Starting to Save for Retirement? Here’s What You Need to Know About IRAs

So you’ve been out of college for a few years, and have settled into your first real job. It’s paying the rent, but you’ve got student loans to pay back, friends to spend time with, trips and adventures and a whole bucket list of things on which you’d also like to spend that paycheck, which suddenly seems significantly smaller than it had first appeared.

Sorry to be the bearer of bad news, but planning for retirement is one of the few things in life that gets harder the longer you leave it. The good news? We spoke to financial advisers who specifically work with younger clientele to find out exactly how you should prepare for your future.

The first thing they all said was “IRA,” aka an individual retirement account — and it’s one of the best things that the federal government has ever done for young people. It lets you earn interest tax-free on money you put away every month (or every year) so that you still have a private paycheck when you retire. Ahead, we’re breaking down everything you need to know about getting the most out of yours. 

Why do I need an IRA?

Even as Americans are increasingly working well into their 70s, the wages of age may no longer be enough to cover the costs of a decent life. Even if you are one of the 20 percent of American workers with a guaranteed benefit pension plan —mostly government and union workers—you’ll likely need more money to live comfortably. 

Know your flavor: Traditional or Roth? 

Simply put, in a traditional IRA, you can invest your money without paying taxes on it now, and then pay income tax on it when you start withdrawing it. At that point it’s taxed like ordinary income.  

With a Roth IRA, you contribute after-tax money now and your withdrawals are tax-free. You are eligible to contribute to a Roth IRA if you earn below a certain income level. Roth IRAs have an additional benefit — they can serve as a tax-advantaged rainy day fund. That’s because if you need the cash you stowed away, you can withdraw your principal with no penalty and no new taxes at any time. You just have to keep the interest or appreciation in the account to avoid penalties.

Most financial advisers will say save now, pay taxes later, because you’re likely to be in a lower tax bracket when you retire. But for someone who’s still in their 20s or early 30s, it may make sense to start with a Roth, and put away what you can while your income and your tax bracket is low, and when your income rises above what it will likely be when you retire, start saving with a conventional IRA. (Of course, this depends on tax rates being more or less the same as they are now.)

When should I start?

It’s never too early to get started. The miracle of compound interest is astounding. Saving just $500 a month for 40 years would allow you to put away $240,000 over that time. But at a simple 3% annual interest, you could end up with around $464,000 at retirement time. That’s a nice nest egg. Stock market returns are riskier, but they can be sweeter. 

“Start saving into your IRA as early as possible, because of the nature of compound interest,” says Calvin Griffin, a 25-year old investment adviser at Blue Spark Capital in New York, who started his IRA at age 16, when he was scooping ice cream for a summer job. “Start as soon as you are out of college, even if you slow down when you have a kid, you are still making more in the long run than someone who doesn’t start ‘til their early 30s.”

And there can be incentives for younger people, especially low-earners. For instance, the Federal “savers’ credit” gives you a credit against your income tax payments of up to 50% of your contribution, but only if your income is at or below $34,000 (for the full 50% credit, your adjusted gross income has to be below $20,500, which means with today’s rents and food prices, you’re probably unlikely to have any money to put away at all). 

But where do I put my money?

You’ve heard about all these growth stocks — tech stocks, electric cars, online retailers and the like. How do you get a piece of that fast growth action? The answer to that is what financial advisers call “asset allocation.” That means balancing your portfolio among investments that carry different degrees of risk — and corresponding hopes of returns. Most advisers counsel young savers to put their money in a simple tracking fund. Look for a no-fee fund from a major brokerage, and track one of the main stock market indices, say the Dow Jones Industrial Average and the S&P 500. The Dow and the S&P are widely viewed as proxies for the US economy, and because they are spread among 30 of the largest companies in the US (the Dow), and 500 stocks (the S&P), they are liquid (easy to cash out of) and over the long term have always shown to grow significantly faster than inflation.

“Don’t forget the rule of 72,” says Danielle Margulis, a Certified Financial Planner at Meyer Capital Group in New Jersey. Divide 72 by the interest rate you expect to get and how many years it will take for your investment to double. Say you are getting 4% interest, then 72 divided by 4 gives you 18 years. 

How do I do it? 

Tackle the inertia of saving by using your phone or desktop. You can easily set up an automatic monthly transfer from your bank account and it’ll all be added up without you even noticing that you’re putting the money away. At Betterment, for instance, a number of easy-to-use-and-tweak features let Betterment transfer a fixed amount from your account every month, and automatically adjust your portfolio to maximize returns.

“Everyone likes the idea of saving,” says Griffin. “But little things like sitting down at the computer and making payments are easy to put off,” especially with pressure to pay the rent, student loans and all that Grubhub. “Look at it as paying your future self, not as taking money out of your budget,” says Griffin. “It will help you see your future as stress-free.”

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