Starting a full-time job can be daunting for more than a few reasons. New coworkers, new environments, and an abundance of information to learn paired with a limited timeframe in which to learn it can make the prospect of starting work intimidating for any young adult. One of the most stressful and confusing subjects across all industries, however, is how to properly save for retirement. To many, the idea of foregoing money now in order to receive money later seems impractical. When young adults first start full-time work their expenses are high and their salaries are low; it may seem more reasonable to spend money on expenses when they are young and begin saving later than to go without today and have more money in the distant future.
To some extent, that logic can be correct in certain situations. If a worker has to choose between saving for retirement and paying off high-interest debt, such as student loans or credit cards, it is usually better to pay off the debt. As wonderful as compound interest is when applied to savings, it can be equally devastating when applied to debt. In most other cases, however, it is better to begin saving for retirement as soon as possible.
After someone makes the decision to save, they have to determine what method of saving is best for their unique situation. This means evaluating where they are in their life and career, and where they expect to go. For most young adults this might seem like a veritable shot in the dark; how can they expect to know where they will be in fifty years when they barely even know where they’ll be in five? Thankfully, for most Americans there are three main plans to consider: Employer-sponsored plans (such as 401(k)s and 403(b)s), Traditional IRAs, and Roth IRAs.
Individual Retirement Arrangements, or IRAs, are tax-advantaged savings accounts that an employee can contribute to on a limited basis even after maxing out employer-sponsored plans like 401(k)s or 403(b)s. Traditional IRAs are tax-deferred, which means contributions aren’t taxed until money is withdrawn. Roth IRA contributions, on the other hand, are fully taxable, but their earnings and withdrawals are generally tax-free. Employee-sponsored plans are tax-deferred, like Traditional IRAs, but may receive contribution matching by the employer. This difference makes one method of comparison immediately evident: A Roth is preferable to a Traditional or 401(k) if you expect to be in a lower tax bracket when contributions are made than in retirement. The opposite is true if you expect to be in a lower tax bracket during retirement.
This is most apparent when applied to an example. Say you deposit $5,000 into a Traditional IRA or Roth IRA at age 20, when your income tax is 15%, and leave it there for 50 years at an average annual return of 4%. You withdraw the entirety of the account at age 70, when your income tax is 30%. The initial after-tax contribution to the Roth IRA will be $4,250, which will grow to $30,203 over 50 years. The initial contribution to the Traditional IRA will be $50,000, which will grow to $35,533.42, but after a 30% tax on withdrawal will only put $24,873 in your pocket. The same comparison would be true between a 401(k) and a Roth.
Of course, this is a very simplified view of retirement plans that only addresses the tax benefits of each account type. Other factors such as AGI, debt level, and actual projected retirement income should all be considered when determining how to save for retirement. For more information on how best to supplement retirement savings in your specific situation, contact a financial professional.