Retirement Planning For Millennials
Since the Employee Retirement Income and Security Act (ERISA) was enacted in 1974, the government has used tax incentives to encourage Americans to save for retirement. Unfortunately, many Americans don’t put much effort into planning for retirement, and don’t take advantage of the tax incentives offered to them. Studies show that the most recent entrants into the workforce, the millennial generation, may be the most apathetic. Millennials, a generational moniker referring to those coming into adulthood around the start of the 21st century, have a lot of things going for them. Most obvious and perhaps redundant is the advantage of time. Being young, Millennials have time to plan careers and other life goals, to enjoy a certain freedom from responsibility before settling down, to travel, to pursue a passion project or volunteer work and to figure out what makes them happy. Conspicuously absent from this list (and probably from the lists many Millennials might put together) is the time to plan for retirement. One reason for this is that Millennials are less consumerist than their predecessors and more focused on mission and meaning. Like Gen X (the preceding generation), they question authority. Partly due to the Financial Crisis of 2007-2008 and partly due to new options not previously available, they are highly distrustful of large financial institutions, banks especially. They are increasingly likely to be "unbanked" - avoiding traditional banks and instead opting to manage their finances through services offered by some of the most innovative financial technology (fin-tech) companies.
Millennials Keep 52% of Investable Assets in Cash
The newest generation also isn’t counting on retirement assistance programs such as Medicare and Social Security to be around when they retire. This, combined with their distrust of financial institutions (including Wall Street), has left Millennials a bit cautious when it comes to their finances. They keep 52% of their investable assets in cash and only about a quarter in stocks, the complete opposite of the previous generation. And 43% describe themselves as "conservative investors," as opposed to only 27% from Generation X.
On the other hand, Millennials can be quite savvy when it comes to their money. They are accustomed to having their finances at their fingertips and to using mobile technology to compare prices on the spot. They may distrust banks, but they are relentless connectors and place greater faith in personal networks than in large institutions. They don’t like to take big risks, but they are essentially entrepreneurial in spirit.
This entrepreneurial spirit, put in motion by their distrust for larger institutions, has established a do-it-yourself mentality within the generation. And today, there have never been so many alternatives for Millennials to do it themselves. With discount brokerage services recently having completed a transition to mobile platforms and the new variety of fin-tech options, Millennials worrying about retirement are planning for the big day without the help of a CPA or financial advisor. And here lies the problem. The average individual equity investor underperforms the general stock market by an average of 5% per year.
The most recent DALBAR study found that the average individual equity investor who uses a discount brokerage underperforms the general stock market by an average of 5% per year. This is for three reasons. The first and most obvious is that they tend to make poor investment decisions, following the hottest stock or mutual fund. Secondly, they tend to choose investment options that charge high fees and expenses. Third, perhaps the most important and the primary point of this article, is that they don’t optimize tax-efficient accounts.
Tax-efficient accounts allow investors to forgo paying the four types of taxes that normally apply to non-tax sheltered accounts.
1. Income taxes. Interest that is earned from fixed income investments is taxed at the same rate as ordinary income. This can be as high as 39.6%.
2. Capital Gain taxes. Proceeds from selling an investment (if one sells it at a higher price than they bought it at) is subject to tax. If an investment is held for less than 12 months, this rate will be equivalent to the investor’s ordinary income tax rate. If the investment is held for more than 12 months, the gain will be taxed at the current long-term capital gains tax rate of 10% or 15%.
3. Dividend taxes. Dividends received from holding stocks can be taxed as either ordinary income or at a qualified dividend rate that is often lower, depending on certain qualifications.
4. State and Local Taxes. Since most states do not differentiate between sources of income, whatever you make from your investments will be taxed at your normal state income rate. There are, of course, some states where this doesn’t apply.
Quantifying the Advantage
Millennials are in a great position to benefit from tax advantaged accounts. Similar to how small, consistent gains can, over time, substantially increase the value of an investment portfolio (a phenomenon known as compound return), small losses of value, paid in expenses, over time, can substantially reduce its value. John Bogle, Founder of investment firm Vanguard, noted the magnitude of even the slightest increase in cost when he called this phenomenon the “tyranny of compounding costs” in a Wall Street Journal article in 2005. And, these four taxes, which a Morningstar study found can eliminate up to 2.5% of investment gains, over time, are by and large an investor’s greatest expense Consider a young millennial investor who invests $1,000 into the stock market on his 20th birthday, planning to retire at age 65. Assuming 6% consistent growth annually, his $1,000 investment would be worth around $13,750 by retirement. Now if that same investor gave up 2.5% of his gains each year to taxes, his $1,000 initial investment would be worth only around $4,700 by retirement.
The numbers are clear, deferring taxes can substantially impact one’s portfolio over time. The general rule is the more time, the larger the impact. But this isn’t all. There are the additional tax-advantages millennial investors can realize by contributing to tax-advantaged accounts such as the individual retirement account (IRA) and 401(k).
Advantages such as:
- Investors can contribute a certain amount of their pre-tax income to the account, leading to a lower tax bill and more money that can be invested.
- The possibility of a match and its effect over time.
- Asset protection from creditors
- Employer-sponsored retirement plans may allow investors to take loans up to 50% of portfolio value.
- Employer-sponsored retirement plans can be rolled over into other qualified plans.
The benefits come with a few restrictions that are actually there for the investor’s best interest. These are as follows:
1. The investor will be penalized for withdrawing from the plan prior to turning 59 ½ (some exclusions apply). The current early withdrawal penalty is 10% of the withdrawal amount plus taxes due.
2. The investor is required to take annual required minimum distributions (RMD) from the plan starting at age 70 ½.
3. In the traditional account, the investor will be taxed at their ordinary income rate upon withdrawing from the plan.
4. In many employer sponsored plans, investors are limited to pre-approved investment options. These pre-approved investment options are usually diversified, and some are professionally managed. Investment options often include target-date funds.
The 401(k) Match
A 401(k) is an employer-sponsored retirement account. Employees elect a specific amount that automatically deducts from their paycheck each pay period. While each plan is unique in how it is constructed, most offer some type of an employer match. A common matching option is 50% of the first 6% of the employee’s contributed income. For someone making $100,000 per year and contributing $6,000 or more, that is $3,000 of employer match per year, assuming no limit is put in place.
By using a free retirement plan calculator found online, Millennials can determine how much their 401(k) match can accumulate over time. They may be pleasantly surprised. For example, a $3,000 match per year invested into a portfolio bearing 6% consistent growth annually will accumulate to about $116,000 over 20 years.
The "match" doesn't officially become theirs until they are considered "fully vested" in the plan.
Young investors can think of the match as free money if, and only if, they plan to stick with that company for the long-haul. Those who plan to change careers (or firms) should understand that the "match" doesn't officially become theirs until they are considered "fully vested" in the plan. Vesting requirements differ from plan to plan. Millennials who don’t expect to change careers or employers may benefit most by maximizing their employer match prior to contributing to alternate accounts.
The IRA Freedom
IRAs share many of the same benefits as the 401(k), such as pre-tax deferred growth, but they also have a few exceptions. Most obvious, there is no match, and contributions don’t automatically deduct from earned income. The account is entirely self-managed. Investors can open an IRA account at a brokerage firm and can invest in a variety of securities such as individual stocks, individual bonds, and any mutual fund or ETF of their choosing.
But the IRA has two major disadvantages when compared to the 401(k):
1. Contributions are only fully tax deductible if the individual makes less than a certain amount of income per year. Single men and women that are already invested in another retirement plan, such as a 401(k), won’t be able to fully deduct contributions if they make more than $71,000 in income per year. Married couples filing jointly won’t be able to fully deduct contributions if they make over $118,000 in income per year (2015). For individuals and for married couples filing jointly who aren’t already contributing to another retirement plan, there is no restriction.
2. The maximum contribution for an unmarried individual is $5,500 in 2015, compared to $18,000 for a 401(k). Most Millennials don’t make enough income to be restricted from making a fully tax-deductible contribution to their IRAs. Therefore, the IRA is an effective retirement option, especially if the Millennial has maximized his or her 401(k) contribution or works for a company that doesn’t offer a 401(k) plan.
Most Millennials don’t make enough income to be restricted from making a fully tax-deductible contribution to their IRAs. Therefore, the IRA is an effective retirement option, especially if the Millennial has maximized his or her 401(k) contribution or works for a company that doesn’t offer a 401(k) plan.
TRADITIONAL VS. ROTH
IRAs and some 401(k) accounts come in two varieties – the traditional account (the type of IRA discussed so far) and the Roth account. The basic difference between these two forms is that, unlike a traditional account, contributions to a Roth account aren’t tax-deductible. Instead, the investor receives the tax benefit by being able to withdraw money from the account tax-free starting at age 59 ½; that is assuming they have been contributing to the account for a minimum of five years. Factors that Millennials should take into consideration when determining which account type of account is best include:
- If an investor expects to be in a lower tax bracket in the future, taking the deduction now and deferring taxes is likely to save more money. Therefore, a traditional account might be preferred.
- If an investor either expects to be in a higher tax bracket in the future or believes that the government will raise tax rates to pay down governmental deficits, a Roth account might be preferred.
- If an investor expects to withdraw money before age 59 ½, either to pay for a first home or for any other reason, Roth accounts allow the investor to withdraw $10,000 or any contributions (not gains) without penalty.
The first priority for the millennial investor is not deciding between the two but rather becoming educated about these tax incentives.
The Roth option appeals to the average Millennial who is generally in a lower tax bracket and may need to withdraw funds in the future to pay for a first home. But for other investors, the difference between the two types of accounts is insignificant compared to the benefits of using either. The first priority for the millennial investor is not deciding between the two but rather becoming educated about these tax incentives.
By working alongside a trusted CPA and financial advisor, and by maximizing contributions to tax-deferred accounts, Millennials are taking a big step on the way to ensuring a comfortable retirement.