Is Now the Right Time for Millennials to Focus On Retirement?
This is the second article in a four-part series designed to help millennials plan, invest and save for retirement. As we mentioned in part one of this series, “Why Millennials Aren’t Investing for Retirement“, Barron’s September 20th issue mentioned a survey that suggests only 43 percent of millennials are investing for retirement.
Another study co-conducted by BNY Mellon Bank and University of Oxford’s Said Business School on millennials suggests that there are three possible reasons as to why this is so. Each of the subsequent posts in this series addresses one of the three hurdles.
This post addresses the first hurdle; 55 percent of millennials don’t understand retirement plans. Though there are many types of retirement plans, they fundamentally have the same goal. Each is an account in which money is placed and investments such as stocks, mutual funds, and Exchange Traded Funds (ETFs) are purchased, held and sold.
There are two types of retirement accounts or plans. The first is individual retirement accounts that individuals establish and manage on their own or with the help of an advisor not related to an employer. The second is employer-sponsored accounts, accounts established by employers for the benefit of employees.
In an ideal world, everyone would take advantage of the full benefits of both an individual retirement account and an employer-sponsored plan. The world is not perfect and most people can’t do this, at least not right out of school. Our advice is to save and invest as much as possible, so as to not let your savings and investments cause you to refrain from creating an emergency savings account or use credit cards.
The best part of retirement accounts is that investments in these accounts should be purchased for the long-term, ideally longer than five years. Therefore, whether you independently research and make your investment decisions or use the help of an expert, minimal day-to-day management is required. Because of market changes and investment risk, most professionals suggest rebalancing your portfolio annually to keep your portfolio in line with your risk tolerance and investment objective. This should take no more than a couple of hours a year.
Which Is the Right Account for You?
Below are the most common types of retirement accounts to help you understand the differences and to decide which is right for you.
Individual Retirement Accounts (IRA):
A tax-deferred account, meaning contributions are deducted from your income taxes, that lets you invest up to $5,500 annually if you’re under 49 and $6,500 if you’re over 50. It’s likely your income tax rate in retirement will be lower than during your working years, so the tax-deferral is especially beneficial for high-income earners. For lower income earners, a Roth IRA may be more appropriate. Some employees with a company sponsored retirement account, such as a 401(k) may not qualify for a Traditional IRA and should, therefore, opt for a Roth IRA. Traditional IRAs let you invest in common investments, such as stocks, bonds, mutual funds, ETFs and more.
Unlike a Traditional IRA, Roth IRA contributions are not tax-deferred, but earnings grow tax-free. This means that any growth in the account over what you contribute is not taxed as long as these funds are withdrawn after the age of 59 ½. Similar to a Tradition IRA, you can invest up to $5,500 annually if you’re under age 49 and $6,500 if you’re over age 50. Similar to Traditional IRAs, Roth IRAs let you invest in common investments, such as stocks, bonds, mutual funds, ETFs and more.
For help to determine which type of IRA is appropriate for you, use Bankrate’s Roth vs. Traditional IRA Calculator.
A pension plan is a tax-exempt employer-sponsored retirement account. The employer contributes funds into an account shared by all employees from which each employee benefits in retirement. The three most common pension plans follow.
Defined Benefit Accounts
A pension plan that guarantees a definite payout in retirement, regardless of investment performance. This is risky for the employer, but a benefit for the employee.
Defined Contributions Accounts
A pension plan in which the employer makes pre-defined contributions, sometimes no contributions and the final payout is heavily dependent on the contribution amount of both the employer and employee and investment performance. The payout is not guaranteed. The two most popular types of defined contributions plans follow.
An employer-sponsored account in which an employee contributes a portion of their pay tax-free. The annual contribution limit starting in 2015 is $18,000. Employers can match employee contributions and this match can have a significant, long-term benefit. 401(k)s typically let you invest in a list of pre-determined mutual funds.
Similar to 401(k)s, but for public educators and certain non-profits. Starting in 2015, the contribution limit is also $18,000. 403(b)s typically let you invest in a list of pre-determined mutual funds.
Small Business Retirement Accounts
401(k)s are expensive to establish and manage. Small businesses can find more affordable options in a Simplified Employee Pension (SEP) IRA or a Savings Incentive Match Plan for Employees (SIMPLE) IRA.
A retirement account similar to Traditional and Roth IRAs, but is a profit sharing account in which an employer contributes up to 25 percent of an employee’s wages. Contribution limits are the lesser of 25 percent of the employee’s wages or $53,000, starting in 2015.
A tax-deferred retirement account that acts similar to a 401(k), but is less complex and costly in part because of fewer regulations. Employees can contribute pre-tax wages. Contribution limits for this type of plan are the lowest of all types of employer-sponsored plans and capped at $12,500 annually, starting next year.
A Little Bit More
For more information on contribution limits, check our Savvy James’ post, “Retirement Plans – Contribution Limits Announced”.
These are the most common types of retirement accounts. Now that you understand the basic differences and benefits of each, find out the type of employer-sponsored plan your employer offers. You can do this by contacting your Human Resource or Employee Benefits department.
If you are a new employee, you’ll receive the necessary information to establish your employer-sponsored plan in your new hire kit. If you are no longer a new employee, you may enroll in your employer-sponsored plan once a year during what’s called “open enrollment”, typically between October and December.
In both cases, you’ll fill out an account application. Once your account is established, your account will be online where you can manage your savings and investments. Select from the list of mutual funds or other investments available to you. For tips to determine appropriate investments and investment allocation, read 10 Simple Steps to Investing.
Whether you have an employer sponsored retirement plan available to you or not, consider an individual retirement account to invest in and manage on your own. The investment options in these accounts are not as restrictive as with employer-sponsored plans. Our “10 Simple Steps to Investing” is still applicable. Search for long-term investments with low expenses and adjust your allocation annually, as needed. For most, mutual funds and ETFs are the best options, unless you use the expertise of a stock broker or financial advisor.
All in all, retirement accounts of all types are vehicles to save and invest for your future. These are long-term plans with benefits to help you plan for retirement. The keys to being prepared for retirement is to start early, invest regularly and avoid debt (both revolving and non-revolving debt). Whether you just started your first job or have 30 years tenure, start investing today.
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