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Retire
Early
by
Gary Foreman of The
Dollar Stretcher
Dear
Gary,
I'm
22 years old, about to graduate college, and thinking about
retirement. Everyone
I know who is between the ages of 40 and 70 tells me how much
they wished they had planned ahead for retirement when they were
my age. I don't
want to say that when I'm older. What can I be doing right now when I'm starting my career
that will allow me to retire as early as possible with as much
financial security as possible?
I have heard great things about Roth IRAs and 401k plans.
Russell
F.
Let's
begin by congratulating Russell. Not only for his graduation but
also for his foresight. Because his generation faces some new
challenges in retirement.
For
the last 50 years Americans have become increasingly dependent
on Social Security to provide retirement income. And so far the
system has done a good job of filling that need. So good, in
fact, that many people retire today without having accumulated
any savings to supplement their income.
That
could be dangerous for someone who's Russell's age. The Social
Security Administration calculates something called the
"Aged Dependency Ratio". It compares how many people
are over age 65 to those between the ages of 20 to 64. In other
words, how many people are retired compared to those who could
be working and contributing to Social Security.
In
1940 the ratio was 11 retirees to 100 potential workers. Today
the ratio stands at 21 retirees per 100. In the year 2045
Russell will be 67. At that point there will only be three
potential workers to provide Russell's Social Security payments.
Russ would be foolish to solely depend on those three people to
pay enough to fully support him on Social Security.
So
what should Russ try to accomplish with his retirement savings?
Naturally, he'll want to accumulate money that can be used to
pay living expenses when he's retired. Perhaps he'd like to
reduce his taxes today. And he might want to have access to his
money for extraordinary expenses before retirement.
All
retirement plans work under the same basic premise. You can pay
the IRS now and then avoid taxes on the distributions later. Or
you can avoid taxes now, but pay them when you take the money
out.
One
of the advantages of the regular IRA and 401k plan is that the
contributions you make are deductible now. You'll pay taxes on
the money when you withdraw it. Many people expect to be in a
lower bracket after they're retired. So they'd pay less in
taxes.
The
Roth IRA is different. You contribute money that's already been
taxed.
All
three programs share one advantage. Earnings on the money
invested in the plans are not subject to taxes each year. And
that can be a major factor.
Let's
suppose that Russ puts away $2,000 every year and earns 6%.
Let's also assume that he's in the 28% tax bracket. By the time
he's 70 he will have accumulated $306,229.
But,
if he put that same contribution into a retirement plan it would
have grown to $513,129 because taxes aren't due each year. A
higher investment return would increase the difference.
The
401k does have one unique advantage over the IRA's. Many
employers will contribute $1 for every dollar or two that the
employee contributes. It's pretty hard to beat an investment
that earns 50 or 100% the very first day!
But,
the 401k does have some limitations. Check your plan for
investment options. Generally the employer will choose how their
contribution is invested. And the employee may have limited
choices for their own contributions, too.
Both
the traditional and Roth IRA's offer a wide variety of
investment choices. You can choose investments ranging all the
way from very safe to quite risky.
Putting
money into a retirement plan is great, but Russ will want to be
able to get it out, too! And that can be a little confusing
because each plan has different taxes and penalties.
The
Roth IRA gives you a break if you need to take a small early
withdrawal. You can withdraw an amount up to your original
contributions without paying taxes. That's because you paid tax
on that money before you contributed it.
Your
earnings can be withdrawn tax-free if you're over age 59 1/2,
become disabled or want to use it for a first time home purchase
and the money has been in the account for five years. Unlike a
traditional IRA, the Roth IRA doesn't have any required
distribution date. So you won't be forced to make distributions.
If
you want to take money from your 401k without paying taxes
you'll need to see if your plan permits loans. You'll borrow
from the account and repay it on a set timetable. Each plan will
specify the rules for borrowing. They can restrict how you use
the money. Check your plan for details.
When
you leave your employer you'll be required to close out the 401k
account. You can take it as a lump sum distribution and pay
taxes on it. Or you can roll it over into a regular IRA account
and defer the taxes.
Getting
your money out of a regular IRA is a little harder. If you
haven't reached the age of 59 1/2 you'll face a 10% penalty and
ordinary income taxes on any distributions. And you must begin
taking your money out at age 70 1/2 whether you need it or not.
All withdrawals are taxable.
So
how does Russ decide where to put his money? In most cases, if
he's eligible for a 401k with an employer matching contribution,
that's the best option. After that, most people who haven't seen
their 40th birthday should add any additional savings to a Roth
IRA. Having that money accumulating tax free is too big a
benefit to pass up. If you're older or fighting tax problems and
want the deduction a traditional IRA would fit the bill.
One
final thought for Russ. Every dollar that he saves in his 20's
is the equivalent of four dollars saved in his 50's. So it's
much easier to accumulate enough for a comfortable retirement if
he starts early.
Gary
Foreman is a former Certified Financial Planner who currently
edits The
Dollar Stretcher website and ezines. You'll find hundreds of
free articles to save you time and money. Visit today!
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