely your accounts are to recover from any changes—another reason to start saving when you’re young.)
Most people don’t start saving for retirement until they have completed their education and started earning steady paychecks. If you worked in high school, though, and have built up a savings (that you won’t need to tap into to pay for education, housing, etc.), you could hypothetically start saving for retirement sooner. While you may not be able to “max out” your annual deposits, the money that you invest early on has the highest potential for growth. Once you graduate and start working, you may be able to increase your annual contribution to your retirement account.
If you’re lucky, at some point in your life you will work for a company that offers an employer-sponsored retirement plan. Often, you can tell your employer to take a percentage of your paycheck and invest it on your behalf in an account like a 401k or a Thrift Savings Plan. Some companies will offer plans where they will match your contribution to your account (free money!), while others will make contributions for you or offer you stock options instead. The type of retirement plan depends on the company for which you work; sometimes the same company will offer multiple plans. Be sure to explore all your options and talk with both an HR representative and financial adviser before making any decisions.
If you don’t work for a company that offers a retirement plan to it’s employees, there are still ways for you to save for retirement. No, this doesn’t mean that you funnel all of your extra cash into your savings account. In fact, you shouldn’t. Most of the savings accounts offered through banks have dismal interest rates, rarely breaking 1.5%. With a retirement account, your return on investment is tied to market fluctuations and the types of investments you choose to make. According to Bankrate, “The Standard & Poor's 500 (S&P 500) for the 10 years ending December 31st 2016, had an annual compounded rate of return of 6.6%, including reinvestment of dividends.” This is significantly higher than what you will find through your bank. Remember, though, there is no predicting the future. Investing in a retirement account is inherently a gamble. That being said, if you’re ready to save, there are two types of individual retirement accounts to choose from:
Contributions: Individuals may contribute up to $5,500 ($6,500 if they’re older than 50) to a Roth IRA each year. However, there are income limits for individuals who want to contribute to these accounts. If you’re single, you must make less than $133,000 annually; if you’re married filing jointly, you must make less than $196,000 annually. The total amount of money you are allowed to contribute to your Roth IRA is reduced if you make more than $118,000 (filing single) or $186,000 (married filing jointly). If you are married filing separately and lived with your spouse at any point during the year, you may only contribute to your Roth IRA if your income is less than $10,000 annually.
Taxes: Any money that you choose to put into a Roth IRA must first be taxed. When you take money out of the account in retirement, however, you will not have to pay any taxes, since you’ve already done so. This is a terrific advantage if you don’t need the tax break at the time of contribution.
Withdrawals and Penalties: If, for some reason, you need to take money out of your retirement account before you reach retirement age, you may do so. Provided you take out a sum of money that is less than the total you have contributed to the account (you’re taking out less than what you paid in, not anything that you’ve earned), you will not have to pay a penalty fee. If you withdraw more money than you’ve contributed before you turn 59 ½ years old, however, you will be taxed on it and subjected to a 10% penalty fee. After you turn 59 ½ years old, provided the account has been open for longer than five years, all withdrawals are tax- and penalty-free.
Age Limits: There is no age at which you must begin mandatory withdrawals. You can leave your money in your Roth IRA for as long as you want. You can also continue to contribute to your Roth IRA for as long as you want, provided you meet the income requirements. The longer the money stays in your account, the more it will grow.
Contributions: Individuals may contribute up to $5,500 ($6,500 if they’re older than 50) to a traditional IRA each year. If your income was less than this limit, you may contribute the full amount of your income. There is no cap on income; you can contribute to a traditional IRA each year no matter how much money you make. However, your tax deductions will vary based on your income.
Taxes: Money that is put into a traditional IRA is done so before taxes and you may receive a tax deduction at the time of contribution. The amount of money you can deduct on your taxes depends on your contribution, whether you have a employer-sponsored retirement plan, and whether your spouse has an employer-sponsored retirement plan. Upon withdrawal from the account, taxes must be paid.
If you also have an employer-sponsored retirement plan, your tax deduction will vary. If your income is more than $72,000 (filing single) or $119,000 (married filing jointly), you will receive no tax deduction. If your income is between $62,000 and $72,000 (filing single) or $99,000 and $119,000 (married filing jointly), you will receive a partial tax deduction. If your income is less than $62,000 (filing single) or $99,000 (married filing jointly), you will receive a full tax deduction up to the amount of your contribution limit. If you are married filing separately and lived with your spouse at any point during the year, you will receive a partial tax deduction if your income is less than $10,000 annually.
If you do not have an employer-sponsored retirement plan, but your spouse does, you will receive a full tax deduction for the amount of your contribution if your income is less than $186,000 (married filing jointly). You will receive a partial deduction if your income is between $186,000 and $196,000 annually. You will receive no deduction if your income is over $196,000. If you are married filing separately, you will receive a partial deduction if your income is less than $10,000.
If neither you nor your spouse have an employer-sponsored retirement plan, you will receive a full tax deduction up to the amount of your contribution limit.
Withdrawals and Penalties: If you remove money from your account before the age 59 ½, you must pay taxes and a 10% penalty on the amount of the withdrawal. Any withdrawals after the age of 59 ½ are subject to standard income tax.
Age Limits: Provided you are younger than 70 ½ years old and have an income, you can continue to contribute to a traditional IRA. However, once you turn 70 ½ years old, you are no longer permitted to contribute. That same year, you are also required to begin making withdrawals, called “required minimum distributions.” The amount that you are required to take out depends on the balance of the account and your life expectancy.
There’s no right answer when deciding between a Roth and traditional IRA. It depends on whether you have the money to pay taxes now or would rather pay them later, as well as your income level and filing status with the IRS. If you are deciding between a Roth and traditional IRA, first take a look at your income. There are income limits for Roth IRAs, so if your income is too high, it’s an easy decision; your only option is a traditional IRA. If you can see it both ways, though, talk to a financial advisor before making a decision.
You may also choose to open both a traditional and a Roth IRA. However, if you choose to open both types of accounts, the same contribution limit stands; no more than $5,500 (or $6,500 for individuals over 50) can be deposited between the two accounts each year.
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