Dear Dr. Don,
My husband and I are fairly young, 25 and 26, but I've been reading a lot about people retiring without enough money saved. I want us to try and save money for our retirement, but we make very little right now. Our household income is around $28,000. We have no children at the moment, but likely will within the next couple of years. We're each contributing about 1 percent to our 401(k)s, but only started doing so in 2010. I've read a lot about IRAs, but I'm not sure if that's something we should consider, or are even able to consider due to our age. We'd rather not risk the principal on our meager savings quite yet. Can you help us?
-- Erica Accrete
Dear Erica,
It's hard to make a commitment to retirement savings in your 20s. There are just so many competing financial goals, and you're just starting out in your careers so you don't have a lot of disposable income. But it's the money you set aside in your 20s that will have 40-odd years of investment earnings before you retire.
One percent of $28,000 is $280. You can use the Bankrate tax calculator "What is your tax bracket?" to show your 2010 average and marginal federal income tax brackets. I used the calculator with your income numbers and a couple of assumptions about your filing status and deductions, and it showed you to be in the 10 percent marginal tax bracket. That means you're not getting a whole lot of bang for your buck out of the tax-deferral features of your 401(k) plans. That $280 in contributions reduced your combined paychecks by about $252.
If your companies have an employer match to the 401(k) plan, then you should continue to contribute to the 401(k) plan. Ideally, you'd want to contribute up to the limit of the employer match. The typical match allows you to contribute up to 6 percent of your salary and the employer match is for half of your contribution, or up to a maximum of 3 percent of salary. With this type of match, you're making 50 percent on your money before you even decide where the money will be invested. The Bankrate calculator "Retirement contribution effects on your paycheck" shows the effect on your paycheck as well as the forecasted results in your retirement nest egg. You'll want to know whether the employer contribution is immediately vested or if it vests over time. If it vests over time and you change employers, you could lose all or part of the employer contributions when you change jobs.
If neither employer offers matching contributions, then you should consider funding Roth IRA accounts instead of the 401(k)s. You're contributing after-tax dollars, but your low marginal tax rate makes this easier to do now versus later in your careers, and qualified distributions out of the account will be free of federal income tax.
One caution here relates to any account fees or expenses, and it's something to consider whether you're investing in a 401(k) plan or a Roth IRA account. Let's say that you and your husband each contributed equally to a 401(k) plan in 2010. That has each of you contributing $140. If you each had to pay an account fee of $25, you'd see $50 of your contributions go to fees. That's about an 18 percent drag on the account balances. It will diminish with time as the account grows in value, but in this situation, you might consider concentrating the investment in one spouse's 401(k) plan. Talk to your plan administrators about account fees and expenses.
There's no more risk in holding your money in a Roth IRA versus a 401(k) plan. It's not the type of account, but how the funds in the account are invested that creates volatility (risk) in investing. Don't swing for the fences, but don't be too conservative in investing your retirement funds in your 20s. Bankrate's "Asset allocation calculator" can provide a starting point for how you might want to invest your retirement savings.
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