An Introduction to Retirement for Young People
Intro
Retirement is important. Unless you’re one of those lucky people who loves and lives their job to the fullest (in which case, serious congrats) you probably want to be able to retire at some point in your life, and perhaps ideally, as soon as possible. In this article I’m going to try to give a quick summary of what you, as a young person, should prioritize in putting money into if you want to be able to retire smartly and as soon as possible.
IRAs — The Minimum
Benjamin Franklin once said “In this world, nothing can be said to be certain, except death and taxes.” I can’t give you much advice on avoiding death, sadly, but when it comes to legally avoiding taxes, I can safely say an IRA is probably one of the best things the U.S Government has ever created.
IRAs (or Individual Retirement Accounts) are special accounts for you individually to store money that is designed by the government for retirement purposes. These accounts give you various key tax advantages that encourage you to save money in them over other places to help you retire. You can open an IRA at pretty much any brokerage firm (i.e. TD Ameritrade or Vanguard) or robo-advisor (i.e. Wealthfront or Betterment).
IRAs come in two flavors, Traditional and Roth. Given that you are a young person, I’m just going to skip explaining the Traditional one for now since you should almost always open a Roth IRA. This is because any money you make in your Roth IRA is gained tax-free, and since you have so much time to gain money before retirement since you’re young, the value of your money can grow significantly over time without you ever having to pay taxes on it. The combination of being able to grow your money tax-free and having so much time in the market as a young person makes Roth IRAs powerful retirement vehicles for your money.
IRAs are so OP at positively avoiding taxes there are government restrictions as to how much you’re allowed to contribute to them, the limit being $6,000 for 2021. Additionally, you’re only able to contribute a partial amount to an IRA if you have an annual income over $125,000.
It should be noted that your IRA is just an account, and not an actual investment itself. You still need to invest the money inside your IRA into other stuff like stocks, index funds, etc. Figuring out what to invest in could be an entirely separate article to this one and depends on your appetite for risk but the TL;DR general best advice is to put your money in low-fee Index Funds or ETFs that mirror the entire U.S stock market. For simplicity, check this link and invest in 2 or 3 of these funds. In general I’d recommend Vanguard funds. Since you have so much time before retirement given that you’re young, these long-term holds will accumulate large gains over time.
The money you put into Roth IRAs is money you gained after taxes (so what you take home from your paycheck). The hardest part for a lot of people when it comes to investing is the act of simply putting the money into the account. We’re living in the world of Instagram and increasing consumerism, advertising to you constantly, pressuring you to spend money on $425 Common Projects sneakers or $430 Coachella tickets or $500 Nvidia graphics cards because now you’re an adult and “you can afford it.” Note: I’m not saying you should never buy anything nice and live your life as frugally as possible, but it’s important to remember the money you save now has the potential to grow exponentially tax-free over time and bring you way more happiness and value over time. By not investing now, you are turning down tens or hundreds of thousands of dollars in the future.
One way to make it easier can be to make it a habit to auto-invest $500 into your Roth IRA every month, and just forget that money even exists in your monthly expendable budget. Ultimately, it takes a sense of diligence to prioritize investing in your own financial freedom over other material things, but I promise it is worth it.
If you maxed out your Roth IRA every year for 10 years, assuming an average of 6% growth in the market each year, you would turn $60,000 into $90,000, making back 50% of the money you put in as tax-free profit. If you did this for 40 years, you would turn $240,000 into $930,000, making an almost 400% return and be pretty close to becoming a millionaire.
You’ll notice that this section says that IRAs are the minimum when working towards retirement. While these returns are obviously great, there are other vehicles for retirement besides IRAs that can also be a great help for you to retire faster and with more money.
401Ks — Going Bigger
A 401K is a retirement account like an IRA, except that it’s sponsored by the company you work for. Depending on where you work, you might not be offered a 401K, which is a shame because 401Ks allow you to invest a lot more tax-free or tax-deductible money into them, deducted from your paycheck, compared to IRAs. If your company doesn’t have a 401K, you can skip to the next section, or just continue reading for the info.
Similar to IRAs, 401Ks come in the same two flavors, Traditional and Roth. In general, you should open and put money into a Roth 401K for the same reasons mentioned above favoring Roth IRAs (being able to grow money exponentially and tax-free over a long period of time). However, with the kind of ridiculous salary and stock people make now in the tech industry, contributing to a Traditional 401K can also be a good strategy.
Contributing to a Traditional 401K is tax-deferred rather than tax-free. This means that you contribute to your Traditional 401K with money before taxes, meaning after you contribute your overall taxable income is lowered, meaning you pay less in taxes and will have more money in the short-term. However, when you withdraw money from a Traditional 401K, you pay taxes on it as ordinary income. This process is often worse than paying your taxes up-front with a Roth 401K, since usually as you get older your salary increases and you’d be paying more income tax later on when withdrawing from a Traditional 401K. However if you’re making crazy money in tech right now you might already be paying high income taxes and it might be worth it to invest in a Traditional 401K to defer those taxes later on.
The decision between investing in a Traditional 401K vs a Roth 401K is a personal one, but for most young people I would recommend a Roth 401K if you want to be extra frugal, and a Traditional 401K if you’d rather have a bit more money now. Either way it doesn’t really matter in the long-term that much as long as you’re consistently investing in one of them.
One key difference between a 401K and an IRA is that a 401K’s contribution limit, aka how much money you can put in to it, is much higher than that of an IRA. The limit for a 401K for 2021 is $19,000 which is over triple the size of an IRA’s contribution limit of $6,000. This gives you a lot more capacity to save money, potentially completely tax-free.
Another key difference with 401Ks is that many companies will often offer to match a contribution that is some percentage of your own contribution to your 401K. This is literally just free money and you should always contribute as much to maximize your company’s match, which helps reach the $19,000 limit.
It is certainly possible to reach your retirement goals with just having a 401K instead of an IRA. Since a 401K is triple the size of an IRA, can be aided by company matching with contributions deducted directly from your paycheck, it can be an even greater vehicle for retirement than an IRA. Ideally though, you should try to maximize both a 401K and an IRA since they both offer serious tax advantages for you to save money long term.
Other Money Accounts — Bridging it together
If you’re maxing out your 401K and IRA every year, you’re honestly doing amazing and are set to have a great and bountiful financial future. However, there are additional ways besides these accounts to potentially invest in and retire even earlier. Because you’re only able to access your 401K and IRA money penalty-free when you’re age 60, if you want to retire earlier than that you’ll need additional income streams to carry you over until then. This last section is on what to do with the rest of your money.
Brokerage Accounts have a bit of an intimidating name but are basically accounts you have with stock trading firms that let you buy and sell stocks. For example, a Robinhood account is a Brokerage Account since you can put money in it to buy and sell stocks. There many different brokerages out there such as TD Ameritrade, Fidelity, Charles Schwab, E-Trade, etc. and you can use this link to compare them, or use Robinhood on your phone.
When trading stocks, any money you make in these accounts will be taxed by the Capital Gains Tax, which will change depending on your income and how long you’ve owned the stock. This means that putting money into these accounts for retirement is strictly worse than putting money into your IRA or 401K since money gained in those accounts will be untaxed. The benefit to these accounts though is that you can cash out and spend the after-tax money gained on whatever you want, giving you more flexibility.
If you want to have more active investing goals, like following stock news and setting up trades yourself, I would put the rest of your money into a Brokerage Account. Having money in a Brokerage Account means you can be flexible about how much money you are willing to risk. If you are really risk-hungry you can day-trade stocks (not recommended) or if you are more risk-averse you can continue to invest in low-fee Vanguard Index Funds and ETFs. However, if you don’t want to or don’t care enough to follow news about the stock market and just gain money without thinking about it, there are more passive investment options.
Robo-advisors are like brokerage accounts except you don’t make any of the stock trades yourself, and instead hire a robot to algorithmically buy and sell stocks for you. Robo-advisors are pretty new in the finance game and can be an attractive alternative to a Brokerage Account since you don’t need to do any work yourself, and instead let the Robo-advisor trade for you, paying a fee for their services. The two most popular Robo-advisors are Wealthfront and Betterment but other banks and brokerage firms like Goldman Sachs and Fidelity are also getting in on the action and have their own versions. Robo-advisors offer a nice balance of risk between actively trading in Brokerage Accounts and passively storing money in a Savings Account. You check this list of Robo-advisors for an overview of interest rates and commissions.
Savings Accounts are bank accounts where you can store money and earn a small percentage of it each year as interest, also known as an APY or Annual Percentage Yield. Normally this rate fluctuates anywhere between 0.5% to 3% depending on who your bank is and the interest rate set by the Federal Reserve. The gains on your initial deposit into a Savings Account will compound on itself year after year without you having to do anything, in what is known as Compound Interest. There are a lot of online resources about how powerful Compound Interest is that you can read on, but the best part of it is that your money will grow all by itself without any work from you!
When opening a Savings Account, try to open it with a bank that is totally online like Ally Bank. This is because online financial institutions don’t need to pay for physical locations, unlike Chase or Citi, and are therefore able to offer you higher interest rates. Personally, I have a Savings Account with Ally since they gave a slightly higher interest rate than most other banks. You check this list of Savings Accounts for an overview of APYs.
I’m writing this article during the COVID-19 Pandemic when the Federal Reserve announced the interest rate would be 0%. This means that overall most Savings Accounts will only give you around 0.5% in interest, which is really not that much. That means on a $1,000 initial deposit, over the entire year you will earn an extra $5. Woo. A Savings Account can be a great place to store cash and grow it slowly, however, if you are looking for larger gains I would look towards Brokerage Accounts or Robo-advisors, especially in today’s pandemic market.
Conclusion
The best way to invest in yourself is to invest in your own financial freedom. Likewise, the best time to invest in your retirement is right now. By opening and investing money diligently into the different accounts I’ve listed above, you will be able to retire securely and afford yourself peace of mind. Being able to retire means you’re forever able to work on your terms and not because you necessarily financially have to.
I wrote this article because I realized how ill-prepared so many people my same age were when it came to financial literacy. I hope this will help guide you to not only think more about your retirement but also to take action to cultivate and secure your own financial freedom. Thanks for reading!
Additional Resources
A lot of this article is based in the FIRE, or Financial Independence Retire Early, movement, which I kinda follow, which preaches how saving a large percentage of your income will allow you to retire super early, like in your 30s. To be honest, this only really works if you’re young and have a very high income aka you work in tech, banking, etc. If you’re interested in learning more about this, check out these links.
If you want to learn more about general personal finance topics, I recommend the PBS-sponsored Youtube channel Two Cents. They cover a wide variety of relatable stuff like How to Save Money at the Supermarket and Budgeting Basics in well-animated and well-explained videos.
