Investing in Retirement Accounts in Your 20s and 30s

By Eric Tyson

During your younger adult years, you may not be thinking much about retirement, because it seems to be well off in the distance. But if you’d like to scale back on your work schedule someday, partly or completely, you’re best off saving toward that goal as soon as you start drawing a regular paycheck.

Maybe the problem with thinking about this goal stems in part with the terminology retirement. Perhaps thinking about it in terms of saving and investing to achieve financial independence is better.

In this section, I explain the benefits and possible concerns of investing through so-called retirement accounts. I also lay out the retirement account options you may access.

Understanding retirement account perks

Where possible, try to save and invest in accounts that offer you a tax advantage, which is precisely what retirement accounts offer you. These accounts — known by such enlightening acronyms and names as 401(k), 403(b), SEP-IRA, and so on — offer tax breaks to people of all economic means. Consider the following advantages to investing in retirement accounts:

  • Contributions often provide up-front tax breaks. By investing through a retirement account, you not only plan wisely for your future but also get an immediate financial reward: lower taxes, which mean more money available for saving and investing. Retirement account contributions generally aren’t taxed at either the federal or state income tax level until withdrawal (but they’re still subject to Social Security and Medicare taxes when earned). If you’re paying, say, 30 percent between federal and state taxes, a $4,000 contribution to a retirement account lowers your income taxes by $1,200.

Modest income earners also may get an additional government tax credit known as the Retirement Savings Contributions Credit. A maximum credit of 50 percent applies to the first $2,000 contributed for single taxpayers with an adjusted gross income (AGI) of no more than $18,500 and married couples filing jointly with an AGI of $37,000 or less. Singles with an AGI of between $18,500 and $20,000 and married couples with an AGI between $37,000 and $40,000 are eligible for a 20 percent tax credit. Single taxpayers with an AGI of more than $20,000 but no more than $31,000, as well as married couples with an AGI between $40,000 and $62,000, can get a 10 percent tax credit.

  • Your employer may match some of your contributions. This cash is free money from your employer, and it’s use it or lose it, so don’t miss out!
  • Investment returns compound tax-free. After you put money into a retirement account, you get to defer taxes on all the accumulating gains and profits (including interest and dividends) until you withdraw the money down the road. Thus, more money is working for you over a longer period of time. (One exception: Roth IRAs offer no up-front tax breaks but permit tax-free withdrawal of investment earnings in retirement.)

Grappling with retirement account concerns

There are legitimate concerns about putting money into a retirement account. First and foremost is the fact that once you place such money inside a retirement account, you can’t generally access it before age 59-1/2 without paying current income taxes and a penalty — 10 percent of the withdrawn amount in federal tax, plus whatever your state charges.

This poses a problem on several levels. First, money placed inside retirement accounts is typically not available for other uses, such as buying a car or starting a small business. Second, if an emergency arises and you need to tap the money, you’ll get socked with paying current income taxes and penalties on amounts withdrawn.

You can use the following ways to avoid the early-withdrawal penalties that the tax authorities normally apply:

  • You can make penalty-free withdrawals of up to $10,000 from IRAs for a first-time home purchase or higher educational expenses for you, your spouse, or your children (and even grandchildren).
  • Some company retirement plans allow you to borrow against your balance. You’re essentially loaning money to yourself, with the interest payments going back into your account.
  • If you have major medical expenses (exceeding 10.0 percent of your income) or a disability, you may be exempt from the penalties under certain conditions. (You will still owe ordinary income tax on withdrawals.)
  • You may withdraw money before age 59-1/2 if you do so in equal, annual installments based on your life expectancy. You generally must make such distributions for at least five years or until age 59-1/2, whichever is later.

If you lose your job and withdraw retirement account money simply because you need it to live on, the penalties do apply. If you’re not working, however, and you’re earning so little income that you need to access your retirement account, you would likely be in a low tax bracket. The lower income taxes you pay (compared with the taxes you would have paid on that money had you not sheltered it in a retirement account in the first place) should make up for most, if not all, of the penalty.

But what about simply wanting to save money for nearer-term goals and to be able to tap that money? If you’re saving and investing money for a down payment on a home or to start a business, for example, you’ll probably need to save that money outside a retirement account to avoid those early-withdrawal penalties.

If you’re like most young adults and have limited financial resources, you need to prioritize your goals. Before funding retirement accounts and gaining those tax breaks, be sure to contemplate and prioritize your other goals.

Taking advantage of retirement accounts

To take advantage of retirement savings plans and the tax savings that accompany them, you must spend less than you earn. Only then can you afford to contribute to these retirement savings plans, unless you already happen to have a stash of cash from previous savings or an inheritance.

The common mistake that many younger adults make is neglecting to take advantage of retirement accounts because of their enthusiasm for spending or investing in nonretirement accounts. Not investing in tax-sheltered retirement accounts can cost you hundreds, perhaps thousands, of dollars per year in lost tax savings. Add that loss up over the many years that you work and save, and not taking advantage of these tax reduction accounts can easily cost you tens of thousands to hundreds of thousands of dollars in the long term.

The sooner you start to save, the less painful it is each year to save enough to reach your goals, because your contributions have more years to compound. Each decade you delay saving approximately doubles the percentage of your earnings that you need to save to meet your goals. If saving 5 percent per year in your early 20s gets you to your retirement goal, waiting until your 30s to start may mean socking away approximately 10 percent to reach that same goal; waiting until your 40s means saving 20 percent. Start saving now!

Surveying retirement account choices

If you earn employment income (or receive alimony), you have options for putting money away in a retirement account that compounds without taxation until you withdraw the money. In most cases, your contributions to these retirement accounts are tax-deductible.

Company-based retirement plans

Larger for-profit companies generally offer their employees a 401(k) plan, which typically allows saving up to $18,000 per year (for tax year 2017). Many nonprofit organizations offer their employees similar plans, known as 403(b) plans. Contributions to both traditional 401(k) and 403(b) plans are deductible on both your federal and state taxes in the year that you make them. Employees of nonprofit organizations can generally contribute up to 20 percent or $18,000 of their salaries, whichever is less.

There’s a benefit in addition to the up-front and ongoing tax benefits of these retirement savings plans: Some employers match your contributions. (If you’re an employee in a small business, you can establish your own SEP-IRA.) Of course, the challenge for many people is to reduce their spending enough to be able to sock away these kinds of contributions.

Some employers are offering a Roth 401(k) account, which, like a Roth IRA (discussed in the next section), offers employees the ability to contribute on an after-tax basis. Withdrawals from such accounts generally aren’t taxed in retirement.

If you’re self-employed, you can establish your own retirement savings plans for yourself and any employees you have. Simplified Employee Pension-Individual Retirement Accounts (SEP-IRA) allow you to put away up to 20 percent of your self-employment income up to an annual maximum of $54,000 (for tax year 2017).

Individual Retirement Accounts

If you work for a company that doesn’t offer a retirement savings plan, or if you’ve exhausted contributions to your company’s plan, consider an Individual Retirement Account (IRA). Anyone who earns employment income or receives alimony may contribute up to $5,500 annually to an IRA (or the amount of your employment income or alimony income, if it’s less than $5,500 in a year). A nonworking spouse may contribute up to $5,500 annually to a spousal IRA.

Your contributions to an IRA may or may not be tax-deductible. For tax year 2017, if you’re single and your adjusted gross income is $62,000 or less for the year, you can deduct your full IRA contribution. If you’re married and you file your taxes jointly, you’re entitled to a full IRA deduction if your AGI is $99,000 per year or less.

If you can’t deduct your contribution to a standard IRA account, consider making a contribution to a nondeductible IRA account called the Roth IRA. Single taxpayers with an AGI less than $118,000 and joint filers with an AGI less than $186,000 can contribute up to $5,500 per year to a Roth IRA. Although the contribution isn’t deductible, earnings inside the account are shielded from taxes, and unlike withdrawals from a standard IRA, qualified withdrawals from a Roth IRA account are free from income tax.

Annuities: Maxing out your retirement savings

What if you have so much cash sitting around that after maxing out your contributions to retirement accounts, including your IRA, you still want to sock more away into a tax-advantaged account? Enter the annuity. Annuities are contracts that insurance companies back. If you, the investor (annuity holder), should die during the so-called accumulation phase (that is, before receiving payments from the annuity), your designated beneficiary is guaranteed reimbursement of the amount of your original investment.

Annuities, like IRAs, allow your capital to grow and compound tax-deferred. You defer taxes until you withdraw the money. Unlike an IRA, which has an annual contribution limit of a few thousand dollars, an annuity allows you to deposit as much as you want in any year — even millions of dollars, if you’ve got millions! As with a Roth IRA, however, you get no up-front tax deduction for your contributions.

Because annuity contributions aren’t tax-deductible, and because annuities carry higher annual operating fees to pay for the small amount of insurance that comes with them, don’t consider contributing to one until you’ve fully exhausted your other retirement account investing options. Because of their higher annual expenses, annuities generally make sense only if you won’t need the money for 15 or more years.

Selecting retirement account investments

When you establish a retirement account, you may not realize that the retirement account is simply a shell or shield that keeps the federal, state, and local governments from taxing your investment earnings each year. You still must choose what investments you want to hold inside your retirement account shell.

You may invest the money in your IRA or self-employed plan retirement account (SEP-IRAs and so on) in stocks, bonds, mutual funds, and even bank accounts. Mutual funds (offered in most employer-based plans) and exchange-traded funds (ETFs) are ideal choices because they offer diversification and professional management. See Chapter 10 for more on mutual funds and ETFs.