What is the best choice to make when starting a retirement plan?
I am 23 years old and just landed my first full-time position. I certainly will contribute the maximum amount to my 401(k) to receive the company match. Having said that, what would be your most crucial piece of advice to someone who is just beginning to save for retirement? Is there anything specific you would recommend I know? Moving forward, what choices should I make in terms of the type of account I should be contributing to and the types of investments I should be applying?
A successful retirement plan will always be a work in progress, keep that in mind. Your success or failure can come from any number of factors: a change in your personal life, the ability to contribute and save, market forces, etc., all will have some effect. Your odds of achieving your goals requires that you participate, set realistic expectations, and follow a 'best practice' approach.
The general pecking order of retirement savings options is to contribute to a Traditional IRA or a Roth IRA. The longer the time horizon until you need access to the funds generally dictates which to use.
For individuals, whose income and tax bracket would drop significantly after retirement, a Traditional IRA may make more sense.
The longer you can wait to access the funds, the better the Roth IRA becomes. The Roth IRA is a great vehicle for those whose tax bracket will remain high after retirement.
Traditional IRA contributions are tax deductible on both state and federal tax returns for the year you make the contribution, while withdrawals in retirement are taxed at ordinary income tax rates. Roth IRAs provide no tax break for contributions, but earnings and withdrawals are generally tax-free.
401(k), IRAs, and other retirement plan annual contribution limits are adjusted each year for inflation. Stay aware of what that number is and if possible, max out your contributions to them yearly.
Regarding specific investments, Know Your Level of Sustainable Risk. With a 401(k) Plan, you will more than likely select from an asset allocation to best meet your investment goals and, generally, a risk assessment is part of your on-boarding for the 401(k) Plan. I recommended that you check annually to see that your allocations to stocks, bonds, international investments, and other asset classes still are in line with the asset allocation you initially selected. Also, keep on top of your plan. Most change yearly, adding or removing investment options. Review the new options (if any) to determine whether you should reallocate all or a portion of your contributions or if a fund you were using has been replaced, and if its replacement makes sense for your strategy going forward.
Within an IRA, you will have more control over what you own versus a 401(k). Whether using Mutual Funds, ETFs, Bonds or Stocks, clarity and discernment should be the core of your investment philosophy. Invest in quality, undervalued companies, stay vigilant, and adhere to your investment plan. Diversification is essential, but over-diversification can equally dilute a portfolio’s ability to grow over time.
For someone in your exact situation, my number one advice would be to contribute every year to a Roth IRA. You can do this in addition to the 401(k).
I would specifically recommend a backdoor Roth IRA conversion. It's a two-step process to get money into a Roth IRA for people who also participate in employer-sponsored plans such as a 401(k) . First, make a nondeductible contribution to a Traditional IRA. $5,500 is the limit for 2017. Then, immediately convert that $5,500 to a Roth IRA. On your tax return, the $5,500 conversion will not be treated as taxable because the original basis you contributed was not taken as a deduction. There is plenty of literature on the web about backdoor Roth IRA conversions. A simple Google search will give you like umpteen different perfectly good explanations of it. I've had good experiences with Fidelity, where they help you open both the Traditional and the Roth IRA accounts, walk you through the backdoor conversion process very clearly, and then once the money hits the Roth, you can buy index funds for zero commission and practically zero fees. They will also let you keep the Traditional IRA account open with a zero balance, so that you can come back in 2018 and do the same transaction over again.
The main financial planning insight I can leave you with is that the Roth IRA is a powerful tool to accumulate and compound tax-free wealth. Even better to start accumulating when you're young and just entering the workforce. A Traditional IRA (or Traditional 401(k) for that matter) is good for taking a tax deduction now and reducing your tax burden this year, especially for very high earners in high tax states, but you end up paying income tax when you are required to start withdrawing in retirement. In your case, doing the 401(k) is a total no-brainer because of the employer match. But now, as to the decision to start a Roth IRA, for young people, it's the right move to put in post-tax, nondeductible dollars now, while you're working, and get the super long runway of completely tax-free accumulation for later on.
Congratulations on your first full-time position and contributing to your retirement plan. You are already setting yourself up for success. Each year, reevaluate if you can make your contribution slightly higher. Your goal is to eventually max out at the most you can. The power of investing early is significant for you. I would not get caught up in too many details. Chose an aggressive fund or target date fund that matches when you will be 65-70. They tend to be lower cost as well as keep you emotionally untied and prevent irrational trading. Just keep putting as much as you can in and things will take care of themselves. The target date funds allow for you to adjust the riskiness in the portfolio as you get older. Once you max out, consider investing additional funds in a Roth or regular IRA.
The other answers, while technically correct, miss an important part of modern retirement planning: multiple income sources.
I won't go into a lot of detail here. Just know that for a 23 year old, the best opportunity for a great retirement will involve income from things other than IRAs, Roths, and public investments.
Some examples: Rental property (commercial and residential), AirBnb, e-commerce site, online course, affiliate income from websites, consulting/coaching, passive ownership of business(es), etc.
Don't fall into the trap of thinking that public stocks, bonds, and mutual funds are the best way to serious wealth. They are a place to keep some wealth for liquidity when you have it. They just aren't the best or only place to build wealth. Entrepreneurship and business ownership are where the vast majority of wealth is created. They can also provide higher income than the traditional 4% rule.
Not trying to be difficult, just wanted to make sure you consider other options.
Hope that helps!
Congratulations on landing your first full-time gig! You are well ahead of many of your peers by starting to think about your long-term investment plans.
When I was 23 years old, I was only focused on two things and it didn't involve saving money! You are on a great path right now to be thinking this way!
Let's be honest, planning for retirement is stressful and generally not fun to think about, but here are a few tips that I believe will relieve some of the tension:
- Get your mind right and educate yourself on some common financial concepts and products, which don't require a finance degree. Here is a list for you to google: Theory of Decreasing Responsibility, Power of Compounding Interest, Rule of 72, High Cost of Waiting, Paying Yourself First, 401(k)s, IRA, Roth IRA, Mutual Funds, Stocks, Bonds, Interest, Net worth.
- Don't just think retirement. Think about your short-term, emergency, needs. Recommended 3-6 months savings even up to what you would like to do within the next 1-5 years. For example, a Money Market or maybe your good old fashioned savings account. Next, what are your mid-term needs? Maybe you would like to buy a house in 5-10 years or more (Mutual Funds). Next, what standard of living would you like to have when you retire in 30 + years (qualified and non-qualified accounts like a 401(k) and IRA)?
- Always take the match! If your employer offers it, contribute up to the match to take advantage of the free money. Once you match, look into a non-qualified account that offers tax-free growth. Once you max that account, now you can consider contributing more towards your employer sponsored plan. Make sure you educate yourself on what the contribution limits are on each type of plan because they do change.
- This is the last step on my list, but in reality, it should be the absolute first thing you do. Get a life insurance policy! Generally speaking, you need 10X your annual salary. Here is a common sense rule about Life insurance. If it's too complicated for you to understand, find one you can understand!
These steps are very general in nature, but that is because everyone is in a different point in their life. A couple things though do not change. Three things are always trying to get to your hard earned money: taxes, inflation, and market fluctuations. Lack of strategy will most definitely hinder your success to combat these three things. Finally, make sure you do business with advisors that you know, like, and trust.