Brandon Renfro, Ph.D.

Retirement - Finance - Investing

Category: Retirement Saving

Retirement Saving/Planning Tips for Millennials

It is no secret that Americans have a tough time saving for retirement. This is particularly true of millennials. The Great Recession has delayed the beginning of well-paying careers for many 18 to 34 year olds. A recent study showed that millennials fear running out of money in retirement, but if you are struggling to pay rent, make a car payment and pay off student debt, saving for retirement is not easy.

Yet if millennials want to ensure themselves comfortable “golden years,” then they have to start investing in their future now, today.  Thinking, “I’ll start saving as soon as I get a raise,” or “I’ll start after at the beginning of the New Year” are surefire ways to never start saving. Before you know it you will be 60 years old and wondering how you are going to get through the next 30 years.

So where should you begin when it comes to retirement investing? Here a few tips to help.

Start Saving and Be Consistent

While you might not be able to invest a lot now, the important thing is to get started and then be consistent about contributing to whatever retirement vehicle you choose. Every dollar that you invest now will be worth much more by the time that you reach retirement age. As your salary increases over the years, then you can save more.

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Traditional or Roth IRA?

So, you have decided to invest. Great. Presumably, you are investing for a purpose. Even better. If that purpose is for retirement you may have even spent time thinking about whether a Roth IRA or Traditional IRA is best.

For 2017, Roth and Traditional IRA contribution limits both remain at $5,500. The key difference in investing through a Roth IRA or Traditional IRA is the taxation of contributions and deductions.

Contributions to a Traditional IRA are deductible whereas Roth IRA contributions are not. As an example, if you contribute the maximum $5,500 in a Traditional IRA you can deduct that amount from your taxable income. If you are in the 25% federal income tax bracket, that means you would lower your tax bill by $1,375. If that same $5,500 is contributed to a Roth IRA, you still pay income taxes on it.

That may seem like a win for the Traditional IRA but there is a difference on the back end when withdrawals are made that for many, especially younger, investors will far overshadow any upfront tax implications.

That advantage lies with the Roth IRA. Withdrawals from Roth IRA’s are not taxed. Since the money was taxed before it went in, it stands to reason that it should not also be taxed when it is taken out. Of course, this situation is reversed for a traditional IRA. Since the money was not taxed when it went in, it stands to reason that it should be taxed when withdrawn.

Tax Impact

So, what? Each dollar is taxed at some point, right? Why does it matter?

Let’s look at an example I have used previously of an investor that is starting when they are 25 and retiring at 65 and compare the differences that would exist between using a Roth or Traditional IRA.

If one were to put $5,500 per year into a Traditional IRA for 40 years they would save $55,000 (40 x $1,375) in taxes if we continue to assume a 25% marginal bracket. This person would have total investments of $1,424,810.85 if we use 8% as an estimated rate of return. Remember though, this final amount is now taxable when withdrawn.

Of course, it won’t all be withdrawn at the same time. A common measure for determining the amount of money that can be withdrawn from a retirement account in each year is the 4% rule. Essentially, you look at the balance of the account and take 4%. In this case, it would be approximately $57,000.

Given the progressive nature of federal income taxes the average tax rate on each dollar withdrawn will be something less than the marginal rate. There are many things that would affect taxation of the withdrawal. I am not a tax professional nor do I want to divert from the main point of this post, so I’ll simply tell you that I am assuming an average tax rate of 12%.

Roth or Traditional?

$57,000 taxed at an average rate of 12% would leave $50,160 in spendable income.

Now, compare that to the Roth IRA. The same numbers apply giving us a withdrawal amount of $57,000. The big difference here is that the full amount is not taxed. That gives the investor an additional $6,840 (the same 12% that would have otherwise gone to taxes) per year in expendable retirement income.

Starting Early

For the past few weeks in my personal financial planning class we have been discussing retirement planning. One of the things I like most about teaching this topic to college students is that I can provide some encouragement to a demographic that often feels overwhelmed, behind, and simply stressed.

It may seem like talking about retirement to a group of young people barely in their 20’s might not be the most engaging conversation, and it often isn’t. However, once the students see the difference time can make their interest is piqued.

One of the key determinants of a successful retirement plan is the length of time to execute. There is a dramatic difference between starting to save for retirement when you are 25, and waiting to start when you are in your 40’s. Continue reading