You did it. School is finished, and you finally have that prized sheepskin in hand. You even managed to land that first good job.
Congratulations! You’re well on your way to retirement!
While having enough money for a secure retirement may be the last thing about which you’re thinking right now, it is the single most important financial goal you will ever have. Accordingly, the sooner you get started, the greater the chances that you will achieve it.
For young investors, the power of compound interest is one of the key components to the success of long-term investing efforts. An early start to the process of reinvesting earnings, or earning interest on interest, allows you to meet your eventual goals without the stress and sacrifice demanded of folks who begin investing for retirement later in life. Because of compound interest, a 23-year-old who socks away $350 a month into an account that posts an average return of 7% per year will have a little over $1 million at age 65…and of that million, only $176,000 will represent principal.
What’s more, you can further maximize the power of compound interest by investing your paycheck under a tax-deferred “umbrella” that allows your invested monies to grow unencumbered by tax consequences to interest, dividends, and capital gains. For most people, this means going with a company-sponsored plan, usually a 401(k), or the do-it-yourself option, the Individual Retirement Account (IRA).
Is one account better than another? The advantage of the 401(k) is that it comes with (much) higher annual contribution limits – for people under 50, $18,000, vs. $5,500 for an IRA. Many companies also offer the unbeatable benefit of company matching, where your job matches your own contributions to the plan, up to a certain percentage of your annual salary. Additionally, 401(k) contributions are made with pre-tax income.
As for IRAs, while contribution limits are lower and there is no matching, you can set up the account at basically any kind of financial institution. This includes discount brokers, where the breadth of available investment options – stocks, mutual funds, exchange-traded funds (ETFs), and more – provides a distinct benefit over the more limited vehicle choices in a 401(k).
Note that if you are inclined to open an IRA, you will have to decide whether to open a traditional or Roth IRA. So, how do you choose between the two?
If you’re making a bunch of dough right now – talk about a good problem to have – and expect to be in a lower tax bracket once you retire, the traditional IRA should be your focus. Conversely, if you are at the relative bottom of the income food chain, presently, and anticipate that your tax bracket will be higher when you retire, the Roth will be the way to go. The reason is that contributions to a traditional IRA are tax-deductible in the tax year you make them (subject to limitations), but the withdrawals you make once you retire will be taxed as ordinary income. With the Roth, the tax benefit essentially works in reverse; contributions to a Roth IRA are not tax-deductible because they are made with after-tax dollars, but when you retire, the withdrawals are entirely tax-free – a good deal if you expect any combination of earnings and retirement withdrawals to put you in a higher tax bracket during your Golden Years.
By the way, you may have both kinds of IRAs, and many people do. That is, some folks hedge their bets and make contributions to each (you are stuck, however, with the annual contribution limit of $5,500, regardless of how many IRAs you own).
For the time being, though, you should try to keep things simple: Unless you’re making a lot of money right now, the Roth is likely your preferred option.
The matter of traditional vs. Roth IRAs aside, your first order of business is to look for any matching available from your new employer. If it is there, you’ll want to concentrate on a 401(k) up to the point where the matching stops. Even if your employer does not match what you put in dollar-for-dollar (and many do), a 50% match means that you’re earning a 50% return on your contributions from the outset.
If the company plan happens not to offer any kind of matching, your best approach will usually be to maximize the IRA first, and then fund your 401(k) with any money you still have available. The reason IRAs are better in this case has to do with the enormous variety of investment choices – your 401(k) will never have as many options as you’ll find in an IRA.
In a nutshell, then, matching (company plan) is best; wide variety of investment choices (IRA – traditional or Roth) is next-best; and tax-deferred growth, a standard feature of both accounts, is always good.
If your investing plans do include an IRA sooner or later, a discount broker will usually be the best place to open one. Discount brokers afford you the best of both worlds – a great many investment options, as well as the most competitive fee structures, in comparison to other institutions.
There is a wide variety of discount brokers from which to choose. As a new investor, pay close attention to the choices that provide you with the best and lowest-cost options for investing in mutual funds and ETFs, investment vehicles that won’t demand as much of your valuable time to oversee. Both TD Ameritrade and Charles Schwab, for example, offer a veritable universe of commission-free ETFs and no-transaction-fee mutual funds.
So, the good news is that you graduated, and the better news is that you landed that first job. Maybe the best news of all? Reaching the first two goals has provided you with the opportunity to begin your journey toward building a meaningful retirement portfolio, something that may not seem all that urgent now, but will, one day, be among the most important of things.
The information contained here is for general information purposes only. The Financial Writer blog and Bob Yetman disclaim responsibility for any liability or loss incurred as a consequence of the use or application, either directly or indirectly, of any information presented herein. Nothing contained in this article, or any other article featured at this blog, should be construed as a solicitation or recommendation to engage in any financial transaction. You should seek the advice of a qualified professional before making any changes to your personal financial profile.