There’s no such thing as “too early” when saving for retirement. Some parents open Roth IRAs in their children’s names when they’re young to give their money as much time as possible to grow. You’re in an advantageous position for recent college graduates because you’re hopefully preparing to enter a high-paying job with an employer-sponsored retirement plan.
Retirement Now for New Graduates?
Even if you’re not entering a job with that “retirement” perk, there are ways you can start thinking about retirement now that will make your life significantly easier. In this article, we’ll break down some of the critical pieces of information you’ll want to have about retirement planning.
Though we’ll focus on strategies and savings plans relevant to recent college graduates, this is good information for everyone, regardless of age.
Key Takeaways
- If you have access to an employer-sponsored 401(k), try to maximize your contributions and take advantage of any contribution-matching benefits.
- A traditional IRA is funded with pre-tax money, meaning you can enjoy current-year tax benefits by getting a tax break for contributions you make in the present.
- A Roth IRA is an excellent option if you think you’ll be in a higher tax bracket at retirement than you are now. Roth IRAs are funded with after-tax money, meaning you pay taxes on contributions you make in the present, but don’t pay taxes on what you withdraw during retirement.
Why Should You Start Saving Now?
None of us stay young forever. And as we age, we eventually lose the energy to continue working. When you retire, you’ll need an income to maintain your quality of life, and more most people, Social Security payments are not enough. The average monthly benefit for retired workers in 2022 was $1,825, with recipients reporting that Social Security accounted for an average of just 30% of their income.
So where will you get that extra money? Typically from a retirement savings account?
Starting a retirement savings plan when you’re young is essential because the more time you spend saving, the more money you’ll have by the time you retire. Compound interest allows you to make your money work for itself. The basic principle of compound interest is that you can earn interest on the previous interest you already earned. Taking advantage of this is key to maximizing your retirement savings.
It’s entirely possible to run out of money during retirement. Saving early is the key to avoiding that situation.
What Retirement Savings Options Are There?
The retirement savings account you’ve probably heard of is the 401(k). This employer-sponsored retirement plan allows employees to defer money directly from their paychecks into their savings accounts. A 401(k) moves money out of your taxable income, meaning you pay less in income taxes each year if you contribute money to your retirement account.
You’ll only pay taxes when you withdraw money at retirement. Often, employers will offer what’s called company matching. This means they’ll match your contributions up to a specific limit. Take full advantage of this benefit if provided to you, as it will increase your savings by a significant margin.
If you don’t have access to a 401(k), the other popular option is to open an Individual Retirement Account (IRA). There are generally two types of IRAs – traditional and Roth IRAs. The former is a tax-deferred account, meaning you contribute pre-tax money to the account and pay taxes at retirement age when you withdraw money.
A Roth IRA is funded with after-tax money, so while you won’t enjoy tax benefits in the current year as you contribute, your money grows tax-free and isn’t liable to taxes when you withdraw it.
Roth IRAs are popular among recent graduates because most of them anticipate being in a higher tax bracket by their retirement age. The logic is that it’s wiser to pay taxes when you’re young and in a lower tax bracket, rather than wait to pay taxes when you’re older.
You can set up an IRA at almost any bank or brokerage. All it takes is a signature and an initial contribution to your account.
If you’re self-employed or run a business with your partner, you can also open a solo 401(k) and contribute to it as both employer and employee.
How To Divide Your Paycheck
You may still wonder how much money you should put into a monthly retirement account. In 2021, the annual contribution limit for traditional and Roth IRAs was $6,000. That amount applies to all your IRAs, so don’t think you can save more just by opening more accounts. The contribution limit increases when you’re over 50 years old so you can save at a faster rate leading up to retirement.
While there’s no exact amount we recommend since everyone’s financial situation is different, it’s a general rule of thumb that 50% of your paycheck should go to essentials, 30% should go to “wants,” and 20% should go into savings.
Essentials could include rent, car repairs, insurance payments, utilities, and groceries. “Wants” might consist of things like movie tickets, drinks with friends, or a fancy dinner with a significant other. The 20% of your paycheck you put into savings doesn’t need to be entirely dedicated to a retirement account.
Investing in things like stocks, mutual funds, or ETFs is smart when you’re young because the stock market has always historically increased, so putting your money there for a longer period of time will likely lead to higher returns than a traditional savings account.
Other Finance Tips for Recent Graduates
There are many other money-related tips it’s good for recent graduates to keep in mind. One of the most important is to start keeping a budget. It’s easy to go through young adulthood not focusing too much on expenses, but as you get older and closer to retirement, you’ll want to make every last dollar count.
Building an emergency fund is another essential thing to do for recent college graduates. Most Americans currently don’t have the savings to afford a $1,000 emergency expense. Try to build three to six months’ worth of savings so you can be ready in the event you’re unexpectedly laid off.
A third tip we have for recent graduates is to automate their savings and card payments. You don’t want to miss payments or forget to transfer part of your paycheck into savings. Automating these paycheck deferrals is a great way to take the ball out of your court and force yourself to save consistently.
Spending less money on your credit card is another great piece of advice many young people don’t know about. How much credit you use factors into your credit score, so minimizing the amount of money you spend will actually help you in the long run.
Make a financial plan with concrete goals in mind, like when you want to retire and how much money you think you’ll need to reach that point. You may have heard of the FIRE movement, which stands for Financial Independence, Retire Early. This movement comprises people who want to retire young (usually in their late 30s or 40s). If you’re going to retire early, saving more of your monthly paycheck (closer to 50%) maybe be essential to reaching your goal.
The Bottom Line
Saving money as soon as possible is the best way for recent graduates to have enough when retirement rolls around. Compound interest allows you to make your money work for you. Look into what retirement savings options are available to you.
If your employer offers you a 401(k) with employer matching, take full advantage and try to maximize your contributions right away. If you don’t have access to a 401(k), opening a Roth IRA is another way to start saving after-tax money.
Featured Image Credit: Photo by Joshua Mcknight; Pexels; Thank you!
