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Tue 05 August 2014

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Retirement for Millennials: a step by step guide to getting started

MillenialsInfographic Source: TD Ameritrade - Investor Insights

Some 62% of Millennials rate themselves disciplined or highly disciplined as money planners, compared to 54% of folks aged 60 or over, according to the firm’s 2014 Planning and Progress study...Yet 68% acknowledge room for improvement in managing their finances, suggesting a degree of humility not often seen with this age group. They appear open to learning more but aren’t sure where or how to find a trusted source. ” -Time Magazine

Retirement for Millennials: a step by step guide to getting started

Millenials68percent Millenials30percent

Source: Northwestern Mutual

Why it's important

No one wants to think about retirement planning in their 20s but it’s a much easier subject to grasp than one would believe. Retirement is a word that brings to mind images of old couples on a golf course or beach in Florida. Well that’s pretty accurate, but how do you think those people end up in those situations rather than working for minimum wage well into their 70s? They planned ahead. Remember the kids in highschool or college who didn’t take life seriously versus those who did? In your 20s you begin to see the drastic differences of where that puts us in our careers, income levels, etc. The result from lack of discipline and hard work during highschool and college will show within years. Retirement is the same story but told over a longer time line. You only begin to see who planned and who failed to plan after 20-40 years of disciplined savings and investing, or lack thereof. For most, the saying, “it’s never too late” is true; unless you're 60, failed to save, and would like to retire by 65. My advice to those? Start playing the lottery. On a more serious note, even if you’ve found yourself in your 30s or 40s with little to no retirement planning done, it’s not too late. It simply means you need to be more aggressive now than if you had started 10 years prior.

For those just getting started, below is a guide i’ve put together to be as straight forward as possible. I’ll not over-complicate it with too many details, or details about all the different kinds of retirement accounts. When it comes to providing retirement advice to Millennials, I point nearly every one of them towards a Roth IRA account - barring they aren’t a sort of outlier (i.e. a 22 year old making $150,000 right out of college!).

Advantages of a Roth IRA

Most people are taught to always have some form of savings account. That’s great, but only up to a certain limit. You’re capped on the returns you can get from a typical savings account. The average interest rate of a Bank of America savings account right now is around 0.03-0.05%. That sucks, no thanks - factor in average inflation of 2% and you're actually losing money! Except for having an emergency fund of x-months of salary in the event of job loss, etc., you really should try and put the rest of your money to work outside of a traditional “savings account.”

How important is it to put your cash to work? The chart below shows the long-term average growth stocks vs the average growth of other asset classes. It is an over-simplification, in my opinion, but really helps illustrate what cash holdings or "savings" returns are over time if not invested.

Stockchart

Source: Betterment

What is a good alternative to having all your cash in a savings account? A Roth IRA. Why? Because it can, in a way, function as a savings/emergency fund while also taking advantage of possible higher returns. As with any investment, you are exposed to market risks or potential loss of capital. How you invest that money is important, but I’ll address that later.

IRS Roth IRA contribution rules in 2014 are as follows: as a single person, one can contribute up to $5,500* a year if they make less than $114,000 annually. For most recent college graduates, or those in their 20s, I would say these limitations aren’t too restrictive. For married couples, the contribution limit is $5,500* a year as well, but they can make up to $181,000 jointly before they are barred from contributing.

*Individuals age 50 and over can contribute up to $1,000 extra per year to "catch up" for a total of $6,500.

As with any type of retirement account, there are withdrawal restrictions. Fortunately for a Roth IRA (versus other retirement accounts), whatever you contribute you can take out penalty-free. In traditional IRAs and 401ks, the money you contribution is pre-tax money. If you want to withdraw that contribution prior to retirement age of 59 ½, you pay taxes as well a 10% penalty. Not good if you need quick access to that money. In a Roth IRA, however, you don’t pay those taxes or penalties on contributions because the money you contribute is post-tax money. You DO however pay taxes and penalties on any gains from your contributions, but that is understandable. Below is a table comparison of what I’ve stated above to give a visualization of the primary differences between a Roth IRA and a Traditional IRA:


IRAComparison

*The 5-year holding period for Roth IRAs starts on the earlier of: (1) the date you first contributed directly to the IRA, (2) the date you rolled over a Roth 401(k) or Roth 403(b) to the Roth IRA, or (3) the date you converted a traditional IRA to the Roth IRA. If you're under age 59½ and you have one Roth IRA that holds proceeds from multiple conversions, you're required to keep track of the 5-year holding period for each conversion separately.

**Distributions received before you're age 59½ may not be subject to the 10% federal penalty tax if the distribution is due to your disability or death; is distributed by a reservist who was ordered or called to active duty after September 11, 2001, for more than 179 days; or is for a first-time home purchase (lifetime maximum: $10,000), postsecondary education expenses, substantially equal periodic payments taken under IRS guidelines, certain unreimbursed medical expenses, an IRS levy on the IRA, or health insurance premiums (after you've received at least 12 consecutive weeks of unemployment compensation). Source: The Vanguard Group

For those interested in comparing the growth of the two types of IRAs, here is an easy calculator to do so. While a traditional IRA may be worth slightly more (due to tax savings), remember that a Roth IRA is tax-free once it comes time to withdraw at retirement. Withdrawals on the traditional IRA will be taxed at your current tax rate upon retirement.

When it comes to retirement savings, a Roth IRA can make a big difference versus only investing in a taxed investment account. All future earnings are sheltered from taxes. Use this Roth IRA calculator to simply show how much can be saved between now and retirement.

What is the main takeaway? Most young people do not have the luxury of having a reasonably sized savings account as well as a retirement account. The Roth IRA offers the benefits of both without much compromise. It’s one of the best things to do with your first $5,000-10,000. If you hit a snag and need to pull out $3,000, you can. With a traditional IRA or 401k, it’s not that simple, and you pay the penalties to do it. If you don’t end up needing to withdraw money, great, it’s being put to work in the market! Forget earning 0.03% in a savings account on $10,000! Invest half of it; with a Roth IRA you easily can do so!

Getting started

If you’ve decided to contribute $5,500 (or less) this year to a Roth IRA you’re probably wondering what’s the best way to do it? Well, fortunately there are a number of great companies through which you can do so. I personally recommend Interactive Brokers as I’ve always had a great experience with them and their rates are incredibly competitive. Scottrade, ETrade, TD Ameritrade, etc., are also good brokers that offer the platforms necessary to provide any new investor with what they need. I’m not sure about all brokers, but I like that Interactive Brokers offers two different commission types: share-based or flat-fee. The share-based fee is an excellent choice for investors with small accounts that will be trading very infrequently. You just pay a small fee based on the volume of shares you will be buying/selling. Most places offer flat-fee-based commissions which are on average $9.95 per trade, regardless of share amount. In the long run, on a small amount of capital, the share/volume-based choice I believe is the best rather than the flat-fee setup. Just food for thought.

ETF vs Mutual Fund comparison

This is one area I can’t stress enough the importance of understanding what investment vehicles you choose to invest in. You essentially have three options, but two of them are the easiest. You can invest in individual stocks, that works, but it’s only beneficial if you truly know what you’re doing. The other two options are ETFs (exchange traded funds) and mutual funds. I’m sure you have heard the term mutual fund before as they have been around for decades and are typically the investment vehicle of choice for most investors. Does that mean they’re the best choice? Not really. ETFs came about in the early 1990s but it wasn’t until the last 10 years or so that they have gained in immense popularity. Why? Because they’re an excellent and cheaper alternative to mutual funds. Mutual funds are often the product of choice among financial advisors for a few reasons: they’re easy to use, they don’t require much attention, and some provide attractive commissions to the advisor. The great thing about ETFs is they’re also easy to use, don’t require a whole lot of attention, their fees are considerably lower and they aren’t designed to pay any sort of commission to an advisor (if you have one).

ETF Database offers a mutual fund to ETF converter that is incredibly helpful for those looking to set up their own portfolio without having to use mutual funds. The converter can be found here.

You can either go down the list of mutual funds and click to see the ETF alternatives, or if you know the mutual fund’s symbol, you can enter it to see what ETF(s) is a good alternative.

Mutual funds have all sorts of fees/costs that ETFs do not, such as: additional tax costs, cash drag, additional advisory fees, etc. For a deeper look into the costs of owning mutual funds, read this Forbes article.

Below is a simple chart to visualize the main advantages of ETFs over mutual funds as discussed above:

ETFAdvantages

Source: ETF Database - Five Advantages of ETFs Vs Mutual Funds


The Fun Part - Putting Your Money To Work

When it comes to investing, you have a few options. Unless you’re an avid investor or keen on doing everything yourself, this is something you should outsource. Below is a breakdown on your options:

Outsourcing all of it:

Find an advisor or online advisor and have them open an account for you and manage it accordingly. This option will typically cost you the most and is the least transparent (some people don't care about transparency). You do need to ask them how your money will be invested: stocks, ETFs, or mutual funds? Your advisor should be someone you trust, and one that is open and willing to discuss their investment approach, as well as all fees associated with their services and investment choices. In this industry, the fee discolsure is typically the area where people can be taken advantage of; be knowledgeable of this. It is very important to understand the impact that high fees can have on the long-term compounding growth of one's portfolio.

Outsourcing part of it:

Mutual Funds - you pick a brokerage company, like one of the ones mention earlier in this article, and then you invest in mutual funds. That is a form of outsourcing your investments. What mutual funds you choose to invest in is entirely your choice. However, when it comes to ease of investment and “proper” (I use this word lightly) allocation, your best choices are typically the age-based or target-date mutual funds. You simply pick the year range of your retirement and invest all of your capital into those funds. For someone in their 20s today looking to retire by age 65, you’d pick a 2050-2060 (year) type fund. The downside to this option is they don’t account for your risk tolerances and they are too generic, non-flexible.

ETFs - you pick a brokerage company, like one of the ones mention earlier in this article, and then you invest in ETFs. This is a more hands on approach than choosing mutual funds which gives you greater flexibility and is often less expensive. When it comes to choosing the right ETFs to invest in, you’ll want to seek outside guidance and stick to it completely - that is the outsourced part. For most, this means subscribing or following a group that offers ETF investment advice for a fee. You can follow their picks or recommendations and invest in ETFs accordingly. This is a bit more hands on than the prior mutual fund approach but it is still not as involved as doing it all yourself. As recommended by most professionals, instead of trying to become a good trader, find someone who is and use a system they have developed. This comes at a cost, but it’ll save you a lot of headaches and allows you to use the years of experience and research of that group instead of relying on yourself.

Doing it all yourself:

This is pretty self-explanatory, but do know it is the riskiest option. You pick a brokerage company, like one of the ones mention earlier in this article, and then you invest in ETFs, stocks, etc. If you’re an avid investor or someone looking to get into it as a side hobby, this is your best option. With this approach it is still recommended you find a legitimate trader or group that offers advice or signals on stocks, ETFs, etc. and follow their suggestions. Doing so allows you to grow as a trader or investor without having to suffer from a lot of the mistakes as someone who goes at it completely un-aided. Emotions play a large role in investment decisions when it's only you, as a human, making the decisions. Trust me, I learned the hard way and it's very costly if it goes on for a long time!

What's the takeaway summary?

1) Roth IRAs are generally the best option when first getting started on investing for retirement.

2) Invest in ETFs if you can.

3) Hire a trusted advisor or, if you plan to manage the portfolio yourself, use a legitimate investment professional to provide you with independent investment advice.

The information provided in this article is for educational purposes only. You should consult a tax attourney or accountant regarding any specific tax questions.

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