Saving for retirement in your 20s and 30s can feel a lot like trying to build a three-story house with toothpicks. You may have dutifully signed up for a 401(k) or IRA and are socking away as much as you can stomach. But with report after report seemingly spelling doom for America's future retirees, you might start to wonder whether you should go beyond saving in a traditional 401(k) or IRA.
If you’ve taken the first step and are contributing to a retirement fund, there are ways to maximize your savings potential — especially if you’ve got extra cash to burn. It’s all about strategy.
1. You won't get far on a cash-only savings plan.
According to a recent survey by Bankrate.com, millennials are three times more likely than other generations to choose cash over stocks as their preferred long-term investment.
Having cash on hand is smart -- you might need it for a medical emergency or graduate school tuition. But socking your money in a savings account won’t do you much good because if you’re getting 1% on that money, you’re losing purchasing power to inflation. You’re basically losing out on growth.
Since you’ve got time on your hands, don’t be coy about investing in stocks. Long-term annual stock returns have averaged around 10%, based on Ibbotson Associates data -- and it’s this kind of superior growth over the long term that will sustain a 30-year-long retirement. Workers in their 20s and 30s have the luxury of decades to bounce back from any market setbacks and can afford to invest more heavily in stocks (more risk = higher potential reward) than someone who’s older.
For an easy way to figure out your proper asset allocation, subtract your current age from 110. That’s the percentage of your portfolio that should be in stocks, and the remainder should be held in low-risk assets like bonds. So if you’re 25, aim to invest around 85% of your portfolio in equities. If you’re more conservative, subtract your age from 100.
2. Don’t be afraid to ditch your employer’s 401(k).
Not all company retirement plans are the same, and you might find that your employer’s offerings aren’t the best match for what you need.
“Ultimately the number one red flag for funds inside of a 401(k) is the mutual fund expense ratio,” says Alan Moore, certified financial planner and co-founder of the XY Planning Network, a network of fee-only financial advisors focused on working with Generation X and Y clients. “If good, low-cost index funds aren't available, I would be looking outside the 401(k) for additional investment opportunities.”
Like Moore, most financial experts recommend investing in passive, low-cost index funds, like the Vanguard 500 Index (VFINX), which mimics the performance of the broad-market S&P 500 index. Typically, most passively managed funds have expense ratios (the cost of managing the fund) of less than 1%, but Moore suggests aiming for one that charges less than 0.50% (the Vanguard 500 index charges 0.17%, for example).
Marcio Silveira, a fee-only certified financial planner in Arlington, Va., also says to look for opportunities to invest in small-cap and international (including emerging markets) equity funds, which ensure greater diversification.
What to do if you’re unhappy with your plan’s offerings? If you’re offered a company match, don’t go running just yet. Contribute as much as the company will match, says Silveira.
Your next step is to check out big brokerage firms like Vanguard, Fidelity, and Charles Schwab where you can open either a traditional or Roth IRA with as little as $1,000.
3. Enroll in automatic contribution increases each year.
The majority of millennials today are only saving 6% for retirement, according to Fidelity. Most financial planners recommend saving twice that much. Starting small is fine, but as you advance in your career and (hopefully) earn more, bump up your contributions in real time. The easiest way to do that is by opting into automated annual contribution increases of 1% or 2% through your plan administrator. You’ll hardly notice the difference in your pay stubs and you’ll be all the richer for it.
4. Invest in an Health Savings Account.
The most you can contribute to an IRA in 2015 isn’t that much -- $5,500, and $6,500 if you’re 50 or older -- so if you’re still looking for another retirement savings vehicle, health savings accounts are becoming an increasingly popular tool. You can contribute up to $3,350 per year as an individual and up to $6,650 as a family.
The catch: You have to have a high deductible plan in order to qualify for an HSA, since the primary purpose of HSAs is to help people save money on out-of-pocket medical expenses.
But some of those funds can also be invested just like a regular IRA. Which kinds of funds and how many depends on your plan administrator’s options. For example, Wells Fargo offers a dozen of its own mutual funds, while HSA Bank offers savers a free TD Ameritrade account and choose from thousands of funds.
Not only are HSA contributions sheltered from taxes, the money grows tax-deferred and you can withdraw funds tax-free in retirement so long as you wait until after you turn 65. If you make early withdrawals for anything not related to health expenses, you’ll face a whopping 20% tax penalty.
For these reasons, consider an HSA a truly long-term investment option, not something you’d want to use as a rainy day fund or college fund for your kids.
“HSAs are for folks that are just crushing it and maxing out all their other [retirement savings] options first,” Moore says.
5. Update your "Rainy Day Fund" needs each year.
Everyone’s first investment should be in an emergency fund, and if you’re still relying on that $6,000 fund you managed to scrounge up in college to cover you into your late 20s and 30s, you might want to revisit it. As your income grows, your emergency fund should be growing as well. Six months’ worth of income is the typical rule of thumb, and it’s likely you could live on a lot less when you were 21 than you can at 31, especially if you’re factoring things like a mortgage and kids into the mix. Moore suggests saving at least 1% to 2% of the current value of your home in a fund for home repairs and maintenance.
“We get really focused on retirement savings and investing, and we forget to be sure we have enough liquid investments to cover us” for the unforeseen expenses, Moore says.
The bottom line: Investing for retirement is a slow, boring process — and that's OK.
Unless you’ve gotten to the point where you have fully funded your emergency savings and you’re maxing out your annual retirement contributions, you actually are doing what you should be doing: building up your retirement savings one dollar at a time.
“We want to feel like we have more control, but the smartest people out there can’t predict what the market will do,” he says. “My goal is to make investing as boring and dry as possible because that’s what it should be."
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