Thursday, July 12, 2012

Retirement Savings Options for a Young Professional

Is this type of retirement still possible?

Retirement is the last thing on the minds of many young professionals. However, with all of the turmoil caused by the recent market crash and ongoing global economic recession this should receive much more attention. To reach reach retirement comfortably young professional should start laying the ground work for retirement during their 20's when time is on there side. I've heard many young adults say that they don't know anything about investing so they never get started. The following is my attempt at a high level overview of the 3 most widely used options the 401K, the Traditional IRA, and the Roth IRA.

Traditional 401K

A 401K is a tax deferred account that is provided by an employer to its employees. In these employee sponsored plans the employee elects a percentage of their before-tax income to contribute to the account. This is known as the employee contribution. Many companies elect to also contribute to the account based on how much the employee is willing to contribute. Most companies utilize a program where they match X percent on the first X percent the employee contributes (example: 100% match on the first 3% of the employee's before tax income).

Advantages

There are two big advantages of a 401K:
  1. The money contributed is not taxed up front and is only taxed one time (upon withdrawal). This allows for a larger starting amount that can appreciate with compounding interest.
  2. Any employee contribution is essentially free money. In the event that an individual is lucky enough to get a 100% match on some percentage they contribute, they are essentially guaranteed a 100% return on their money before they even invest it. 
  3. A larger amount of money can be invested in a 401K than any type of IRA ($17,000 for 2012, $22,000 if over 50 years old)

Disadvantages

There is one main disadvantage to a 401K:
  1. A 401K plan only allows the individual to invest in a small number of funds provided by the employer or the administrator of the plan.  Typically 401K's do not have the quality or quantity of options that an IRA has. Also the funds provided in a 401K package typically have higher fees than funds found in IRA's. These higher fees can decrease the overall return by over 1%.
  2. The money invested in a 401K cannot be withdrawn before the age of 59 1/2 without paying income taxes and an additional 10% penalty.
  3. An individual must start taking distributions from the account at 70 1/2. This forces the individual to take money out every year even if they do not want to.

Traditional IRA

A traditional individual retirement account (IRA) is another type of tax deferred account. A bank or brokerage house serves as custodian of the account and determines the funds that the individual can invest in.  Typically these custodian companies allow the individual to invest in every type of fund imaginable.  Any individual is able to open a traditional IRA as long as they have the money to make the minimum contribution. However, an IRA does have a maximum annual contribution which for 2010 was $5,000 for ages 49 and under, and $6,000 for ages 50 and above.

Advantages

A traditional IRA has two advantages:
  1. Like the 401K a traditional IRA is a tax deferred account where the money is only taxed upon withdrawal. This gives a head start to compounding interest.
  2. The traditional IRA has more quality and quantity of investing options.  In an IRA an individual can invest in nearly anyway they choose.

Disadvantages

The traditional IRA has two main disadvantages:
  1. Depending on your age you may only contribute $5,000 or $6,000 per year. This means if you are lucky enough to have more that that amount to save towards retirement each year you will have to look at another account type for the rest of your savings.
  2. As with the 401K, an individual must start taking distributions from the account at 70 1/2
  3. As with the 401K, any withdrawals made before 59 1/2 will be hit with a 10% penalty.

Roth IRA

A Roth IRA is similar to a traditional IRA in structure. It is managed by a bank or brokerage institution. However, there are many differences between the two. A Roth IRA is not a tax deferred account.  The money contributed to a Roth IRA is "after tax" money, but the money is not taxed when withdrawn from the account.

Advantages

The Roth IRA has a couple of advantages:
  1. The money contributed to the account is "after tax" money.  This means that at any time the money contributed can be withdrawn from the account (not including interest) without penalty.
  2. There is no age at which distributions are required.  The individual can leave their money in the account for as long as they want. This makes a Roth IRA a good way to leave money as an inheritance.

Disadvantages

The Roth IRA has one disadvantage:
  1. Depending on your age you may only contribute $5,000 or $6,000 per year. This means if you are lucky enough to have more that that amount to save towards retirement each year you will have to look at another account type for the rest of your savings.

I hope this overview will start to get young adults thinking about which investment type could work for them. In subsequent posts I plan to build on this overview and discuss retirement strategy as well as other savings such as emergency savings, large purchase (house/car) savings etc.

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