If you’re in your early 20s, retirement is probably one of the last things on your mind. You’ve just entered the workforce, why would you ever start thinking about leaving it? Well, retirement is very expensive. Think about it this way, you’re going to essentially work for around 40 years, making money, funding current expenses while also putting away money for an additional 30 years retirement expenses. The last thing you want to do is go back to work at age 80 because you’ve liquidated all of your retirement nest egg.
You might be saying, well how much do I need to put away? Well, that really depends on a couple different factors: time horizon, cost of living, investment account risk tolerance, as well as the quality of life you want during retirement. A more affluent, plush post-65 life is going to require more money than a meager one. It should be noted that when planning for retirement it’s best to work with a financial advisor or planner, so they can accurately refine a plan that meets all of your requirements. This article looks to build a foundation of retirement knowledge, so you can go to both your HR representative and financial advisor with the right questions.
So how do you even save for retirement? Well, you could put all of that money in a savings account and watch it grow at a killer 0.01 percent interest rate. At that point, your money will become devalued by inflation. Best not to do that.
What is much more common are retirement specific accounts. These are qualified accounts, meaning that they meet certain requirements by the IRS. Some of these requirements include that they can’t discriminate amongst employees nor favor top level executives. Qualified accounts have certain tax benefits which we will go into shortly.
The qualified accounts that you’ve probably heard of are the 401(k) and the IRA. The name 401(k) comes from its place in the IRS tax code. A 401(k) is an employer sponsored retirement account. Here, your employer will typically match between up to 3 percent (for financial institutions it can be as high as 6 percent) of your salary to the fund. Contributions are made pre-tax, so you’ll be taxed on your distributions when you take them during retirement. The yearly contribution limit is $18,000. Matched money can be viewed as essentially “free money.” In addition to the 401(k), public schools and nonprofits typically offer a 403(b) tax sheltered annuity (TSA) which acts the same way.
The other common retirement vehicle is the IRA, or individual retirement account. The IRA comes in two forms, the traditional and the Roth variant. The Roth IRA is named after Senator William Roth from Delaware that helped to create this retirement vehicle.
The traditional IRA functions the same as a 401(k), except only an individual makes contributions. The Roth variant is slightly different. Here, if you meet certain income requirements you can qualify for a Roth IRA. Contributions made to a Roth are post-tax. This is advantageous to people that know that their future income will bump them up into a higher tax bracket. By paying taxes now, they’ll end up saving money in the long run. Typically the contribution limits are $5,500.
So how does a retirement account grow? The money you put away into these accounts is invested by fund managers into diversified mutual funds. These mutual funds are tied to the performance of the stock market, so? the value of your account can go up and down. If you retired in 2008, chances are you had a lot less money than you anticipated. The further you are from retirement, the riskier your portfolio will be, as you can always recover from a downturn in the market. Most people will move into more conservative portfolios as they near retirement, as they do not want to risk losing the money they saved up.
Wait, so what do I do if my retirement account gets hit by a down market? Well, you could sell off your assets and live meagerly, or you could make plans early on to hedge against the market. There are two ways in which you can protect yourself in a down market: cash and life insurance. No, I’m not talking about the wads of cash you’ve seen wedged under mattresses. Just like investors that move into cash during a down market, you might want to also.
Financial advisors and investors typically recommend that you have between 3 to 6 months’ worth of living expenses in cash. While this money should be saved for a rainy day, dipping into it may allow the market enough time to recover so you’re not losing a ton of money.
The other major element is life insurance, and no, you don’t have to be dead to get the benefit. While most of us are familiar with term life insurance (which has only a death benefit), whole or permanent life insurance has living benefits, one including a cash value accumulation provision. Premiums are paid and the policy accumulates a cash value that the owner of the policy can borrow against tax-free. The premiums are usually not invested in funds that are tied to the stock market, so they can be used as a hedge if the market goes down.
By taking a loan you might be able to offset the loss in your retirement account. It’s important to remember that not all permanent life insurance policies are created equal so it’s important to check with your financial advisor before pursuing one.
In addition to IRAs, 401(k)s, whole life policies, and emergency funds, we’ll all (hopefully) get some money from Social Security to help us through retirement. Investing in your retirement may be one of the most daunting tasks you do, so it’s important that you study up and work with someone to plan for your future. No one wants to be sitting at a desk, grinding away at spreadsheets while the rest of your friends are touring the world and living out their glory days in Florida.
Sources:
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“Permanent Life Insurance – A Unique Asset | Northwestern Mutual.” Accessed July 21, 2017. https://www.northwesternmutual.com/nm/permanent-life-insurance-as-an-asset.
“PLI Unique Asset.” Accessed July 21, 2017. http://media.nmfn.com/flash/permanent-life-insurance/?cmpid=LifeBreezePres_FWS-Link.
“What Are Defined Contribution Plans?” Money. Accessed July 21, 2017. http://money.cnn.com/retirement/guide/401k_basics.moneymag/index3.htm.
“What Senator William Roth Envisioned For The Roth IRA.” RothIRA.com. Accessed July 21, 2017. http://www.rothira.com/blog/what-senator-william-roth-envisioned-for-the-roth-ira.
“What’s the Right Emergency Fund Amount for You? | Vanguard.” Accessed July 21, 2017. https://investor.vanguard.com/emergency-fund/amount?lang=en.
“What’s the Right Emergency Fund Amount for You? | Vanguard.” Accessed July 21, 2017. https://investor.vanguard.com/emergency-fund/amount?lang=en.
“Whole Life Insurance – Live Mutual – MassMutual.” Accessed July 21, 2017. https://www.massmutual.com/insurance/life-insurance/whole-life.
