Smart Savings: Start Now
You may be a new college graduate, fresh off the campus and at your first job. Or maybe you’ve been out of college for a few years and are just beginning to think about saving for the future. In either case, you're starting to consider your options for stashing away your cash.
Fortunately, you have many options when it comes to saving. Unfortunately, navigating the maze of different savings options can be confusing, if not downright overwhelming, and the result is that many young people end up avoiding the subject altogether. So, in the interest of helping you start a smart savings plan, we're going to break down the best options for new savers, and show you how you can get the most out of that "penny saved" that Ben Franklin loved so much.
401(k) Plans
Starting from the top, we've got the Big Kahuna of savings plans, the 401(k). While 401(k) plans have been around since 1980, they have become much more popular in the last decade. Most companies have started turning away from the traditional defined benefit plans (also known as pension plans) and moved toward defined contribution plans like 401(k)s.
The benefits of a 401(k) plan are fairly simple and straightforward. A 401(k) plan allows you to defer (e.g. set aside) part of your pre-tax salary to a savings account that can then be invested in a variety of options, usually defined by the administrator of the 401(k) plan. The beauty of this is that you end up with a lower taxable income and your contributions grow tax-free until you start drawing on their savings -- which you can start doing at age 59 ½. Recently, many employers have started to offer a Roth 401(k) plan. This plan differs from a traditional 401(k) plan because contributions to a Roth plan are made with post-tax dollars, as opposed to pre-tax dollars with a traditional plan. Another difference (and nice benefit) is that the accounts’ investment gains aren’t taxed at the time of withdrawal.
Besides the tax status of the 401(k) plan, there are a host of other reasons why this way to save should be a no-brainer for you. First of all, it's very easy to do. Once your 401(k) is set up with your employer, your contributions are automatically deposited into your account. Second, many companies match a portion of their employees' 401(k) contributions, essentially giving you free money. In addition, there are usually a few options that will provide you with a hassle-free asset allocation (an asset allocation is basically the strategy of how you pick the funds for your account and how much you put in each fund).
To get started with a 401(k) plan, simply talk to your employer to confirm that your company offers a one and sign up. If you are already signed up, you can talk to your employer or visit the plan website to change your contribution level or investment allocations. For those looking for the easiest choice for investment allocation, many plans offer target-date retirement funds that automatically adjust as you get closer to retirement, or you can call Smart401k to get our tailored allocation recommendations each quarter. A properly diversified portfolio will enable you to participate in several different market segments at once and has also been shown to reduce an account’s volatility and improve long-term returns.
The wide availability, ease of use, tax treatment, relatively high contribution limits, and extra employer incentives of 401(k) plans make them appropriate for nearly all savers.
The Bottom Line |
|
Getting Started: |
Talk to your employer |
Maximum Annual Contribution: |
$15,500 or 20,500 if 50+ (2008) |
Age Withdrawals Can Begin: |
59 ½ |
Easiest Allocation Options: |
Smart401k or target-date retirement funds |
Individual Retirement Accounts (IRA)
Of course, 401(k) plans aren't the only way for you to save. Individual Retirement Accounts are another great option for young savers. IRAs come in two primary flavors -- the Traditional IRA and Roth IRA -- and both have tax advantages. The Traditional IRA is similar to the 401(k) in that contributions are pre-tax and they lower your taxable income. Roth IRAs, on the other hand, take after-tax contributions, but all transactions within the account are tax free, and withdrawals are also typically tax free.
IRAs tend to be very flexible, and they give savers a lot of options on where they invest their money. Depending on the administrator of the IRA plan, investment options can range from mutual funds to stocks, options, bonds, real estate, or even private companies.
The contribution limits for IRAs are much lower than those on 401(k) plans, but they can act as a great sidecar for a saver's core 401(k) savings. Also, the Roth structure can be a great choice for young savers who are still in a relatively low tax bracket. As you might recall, contributions to Roth IRAs are made with post-tax earnings and gains aren’t taxed again at the time of withdrawal. So assuming that you are in a lower tax bracket now then you will be when you retire, you’ll be paying taxes on your earnings at a lower rate.
Getting started with an IRA is relatively easy, but requires a bit more legwork than a 401(k). Most of the well-known brokerages -- such as E*Trade, Charles Schwab, and
TD Ameritrade -- offer IRAs and can help you set one up. Though investment options are typically broader with an IRA, the simplicity-minded can find target-date retirement funds offered through many IRA administrators.
The Bottom Line |
|
Getting Started: |
Talk to an advisor or set up an account online |
Maximum Annual Contribution: |
$5,000 (2008) |
Age Withdrawals Can Begin: |
59 ½ |
Easiest Allocation Options: |
Target-date retirement funds |
Taxable Savings
Let's face it; getting tax breaks for saving is a great incentive to put money aside for the future -- something that we all should be doing anyway. But there are also many reasons why you should have some savings outside of tax advantaged accounts like 401(k)s and IRAs.
First and foremost, while there are certain provisions that allow savers to pull funds from their 401(k) or IRA plan before they reach 59 ½, these provisions are very restrictive. More important, these plans are meant to be used for retirement. Conversely, non-tax-advantaged savings accounts offer the great benefit of being able to withdraw your money at any time, for any reason, without tax penalties.
Since life can often be unpredictable, savvy savers typically try to put away six months of living expenses in a FDIC insured savings account, in case of a job loss or other unfortunate circumstance (online savings accounts at companies like ING Direct, E*Trade and Capital One are easy to set up and often pay higher rates than your local bank). A cushion of savings like this can be indispensible in a time of need, and it can circumvent the need to take out high interest loans or carry large credit card balances. Plus, while you're not using the money in your "cushion account," it pads your pockets by collecting interest.
And while financing everything from cars to flat-screen TVs seems to be the way most people handle big purchases these days, smart savers often demonstrate a bit of foresight and save for big purchases ahead of time. Taxable savings accounts allow savers to put aside money for big future outlays like a house, a car or a big vacation, and they can earn interest on the money while they wait to make their purchase.
The Bottom Line |
|
Getting Started: |
Visit your bank or go online |
Maximum Annual Contribution: |
Unlimited |
Age Withdrawals Can Begin: |
Anytime |
Easiest Allocation Options: |
Online savings accounts & money market funds |
Action Plan
Here's a quick step-by-step plan to get you started. Don’t expect to complete all of these immediately; instead, work toward each goal until you’ve completed it and then move on to the next one. GOOD LUCK!
- Talk to your HR representative and enroll in your 401(k) plan if you haven’t already.
- Make sure that you defer enough of your salary to max out the employer contribution. After all, it's Free Money!
- Open an online savings account and start building an emergency fund. Setting up automatic withdrawals and timing the withdrawal with your paycheck will make saving easy. Try to save 5% of your take-home pay each month until you have saved six months of expenses.
- Increase your 401(k) deferral rate by 1% and use the auto-escalation feature in your account to increase your deferral rate by 1% a year. Since you’ll likely get annual raises at your job, you probably won’t even realize you’re contributing more until you look at your account balance.
- Reward yourself! Now that your emergency fund is built, use the amount you were putting into your emergency account each month and save for something fun like a vacation, a car or a new TV. But remember; don’t withdraw from your emergency fund unless it’s an emergency.
- Increase your 401(k) deferral rate by 1% or open an IRA. An IRA is preferable if you are already maxing out your 401(k) or are interested in investing on your own. Otherwise, increasing your 401(k) deferral is a better bet.
Keep It Simple and Start Saving!
When it comes to saving, the earlier you start, the better. Albert Einstein called compounding interest the eighth wonder of the world, and the longer you save, the more you get to take advantage of it. However, with an overwhelming number of savings options out there, it’s easy to put off the decision for a “later date”. Don't give in to that temptation!
Today, with options like the 401(k) and partners like Smart401k to help with your investment decision-making process, starting to save has never been easier. So get started today and contact us if you have any questions at info@smart401k.com or 877.627.8401.