When you're just out of college, planning for retirement can be overwhelming, especially if you're not familiar with financial terminology.
It's time to demystify saving for retirement.
There seems to be a mantra going around: Young people don't know how to plan for retirement, aren't saving at all for it, aren't doing it well enough — the list goes on and on.
While those may all hold a kernel of truth, much of the advice given to young people rests on staid, conventional wisdom: Start young, diversify your portfolio, make sure to rebalance it, and be more aggressive in your investing when you're young. All good tips.
But when you're just out of college and trying to navigate planning for retirement, it can be a little overwhelming, especially if you're not familiar with the financial terminology that gets bandied about frequently.
Here's what you need to know:
The most common types of retirement accounts you'll hear about are 401(k)s and IRAs. A 401(k) is a tax-deferred, employer-sponsored account, meaning you will pay taxes on the money only when you withdraw it and the employer chooses where the money is invested. You can contribute up to $18,000 a year to your 401(k). Keep in mind that though you may not see them, you do pay fees for your 401(k).
IRAs are also tax-deferred but are not offered through your employer, and you can control where your investments are made. You can contribute up to $5,500 a year to your IRAs.
"You're recreating a salary in the future when you likely can't produce one," said Tim Maurer, a certified financial planner and director of personal finance for Buckingham and The BAM Alliance. "It provides a certain level of freedom."
It's important not to forget about these accounts when you switch employers; avoid simply cashing them out. Cashing out tax-deferred accounts may trigger a 10 percent penalty if you're under the age of 59½. At 70½ you're actually mandated to withdraw a required minimum distribution, or RMD, annually.
Instead of cashing out, you can roll over the 401(k) plan from your previous employer into one from your new employer or into a traditional IRA.
The paperwork for doing this will be provided by your previous employer when you leave. If you've lost the paperwork or never received it, simply reach out to the HR department for a copy, Maurer explained.
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"Even if you only worked there for two years, there could be $1,000 in that 401(k)," said Carolyn McClanahan, a CFP and founder and director of financial planning at Life Planning Partners. "It is a lot of effort and paperwork to roll over a 401(k), but keep it simple and clean — when you roll it over, it's more organized and easier to pay attention to and make sure stuff is invested correctly."
Some employers match their employees' contributions up to a certain percentage. This contribution does not count toward the $18,000 annual limit previously mentioned.
"In general, I like to keep things simple when you're just starting out in the workforce," McClanahan said. "The first thing you want to do is make sure you're saving to your employer's 401(k) plan, at least enough to get the match — and once you've at least gotten the match, then you can save even more — and try to save at least some money in a Roth account."
A Roth IRA, unlike the 401(k) and traditional IRAs, is not tax-deferred; you pay taxes on the money in the year you make the deposit. This account is advantageous for young people who expect to be in a higher tax bracket when they are older.
Your eligibility for a Roth IRA depends on your income and whether you are married or single.
If you are single and make less than $118, 000 a year, then you can contribute up to $5,500 to a Roth IRA.
If you are ineligible but would still like to take advantage of the benefits of a Roth IRA, consider getting a 'backdoor' Roth IRA, which allows you to convert your traditional IRA to a Roth IRA.
In choosing where to open your retirement accounts, with a 401(k), that choice is made for you by your employer, but with IRAs the decision is up to you.
"Make sure to look out for account maintenance fees that they could charge you if you don't have a certain balance. ... Most people choose whatever brand they are familiar with," said CFP Rianka Dorsainvil, founder and president of Your Greatest Contribution.
Look at the custodian's website and see which interface you are most comfortable with, said Sara Rajo-Miller, an investment advisor at Miracle Mile Advisors.
The differences between custodians such as TD Ameritrade, Charles Schwab, Fidelity, E-Trade and others can be fairly minimal, especially in light of a recent "price war." For example, TD's commission fee per trade is $6.95, while Charles Schwab's is $4.95. However, TD does not require a minimum balance, while Schwab requires a $1,000 minimum. It's best to look at the websites yourself and decide which requirements make the most sense for you.
In order to minimize these commission fees, Maurer at The BAM Alliance suggested not trading very often, noting that some custodians will offer commission-free trades for an initial time period or on particular products, like certain ETFs.
As your investments grow and shrink, you will find it necessary to rebalance your portfolio. Rebalancing simply means that you'll reallocate your assets to the original percentage breakdown that you chose — i.e., shift your money back to 60 percent in stocks and 40 percent in bonds after it grew to 80 percent stocks and 20 percent bonds.
"Don't rebalance on a periodic basis," Maurer said. "Do it only when your account is out of balance."
"The financial world has a tendency to demonize people who don't save, [and] a lot of millennials had a bad first investing experience because of 2008," he added. "Most of the advice out there says that you should aggressively invest when you're young because you have a lot of time to recoup any losses.
"This was their first taste of investing, and then they got clobbered — so I don't think you should just be aggressive because you're young," Maurer continued. "The challenge now for millennials is to get kick-started in investing — they are less keen than their parents or grandparents."
When investing, much of the advice centers on having a diversified portfolio. What this means is simply that you should invest in multiple categories. Typically, a person's investments will be divided between stocks and bonds.
Stocks include assets such as exchange-traded funds, mutual funds, index funds and individualized stocks. Bonds include U.S. treasuries, corporate bonds, mortgage-backed bonds and municipal bonds. It can be hard to get proper diversification when you're young and don't have a lot of money, which is why people often invest in mutual funds and ETFs, said McClanahan at Life Planning Partners.
A portfolio is generally considered more conservative when it has more bonds and fewer stocks, while a more aggressive portfolio is more heavily invested in stocks. This increases the potential of high gains but also gives your portfolio more volatility, as stock prices can plunge and skyrocket frequently.
However, "young investors can also be too conservative — they want to be really safe, they want to keep it in cash — but you don't need a conservative allocation if you have a 40-year timeline," said Rajo-Miller at Miracle Mile Advisors. "You can have a more aggressive portfolio when you're in your 20s — something like 70 percent or even 80 percent in stocks and the rest in bonds."
On the other hand, Maurer at The BAM Alliance recommends a balanced portfolio as the default and suggests that young people be slightly less aggressively invested, at around 60 percent stocks, 40 percent in bonds.
"Time horizon is a factor to be considered, but it's not the only factor and it's not even the primary factor in how you should be allocating your portfolio — it's more on your willingness to assume risk and your gut-check test to see whether you can take the hit when the markets go down," he said.
While a 401(k) plan is managed and organized by the employer, traditional IRAs and Roth IRAs offer you more control. Though it can be daunting, you can manage your retirement accounts yourself or use a financial advisor or robo-advisor. There are merits associated with each option.
"In my experience, there are two types of people: the do-it-yourselfers, and then the people who don't want to learn anything about it; they would prefer not to deal with it. In that case, get an advisor," McClanahan said. "Know your personality."
Getting a financial advisor may not be cost-effective when you're young, though it can help to get a second opinion or occasional recommendation.
BAM Alliance's Maurer said the phrase robo-advisor is a misnomer, since there is "no advice, just asset allocation."
"They can be well conceived and can be well utilized ... but if you want something more comprehensive, you should do it yourself or talk to your parents, and maybe their financial advisor will advise you as well," he said.
Regardless of what you choose to do, investors should know the basics and do their own research before allocating funds.
Correction: This story was revised to correct that Charles Schwab's commission fee is $4.95 per trade and TD Ameritrade's is $6.95 per trade.
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