Retire Early

by Gary Foreman


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Dear Gary,
I'm 22 years old, about to graduate college, and thinking about retirement. Everyone I know who is between the ages of 40 and 70 tells me how much they wished they had planned ahead for retirement when they were my age. I don't want to say that when I'm older. What can I be doing right now when I'm starting my career that will allow me to retire as early as possible with as much financial security as possible? I have heard great things about Roth IRAs and 401k plans.
Russell F.

Let's begin by congratulating Russell. Not only for his graduation but also for his foresight. Because his generation faces some new challenges in retirement.

For the last 50 years Americans have become increasingly dependent on Social Security to provide retirement income. And so far the system has done a good job of filling that need. So good, in fact, that many people retire today without having accumulated any savings to supplement their income.

That could be dangerous for someone who's Russell's age. The Social Security Administration calculates something called the "Aged Dependency Ratio". It compares how many people are over age 65 to those between the ages of 20 to 64. In other words, how many people are retired compared to those who could be working and contributing to Social Security.

In 1940 the ratio was 11 retirees to 100 potential workers. Today the ratio stands at 21 retirees per 100. In the year 2045 Russell will be 67. At that point there will only be three potential workers to provide Russell's Social Security payments. Russ would be foolish to solely depend on those three people to pay enough to fully support him on Social Security.

So what should Russ try to accomplish with his retirement savings? Naturally, he'll want to accumulate money that can be used to pay living expenses when he's retired. Perhaps he'd like to reduce his taxes today. And he might want to have access to his money for extraordinary expenses before retirement.

All retirement plans work under the same basic premise. You can pay the IRS now and then avoid taxes on the distributions later. Or you can avoid taxes now, but pay them when you take the money out.

One of the advantages of the regular IRA and 401k plan is that the contributions you make are deductible now. You'll pay taxes on the money when you withdraw it. Many people expect to be in a lower bracket after they're retired. So they'd pay less in taxes.

The Roth IRA is different. You contribute money that's already been taxed.

All three programs share one advantage. Earnings on the money invested in the plans are not subject to taxes each year. And that can be a major factor.

Let's suppose that Russ puts away $2,000 every year and earns 6%. Let's also assume that he's in the 28% tax bracket. By the time he's 70 he will have accumulated $306,229.

But, if he put that same contribution into a retirement plan it would have grown to $513,129 because taxes aren't due each year. A higher investment return would increase the difference.

The 401k does have one unique advantage over the IRA's. Many employers will contribute $1 for every dollar or two that the employee contributes. It's pretty hard to beat an investment that earns 50 or 100% the very first day!

But, the 401k does have some limitations. Check your plan for investment options. Generally the employer will choose how their contribution is invested. And the employee may have limited choices for their own contributions, too.

Both the traditional and Roth IRA's offer a wide variety of investment choices. You can choose investments ranging all the way from very safe to quite risky.

Putting money into a retirement plan is great, but Russ will want to be able to get it out, too! And that can be a little confusing because each plan has different taxes and penalties.

The Roth IRA gives you a break if you need to take a small early withdrawal. You can withdraw an amount up to your original contributions without paying taxes. That's because you paid tax on that money before you contributed it.

Your earnings can be withdrawn tax-free if you're over age 59 1/2, become disabled or want to use it for a first time home purchase and the money has been in the account for five years. Unlike a traditional IRA, the Roth IRA doesn't have any required distribution date. So you won't be forced to make distributions.

If you want to take money from your 401k without paying taxes you'll need to see if your plan permits loans. You'll borrow from the account and repay it on a set timetable. Each plan will specify the rules for borrowing. They can restrict how you use the money. Check your plan for details.

When you leave your employer you'll be required to close out the 401k account. You can take it as a lump sum distribution and pay taxes on it. Or you can roll it over into a regular IRA account and defer the taxes.

Getting your money out of a regular IRA is a little harder. If you haven't reached the age of 59 1/2 you'll face a 10% penalty and ordinary income taxes on any distributions. And you must begin taking your money out at age 70 1/2 whether you need it or not. All withdrawals are taxable.

So how does Russ decide where to put his money? In most cases, if he's eligible for a 401k with an employer matching contribution, that's the best option. After that, most people who haven't seen their 40th birthday should add any additional savings to a Roth IRA. Having that money accumulating tax free is too big a benefit to pass up. If you're older or fighting tax problems and want the deduction a traditional IRA would fit the bill.

One final thought for Russ. Every dollar that he saves in his 20's is the equivalent of four dollars saved in his 50's. So it's much easier to accumulate enough for a comfortable retirement if he starts early.


Gary Foreman

Gary Foreman is a former financial planner and purchasing manager who founded The Dollar Stretcher.com website and newsletters in 1996. He's been featured in MSN Money, Yahoo Finance, Fox Business, The Nightly Business Report, US News Money and he's a regular contributor to CreditCards.com. You can follow Gary on Twitter or visit Gary Foreman on Google+. Gary is also available for audio, video or print interviews. For more info see his media page.

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