Even Millennials who are encumbered with multiple student loans and credit card debt should strive to allocate money into a retirement plan instead of waiting until after their debt is paid down.
Gen Y-ers at the beginning of their careers who are faced with a large amount of debt should attempt to save a nominal amount of money into a 401(k) or IRA. The earlier consumers start saving for their retirement, the less money it will take them to reach their goal, because the interest will compound faster, said Stuart Ritter, a vice president and senior financial planner with T. Rowe Price, a Baltimore, Md.-based investment management firm.
While allocating 15% of an individual’s annual salary for retirement is the ultimate goal, that amount is likely too high for many Gen Y-ers who are just starting their careers. Instead, Millennials who can only save 3% of their income for five years will come out ahead of their counterparts who do not save anything for five to ten years and then attempt to make up the difference by allocating 20% of their funds for retirement. Such is the magic of compounding, and, indeed, starting contributions small and building up contributions is an effective strategy.
“People should develop a plan to be able to eventually save 15% of their salary such as increasing their automatic deferral by 2% every January,” he said. “You don’t reach some magical age where there are no competing priorities.”
Why Saving Now Matters
Historically low interest rates give consumers the opportunity to refinance their high interest rate student loans, credit cards or even mortgages while saving some money for their nest egg, said Jon Ulin, a managing principal of Ulin & Co. Wealth Management in Boca Raton, Fla.
Since 50% or more of Millennials are expected to live into their 80s and lack a traditional pension to buoy their retirement funds, individuals should expect to “fend for themselves,” he said.
Earmarking at least 10% of every paycheck and maintaining six to 12 months of cash reserves in case of a short-term emergency or unemployment occurs is a good strategy.
“It is critical that you start saving in your 20s and 30s,” Ulin said. “One of the biggest financial advantages you have is time.”
Estimating the amount of money people will need to spend when they are retired is not an easy task, but based on a 3.4% inflation rate, the cost of living will double every 21 years, he said.
“Just saving and investing $6,500 each year while earning 6% will land you your first million in 40 years,” Ulin said. “It may surprise you that you may need about 75% more in savings than you expected in today’s dollars when factoring in inflation for a retirement 40 years away.”
Invest More Money Without a Raise
Automating your savings is the easiest way to accumulate retirement funds, said Jamie Hopkins, a retirement professor at the American College of Financial Services in Bryn Mawr, Pa.
“This can be done by setting up automatic payroll deductions for your 401(k) plan or enrolling in payroll deductions for the myRA,” he said. “If you save the money before you spend it or set up required payments, you can help set yourself on a path for financial success.”
Auto enrollment is commonplace with most employer retirement plans, but increasing the allocation each year or when you receive a raise or bonus will help individuals boost their savings. Funds saved in a 401(k) or IRA lower the amount of your income which is taxed.
“If you do not have an employer retirement plan, you should save up to $5,500 per year into an IRA," Ulin said.
Millennials who have extra income should also consider funding up to $5,500 each year into a post-tax Roth IRA.
“Your employer retirement plan contributions have no effect on your Roth IRA contributions,” he said. “A Roth IRA allows you to grow your money tax-deferred and take out your money in retirement tax free. The best part of a Roth IRA is that is allows you to tap your principal at any time without paying taxes or penalties like a 401(K) or IRA.”
Don’t Spend Your Tax Refund
Allocating tax refunds each year into a Roth IRA will give Millennials a tax break later on when they will likely earn more money and be in a higher tax bracket, said Charles Sizemore, a registered investment adviser with Sizemore Capital in Dallas and a portfolio manager with Covestor, an online investing company. With the average refund yielding $3,000, investors who put that amount toward an IRA or Roth IRA will have reached half of the contribution limit for the year, giving them a head start on their retirement savings for the year.
Reinvesting your tax refund each year or using it to pay down debt are better strategies than spending it, said Hopkins.
“Your tax refund can actually be directed straight to the myRA Roth account to get a tax-free investment growth with a government bond,” he said. “Another option can be to use your tax refund this year to pay down outstanding debt obligations like student loans or credit card bills.” Instead of choosing investments which only pay 2% to 3% a year, pay off outstanding debt exceeding 6% to 7%, Hopkins said.
Maintaining a fear of the stock market means your returns will be lower and individuals will need to save a larger amount of money.
“In the long run, the stock market will provide better returns than bonds, CDs or even your home,” he said. “Make sure you have a well-diversified equity position to take advantage of long-term growth.”