Question: I’m 22 years old and just started my first job out of college. I have the option of contributing to a 401(k) retirement account. Do I really need to start saving for retirement so young? ~Tanner, San Francisco, CA
Answer: This is a question I get a lot from young people so I’ll try to answer both your question and the many related questions I’ve received. There are rarely right or wrong answers in investing, only better or worse decisions. The “answers” below are simply my personal opinion, not hard facts.
The Short Answer
If you would like to retire some day, you should start saving for retirement as soon as possible. Invest as much as you can afford in a Roth IRA and 401(k). Choose an index fund with a low expense ratio (like an S&P500 index fund).
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The Long Answer
Should I contribute?
Yes. Your grandparents grew up in an age where they worked at one company for life and that company provided them with a retirement pension. We no longer live in that age. Today, people take many jobs over the course of their lives and are responsible for their own retirements. That’s just the way it is. Social security is underfunded and the rising national debt and aging population add up to a situation where the government cannot possibly afford to give your generation as much in Social Security as it pays now (which is not a lot). If you do end up getting some Social Security, that’s great, but relying on that would be a huge gamble. You MUST save for your own retirement. If you do not, you will probably be poor when you are old or will have to work forever.
How much should I save?
As much as you possibly can. Savings when you are young have decades to compound. A dollar saved at age 25 is worth about 20 dollars at age 65. So think of every $5 coffee you buy as robbing your 65 year-old self of $100. Most financial advisors recommend saving at least 10-15% of your income. Keep in mind that it will be harder to save once you have obligations like kids and a mortgage, so try to get ahead now.
What type of account should I invest in?
Order of priority:
1. Contribute to a 401(k) up to the employer match because it’s free money
2. Max out an Individual Retirement Account (IRA)
3. Max out your company 401(k)
4. Invest any remaining savings in regular taxable accounts
Why? Free money is free money – take it! Max out your IRA & 401(k) (tax-advantaged accounts) before your taxable accounts because the tax savings are huge over time (more on that later). Do the IRA before your 401(k) because IRAs give you greater flexibility in terms of investment choices and withdrawal options and generally charge lower fees.
What is a tax-advantaged account?
The government wants to encourage you to save for retirement so they allow you to avoid some taxes if you commit to putting your money away for that purpose. There are two types of tax-advantaged accounts – IRAs and 401(k)s. Because tax-free investment growth is super valuable and a gift from the government, they put limits on how much you can contribute:
Limits in 2013
IRA – $5,500 limit
401(k) – $17,500 limit
You can do both so your total limit is $23,000. Learn more about IRA contribution limits.
This picture shows the benefits of a tax-advantaged account. A 22 year old who invests $5,000 (and never invests again) can expect to have $137,000 at retirement if he put it in a Roth 401(k) or IRA, but only $101,000 if he put it in a regular investment account (assumes 8% annual return, 3% dividend yield and 25% tax rate). Tax-advantaged accounts are very valuable so use them!
Roth or Traditional?
Both IRAs and 401(k)s let you choose Roth or Traditional (although some companies don’t offer the Roth 401(k) option). Roth means you pay the taxes up front (invest with after-tax income) and then the investment grows tax-free and you get to eventually spend it without ever paying any more taxes on it. Traditional is the opposite – you pay no income tax up front (contributions are tax-deductible), but you pay taxes years from now when you cash out. So the question is “Will my tax rate be higher when I retire or now?” For most people the answer is higher when you retire so I recommend Roth. The current national debt and demographics mean tax rates will likely have to go higher over the coming decades for almost all income brackets. Also, as you get older you are likely to earn more money and be in a higher tax bracket. The only caveat is that you probably won’t be earning much income in retirement so you may be back in a low tax bracket. It’s a judgment call, but in my opinion, the best answer for most people right now is the Roth. Some people choose to hedge their bets by doing a combination of Roth and Traditional. This is a perfectly valid strategy too.
What is a mutual fund?
A mutual fund is an investment option that pools your money with other investors’ money and buys a bunch of stocks. Instead of owning a piece of just one company (buying a single stock), you own a smaller piece of many companies (usually at least 500 and often thousands). A mutual fund is a good idea because it is well diversified since it holds a share of so many different companies. This means you aren’t overly exposed to any one company’s shenanigans so you won’t bet your whole future on the next Enron (which committed accounting fraud and went bankrupt).
What is an index fund?
Some mutual funds are run by portfolio managers who actively choose which stocks to buy, trying to predict which will earn the highest returns. This is called “active” investing. Other mutual funds simply invest in the stocks in a particular index, like the S&P500 or the Russell 2000. Most well known indexes are just a list of the largest companies, but there are also specialty indexes for industries (like Healthcare or Technology) or style (Value Investing or Growth Investing) or company size (Small Cap, Large Cap, etc). An index is just a list of stocks that fit certain metrics for inclusion in that index. Mutual funds that invest by buying all the stocks of an index are considered “passive” investors since they aren’t actively choosing which stocks they think will outperform. These passive, index-following mutual funds are called “index funds.”
Which fund in my 401(k) should I choose?
1. Index Funds – Empirical evidence is very strong that “active” funds (where managers pick stocks) do not outperform passive funds (where the fund invests in a market index) after expenses so I do not believe it’s worth paying for active management. Sure, a great investor like Warren Buffet does occasionally beat the odds, but are you able to spot a Warren Buffet ahead of time? I know I’m not. So choose a fund with the word “index” in the name.
2. Low Fees – Mutual funds take a percentage of the money you invest to run the mutual fund. This percentage is called the “expense ratio” and it’s in the description of your fund. Check the expense ratios of your mutual fund options and go for the lower ones. Anything above 0.50% is too expensive, in my opinion.
3. Stocks vs. Bonds – Stocks (ownership of a company) and Bonds (lending money to a company for interest) should both play a role in your investment portfolio. Stocks are riskier, but have a higher expected return. Bonds add diversification and increase your portfolio’s risk-adjusted return. A good rule of thumb is to invest your age in bonds and the rest in stocks. So a 22 year old would invest 22% in bonds and 78% in stocks. We have also created an info graphic with more details on recommended asset allocation by age. If you’d rather have someone else make this allocation decision, many 401(k)s and IRAs offer “target date” mutual funds that allow you to choose your projected retirement date and have them do the stock vs. bond allocation for you, updating it as you age. Be careful though – many target date funds have high expense ratios and you could easily replicate it yourself at lower cost with a stock index fund and a bond index fund in the proper proportion.
4. Domestic (U.S.) vs. International – A mix of different exposures in your portfolio (stocks and bonds, domestic and international, etc.) increase your risk-adjusted return through diversification (a complex topic for another day). If you choose just one fund, it’s fine to go with just a U.S. fund like an “S&P500 index,” but if your 401(k) provider offers an international fund at a low cost (0.50% expense ratio or less), you might consider putting up to one-third of your money there. As you build your portfolio over time you may want to consider adding specialized funds like real estate investment trusts (REITs), commodity funds, and emerging market funds (investing in young economies like India and China).
Isn’t investing risky? What if I lose money?
Yes, investing is risky and there’s no guarantee you will finish with more money than you started. But consider the alternative. Inflation (the rate at which prices increase) averages about 3% per year so if you keep your savings in cash you will lose significant purchasing power over time. Even if you invest in Treasury Inflation Protected Securities (TIPS) and match inflation, you will still need to save every dollar during your working career that you will spend during your retirement, in real terms. That’s much more than most people will be able to save. Luckily, there is a better way. By investing in stocks and bonds you are allowing a company to use your savings productively to run a business until you need it back. In return, you expect them to compensate you by more than the rate of inflation. Some investments work out and others don’t, but a well-diversified portfolio has historically beaten inflation by a meaningful amount. If you are uncomfortable with high risk, you can invest more heavily in bonds than stocks, but you can expect to have lower long-run returns and have to make up the difference with increased savings. The choice, however, is yours.
Won’t my money be locked up for a long time?
Yes, and that is a good thing (see the first question). You can get into some tricky accounting with borrowing from your 401(k) or cashing out when you change jobs and paying steep penalties, but that is a really bad idea. Sock away money for retirement and think of it as untouchable. That is the only way you’ll ever retire well.
Do I need to start saving at such a young age?
“The most powerful force in the universe is compound interest.” ~Albert Einstein
Time is your most valuable contributor to retirement savings because investment returns compound over time. The below graph shows what a one-time contribution of $5000 at age 22, 25, 30, 40, 50, and 60 could be expected to grow to by age 65, assuming an 8% annual rate of return. So yes, I recommend starting as soon as possible.
What happens if I leave the company?
The money goes with you. I recommend doing a “rollover” into an IRA so that your retirement money is all consolidated in one place. IRAs also have more investment options and often lower fees than 401(k)s. It’s very easy to do and IRA managers are very happy to help you do it (they want you investing more money with them!). Whatever you do, please do not cash out your 401k when you leave a company. You will pay taxes and penalties and most importantly, your will lose your tax-advantaged investment and set your retirement back in a serious way.
About the Author
Joanna D. Pratt, CFA is an experienced institutional investor. She holds a bachelor’s degree in economics and certificate in finance from Princeton and an MBA from Stanford.
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