Should I save for retirement or pay off student loans?
This is a question that I have been asked a lot. Yesterday a reader (Megan) left a comment…
“Hi Bob. I have a question for you. I am a recent grad who had a job and a retirement account during the two years of post-college to starting grad school. Now I’m just starting grad school with student loans and I wanted to find out if it’s best to stop adding to it until I graduate.”
I kind of touched on this in a post I wrote about financial advice for newlyweds.
In the post I was talking about our decision to continue funding our retirement accounts while paying down our debt. I said…
“…I have come to understand the impact that time has over investments. Without getting into too much detail, I will just say that getting started investing early puts you at a high advantage. It is not just a little bit better than waiting, but a HUGE amount better. Having enough for retirement can be a breeze if you get started while in your 20’s. It was for this reason that I wanted to get the ball rolling with my investment portfolio.”
401k’s, Roth IRA’s, and student loans
My student loans were locked in at about 3%, but I don’t think rates that good are available today. I assume a 10% return on my retirement savings, so even if you are paying 5% on your student loans and earning 10% (or even 6%) you still come out ahead. Mathematically, this seems to be the much stronger answer. However, Dave Ramsey’s method -based on our behaviors rather than math - would eliminate any and all debts before investing for retirement.
Personally, if it were me, and I could get 5% or better on my student loans I would be funding an Index Fund within my retirement accounts (401k and Roth IRA). But, at the same time I really hate debt and try to avoid it at all costs.
Do you have any suggestions for Megan? What would/did you do?
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I found this article about Roth IRA’s and I think it is worth posting. It goes over the basics of Roth IRA’s and why you should consider one, if you don’t already have one. If you are thinking, “what’s an IRA?” then you should probably start here.
Right now, you may be wondering why you should invest in a Roth IRA if you currently have a retirement plan (401k, 403b, etc.) with your employer. The Roth IRA has many benefits that other retirement plans don’t have, and chief among them is the fact that your investment earnings may accumulate tax-free. In other words, your Roth IRA has the opportunity to grow without incurring any taxes and can be distributed to you tax free, if some certain conditions are met.
While there are advantages to owning a Roth IRA, there are also some rules you should think about before you decide this is the account for you. First, not everyone can take advantage of a Roth IRA. You or your spouse must have earned income or compensation – this includes wages, tips or salary. However, be aware that earned income or compensation does not include rental, interest, dividend, pension annuity or deferred compensation income. Second, your modified adjusted gross income cannot exceed certain limits. For single people, your modified adjusted gross income must be less than $114,000 and $166,000 for married couples filing jointly.
Contributions you make to the account are not tax deductible, but may be withdrawn any time without tax or penalty. Before taking withdrawals from your Roth IRA you need to determine if you are receiving a “qualified distribution.” Any withdrawal that is not a “qualified distribution” can result in income taxes and IRS penalties. For example, any earnings on your principal will be subject to income taxes should you decide to withdraw them prior to the five-year holding period or before age 59 ½ (contact your state department for state tax rules). In addition, these earnings are also generally subject to a 10% IRS penalty.
Tax and penalty free withdrawal of your Roth IRA earnings for “qualified distributions” can be made once a five-year holding period is satisfied and one of the following applies: you have reached the age of 59 ½, you have become disabled, the funds are used for a first-time home purchase (subject to a $10,000 lifetime limit) or the funds are distributed to a beneficiary after your death.
After thinking over the rules, if you are eligible for a Roth IRA you may be wondering how much you can contribute. For 2008, you may make regular contributions that do not exceed $5,000. If you are 50 or older, you can also make “catch-up” contributions of up to $1,000 per year for a total contribution of $6,000.
A couple of other important items worth noting – contributions to your employer’s retirement plan do not exclude you from making contributions to a Roth IRA, and owning a traditional IRA does not prevent you from setting up a Roth IRA either (although contributing to a traditional IRA for the same year will limit the amount you can contribute to your Roth IRA).
Whether or not you decide a Roth IRA is the right retirement account for you, it’s always smart to plan ahead and save money for the future. Never underestimate the importance of saving for the future and using a variety of investment vehicles to achieve your goals.
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There have been a few changes made this year to IRAs. The one that will probably affect the most people is the contribution limit. It went up $1000 for 2008 for all ages. See below…
| Year | Under Age 50 | Over Age 50 |
| 2002-2004 | $3,000/year | $3,500/year |
| 2005 | $4,000/year | $4,500/year |
| 2006-2007 | $4,000/year | $5,000/year |
| 2008 | $5,000/year | $6,000/year |
From here on out the contribution limits will be adjusted for inflation.
Another nice change to be aware of is that:
You can now roll assets directly from a 401(k) to a Roth IRA. Previously you had to jump through a few hoops by first rolling the funds into a traditional IRA and then converting them to a Roth from there. You still won’t avoid paying the taxes during conversion, but it will make the process easier.
Technorati Tags: IRA Changes, 2008
and here are a few interesting articles I read this week…
Some Surprises in Consumer Reports’ Top 10 Cars for 2008
The one site you must visit before buying anything online
How Much Will That 401(k) Loan Cost You?
Is Term Life Insurance Right For Me?
What to do with old Whole Life policies
Six Ways to Break Free of the “Purge and Splurge” Cycle
The 3 Things That Will Make You Better Than 99% of Investors
My Financial Epiphany - The storm of my life
Words of Wisdom From Warren Buffett
Painfully Slow Progress is Still Progress
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It is so SIMPLE to retire well off, if you make just a little sacrifice now. The alternative is making a huge sacrifice later on (in your 40s) and still probably not doing as well as if you made a small sacrifice now.
You just finished your degree and you are probably looking for your first “real” job. This is the perfect opportunity to decide how you would like your financial life to be. You have the choice to spend and buy whatever you feel like which will likely put you in heaps of debt. If you choose this path, you will be in good company. You can be sure most of your peers will take this path.
Or, you can take the road less traveled. You can be one of the “weird” people out there who refuse to believe that they have to be in debt all their lives. You can get motivated by the thought of the freedom that comes with being debt free. This road can sometimes feel like a lonely road, when everything and everyone around you is yelling, “Spend! Spend! Spend!” But, be assured, those who go down this road get the last laugh. They experience freedoms that most people only dream of.
If you are like I was, you will think, “oh, I can spend now, because I will be making more money later.” Well, the truth is that it doesn’t matter how much money you make. Expenses rise to meet income. So, as your income increases, you can be sure that, by default, your expenses will increase as well. Believe it or not, there are people out there with $500K annual salaries filing bankruptcy and in the same moment, you have people who never made more than $50K a year retiring as millionaires. It is not about how much you make. It is about how much you keep.
So, I say all of this to say, if I could teach a college grad only one financial lesson it would be to:
Max out your Roth IRA for five years
By maxing out ($4000 for 2007 and $5000 for 2008) your Roth IRA for the first 5 years after you graduate - you will likely have over $24,000 by the time you are 27. If you add NOTHING else to it, when you are 67 and ready to retire it will be worth over $1,000,000 (assuming 10% growth). If you can keep adding to it, you can really watch the puppy grow!!
But don’t wait, if you wait until you are 27 to start rather than 22 - the million is now down to $675,000 when you retire. Still not bad, but definitely not a million. And if you wait just 5 more years until you are 32 - you are looking at about $415,000 when you retire. So, you can see the importance of doing this right away - no matter what age you are. You can make this retirement figure a lot larger if you keep adding to it, rather than just doing it for 5 years.
Figures calculated with the savings calculator at CNN.com.
Invest the money in an Index fund
Buy an Index fund that follows the S&P 500 - The average performance of U.S. stocks over the last 80 years is over 10%. You may find a few stock mutual funds that occasionally beat the index, but very few consistently beat the average. This is the big secret of the industry - you will never (yes, I can pretty safely say never) have a financial advisor tell you to buy an index fund, because the fees are a lot smaller with an index fund than with a managed stock mutual fund. Therefore everyone involved in the sale of the mutual fund is getting paid a lot less than if you bought a managed mutual fund. The fact is that the great majority of managed stock mutual funds fail to beat the index.
Bottom line: Buy an Index fund in a ROTH IRA account, max it out for your first 5 working years and forget about it until you retire. If you can’t afford to max it out, don’t worry about it, just do the best you can. The purpose of the article is to emphasize how important it is to START EARLY!!
What I wouldn’t tell the grad (but I am thinking)
The reason this is the one thing I would teach them, is because it will probably help them to spend less than they earn - which is the KEY to financial well being. Secondly, if they can do it for five years - it will likely become a habit that they should be able to continue for the rest of their lives. And lastly, there are a bunch of things I would love to teach the grad, but this was the lesson that got me interested enough in money to learn the other lessons that I needed to learn.
Technorati Tags: college grad, financial advice
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I previously wrote a post called What is an IRA?, but I have had some inquiries about IRA’s, so I will try to keep it simple and explain Individiual Retirement Accounts a bit further for the beginners.
What is an IRA anyway?
- Well, an Individual Retirement Account (IRA) is basically an account that provides huge tax benefits when used to save money for retirement.
- It is an ACCOUNT that HOLDS investments IN it. I find that some people get this part confused, so remember IRAs are NOT investments themselves, they are only the ACCOUNT that holds the investments. Within the account you can invest in stocks, mutual funds, CDs, money market funds, and many others.
- IRAs can be opened at brokerage firms (Merrill Lynch, Edward Jones, etc.), online brokers (Zecco, Scottrade, ETrade), mutual fund companies (TRowe Price, Vanguard), and most banking institutions.
- You get to choose which investments go in the account. Keeping that in mind, many banks will not give you the freedom to invest in stocks and mutual funds, because they do not offer brokerage services (I know the larger ones do, so if you bank with them, go for it). But YOU are the one who decides what investments go in your account.
- You CAN open multiple IRA accounts at different places - keep in mind that there is a maximum amount that you are allowed to put in to your IRA each year ($4000 for 2007). I don’t recommend it; it gets messy. I know from experience. You have to keep track of how much you put in each one each year and make sure the combined amount doesn’t exceed the IRS limit. Another reason for not having multiple IRAs opened up is that…
- There is an annual fee of $30-40 charged by the brokerage firm or bank that you have your IRA with. Some are more, and some are less, but this is a good ballpark figure.
Roth IRA or Traditional IRA?
Of the two most common and basic IRAs, there are two types; ROTH and Traditional. The main advantage of the Roth IRA is that you use after-tax money to fund it, so when you reach retirement age you will not pay ANY taxes on the withdrawals.
The Traditional IRA, on the other hand, offers an up-front tax deduction, but commands taxes to be paid in retirement.
It is generally a safe assumption that the ROTH is usually is the better choice for most people. However, there are major differences between the two, so in order to get the best advice for your particular situation talk to a financial advisor.
There is a whole lot more to learn about ROTH IRAs and Traditional IRAs, but if you can honestly admit that you do not want to spend the time or energy to figure out which one will work better for your situation, then just pick one and start saving. It is far better to start saving, than do nothing while you try to figure out what to do.
Where can I open a Roth IRA?
So, you have learned the basics about IRA’s and you know that now is as good of a time as ever to start one, but where do you go to open one?
Really, you can open them just about anywhere: banks, brokerage firms, discount brokers, some mutual fund companies etc.
Just be aware that WHERE you open it may impact what investments are available to you. For instance, some banks only offer CDs in their IRA’s. www.TradeKing.com is a discount broker that I like (that is just about one of the cheapest places you can go). They allow you to buy mutual funds, stocks, bonds and more.
Questions to ask
No matter where you open your IRA, you should find out the answers to a few questions…
- Is there a minimum initial investment? How about minimum contributions?
- What types of fees are charged?
- Does the company offer automatic contributions?
- What investment options are available? Stocks? Bonds? Mutual funds? CDs?
If you open the account online, you should be able to find the answers to these and any other questions you may have on the company’s website. If not, feel free to call them. Most of them are so excited to have new customers that they will make the process as painless as possible.
(added 04/21/08) Zecco is another option for opening an IRA. They actually offer free stock trades. I haven’t opened an account with them yet, but I am going to be opening one soon. I will write more about it when I do…
Just find some place that you feel comfortable with to open your IRA. As I mentioned the options are endless, but even if you decide you want to move your IRA - you can without much hassle. I will have to go over IRA rollovers later.
Just remember, the hardest part is just taking the first step. It may take you an hour or two to open an account, but it will be well worth it when you look back in 20 years.
del.icio.us Tags: What is an IRA account?
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Open an account. I like going directly to the source. You can get a broker to open an IRA for you which may be more convenient. But, you will pay a hefty sum for that convenience. It has become fairly easy and very inexpensive for the individual investor to open investment accounts online. I like Vanguard and T.Rowe Price. Both will allow you to make free regular investments into your IRA.
Calculate how much you need to save. Now that the account is open, we need to figure out how much of an investment it is going to take to get us from here to there. Try out one of these retirement planning calculators to get an estimate of how much you will need to save on a monthly basis.
Direct deposit. Out of sight, out of mind. Humans are generally very easy to fool. If we don’t see (or have access) to the money, we won’t spend it. The trick is to have our employer direct deposit the money to our 401(k) or IRA, before we can get our hands on it. So, use the information from the calculator to give you a rough starting point of how much to have deposited each month. If the number is larger than you would have hoped, then just start with what you can each month and gradually increase it.
Don’t quit. In order to reach any goal, we must stay the course. There will be times when it is easy and times when it is hard, but consistency is how the tortoise beat the hare. The hare was a lot flashier and could move quicker, but he wasn’t consistent. When it comes to saving, it is not about how much we make, but about how much we keep. Don’t stop putting money towards your goal and commit to never touching your retirement savings (until retirement of course).
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What is an IRA and why do I need one?
An Individual Retirement Account (IRA) is a retirement savings plan that allows you to contribute up to $4,000 a year (in 2007). An IRA is an account in which you can have various different investments. You can put your IRA funds in stocks, mutual funds, CDs, money markets or other investments. The long-term benefit is that you will pay less taxes. We all like paying less taxes, and what this means for your retirement is that you will have more money in your hand when you retire.
With a traditional IRA, your money is put into the account before you pay taxes on them. The downside to this when you retire and begin taking the money out of your IRA you will have to pay taxes on it then. One benefit of paying taxes later, is that it will lower your taxable income for the current year. The alternative to this, which is a great choice for most people, is a Roth IRA.
The main difference between the Roth IRA and the Traditional IRA is when you pay taxes on the funds invested. The main benefit of the Roth IRA is that you use after-tax money to fund it, so when you reach retirement age you will not pay ANY taxes on the withdrawals. That just makes me smile thinking about it.
For more info check out What is an IRA account?
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