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Financial Life Advisor
How to Start Saving
I am 30 years old and have been very bad about doing any financial planning for the future. For a long time, I lived paycheck to paycheck, so there was no room for any outside investments. But I have finally started making some money and now have a cushion with which to play around with. I don't have kids or any huge financial strains at the moment, so I know now is a great time to put away some money that will help me in the future. I have a Roth IRA but have been told I can't put money in anymore because I make too much money, is there and truth to this? Should I start another one? I have a 401(k) at work which matches 50% up to 6% of my salary if I contribute. Should I invest in stocks? Bonds? Ahhhhhhh! Help!!!
A.F. from New York, NY A, many people do not get serious about saving for retirement until they are in their 40’s or even 50’s. At 30, you are not that far behind the curve. That being said, you should not put off saving anymore. By starting at your current age, you can keep your retirement savings at a reasonable level and enjoy the comfortable level of income you are now making.
I have seen people who make hundreds of thousands of dollars per year who have to take out loans to pay their tax bills. Conversely, I have also seen janitors who have saved hundreds of thousands of dollars on a salary most people would struggle to simply “scrape by” on. The lesson is that having a plan founded on knowledge of your resources and their limitations is important. It is very easy to increase spending but painful to reduce it. There is a certain level of pride at stake when you have to admit that you overstepped your financial resources and have to take a step(s) back.
I have found the best way to manage this situation is to always be slow and cautious to increase your lifestyle when you get a raise at work. It sounds like, right now, you have free cash flow each month because you were living on less money and now make more. If you run out and buy a new apartment or a fancy car, you might not enjoy that monthly cash cushion anymore.
To begin with, you should start with saving for retirement. A good rule of thumb for a young person is to set aside 10% of what they make to go directly into retirement savings. Because retirement is many years away, a tax sheltered account of some type is generally preferable. If you do not have to pay tax on the gains every year, it leaves more money to compound year after year. The more years it compounds, the more advantageous the tax sheltering becomes. Most workers have access to a 401(k) at work or some other account (403(b), 457, etc). These are great places to start because 1) they are automatic, and 2) you save regularly. You get the tax deduction right away through payroll, often there is a match, and possibly, the best part is that you do not have to remember to do anything.
You mentioned that your employer has a match for the 401(k). It is like getting an instant raise if you contribute to the 401(k) (if there is a match). If you contribute 7% of your salary, based upon the match you gave me, you would get another 3% put in by your employer. If you calculate that in New York, you are probably paying 35-40% in income tax, you would only see a drop in your take-home pay of about 4.2 to 4.5% of your gross income because you would be saving so much on your taxes. So just to recap, you get a tax deduction for participating, a match (free money) on top of that, and for the next 40+ years, you will be able to grow your retirement nest egg without annual tax on the gains. To put it another way, if you make $100,000 a year and elect to contribute $7,000, you will end up with about $4,200 less ($7,000 x 40% = $2,800 in tax savings) in your paycheck and will be saving $10,000 per year.
You said that you have a Roth IRA already but that you now make too much money to contribute. In 2009, the Roth eligibility phaseout for single taxpayers starts at $105,000 and ends at $120,000. For couples who are married filing jointly, the phaseout starts at $166,000 and ends at $176,000. Congrats on the good paycheck. I would normally say you are rolling in the dough if you make that much, but you live in one of the most expensive cities in the world.
A Roth is a great idea but may not necessarily be the best plan. This is especially true if you do not see yourself retiring in a high tax state like New York. The basic premise of a Roth is that you pay tax now and do not have to pay tax later. It would not make sense to pay 40% now, when in retirement, you might only be paying 25%. Even if your income prevents you from participating in a Roth IRA, your employer may have the option of making Roth 401(k) contributions. The match your employer gives you will always be pre-tax, but you can make your contributions after-tax to the Roth 401(k), and then they will be permanently tax-free. If you do see yourself in New York in retirement, then the Roth is an OK option, but if you have any doubt, I would stick with the regular 401(k) until you build up a serious account balance. At that time, I would invest in sitting down with a professional tax advisor and reviewing your options at that time.
Now that we have established how much you should be putting aside, we need to discuss what to invest in. This is a more complex issue. I believe the most important thing to establish is your allocation between equity stock and bonds. Your 401(k) will generally have a mix of stock and bond mutual funds to choose from. If you are a more conservative investor, at your age, I might recommend 60% stock and 40% bonds. If you are on the more aggressive side of the spectrum, you could go up to 90% stocks, 10% bonds.
It is difficult selecting the actual mutual funds for your 401(k). How do you decide between the various fund options? The most recent performance is only one component to use as comparison and is not the most important information, in my opinion. If the plan has target date, retirement funds ,or managed portfolios (aggressive, conservative, etc), I usually recommend those. Those funds will automatically rebalance and select the appropriate investment mix. If you want to pick your own mutual funds and are not familiar with how to select mutual funds, I would recommend spending a little money and hiring a fee-only financial planner to help select an appropriate mix.
I am glad you are asking these questions, now, while you are young. If you save 10% regularly and invest in a well diversified low cost portfolio, I expect you will have no problems in retirement. If you have any questions, please do not hesitate to ask. Now, go forth and save.
Posted by Ben Gurwitz on 29th October, 2009 | Comments | Trackbacks
Tags: Financial Planning, Retirement Accounts, Oct 09
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