It may be hard for someone in their twenties or early thirties to start thinking about retiring, especially when there is so much interesting stuff to check out on Facebook, Instagram, or Twitter; but this is exactly the time that a Millennial should start preparing for retirement if one wants to have the chance to nail retirement without having to save a lot of money each year. Listen up, Millennials (or Generation Y, if you prefer): One Direction may sing “Live While You’re Young”, but if you started saving for retirement while you are young, then you can chill when you’re old.
The foundation of retirement investing is based off the concept of tax deferral. Tax deferral means that you can postpone taxes on any earnings you make on the money in your tax-deferred accounts. That means your money is growing each year without having to remove any funds to pay tax. For example, if you contributed $2,000 to a Traditional IRA each year for 10 years and averaged a 7% annual rate of return, assuming a 25% income tax rate, your Traditional IRA would be worth $31,291, whereas if you invested the funds personally, you would have just $23,468. Now, imagine that instead of contributing over 10 years, you contributed over 30 years. Assuming the same facts, your Traditional IRA would be worth $244,692 versus just $183,519. Pretty impressive numbers for just saving around $5 a day. If a Traditional IRA was used, you would eventually have to pay the taxes on the income deferred. But here’s the good news. You may be in a lower tax bracket in retirement, so the taxes you pay will be less than if you had paid them during your working years, and you only pay tax on the amount you withdraw from your tax-deferred accounts. The rest of the money in your tax-deferred account continues to grow tax-deferred—and compounding interest continues to work its magic over time. Of course, you could always open a Roth IRA, assuming you satisfied the income limitations, and all your income and gains would be tax-free, assuming you were over the age of 59 ½ when you took a Roth IRA distribution and the Roth IRA had been open at least 5 years.
The thing with tax deferral is that, generally, the earlier you start, the greater the tax deferral power will be. This is exactly why today is a perfect time for Millennials to start saving for retirement and kick-start their tax deferral clock. Of course, it is never too late to start saving for retirement, which bolds well for Generation X and baby boomers, but Millennials are at the perfect age to take advantage of the amazing power of tax deferral. Much has been made of the enormous impact that student loans and a soft job market has had on Millennials, and how it has hurt their ability to save for retirement. This is all true, but the power of tax deferral can help you retire in style by just saving $5 a day – that’s one less Grande Cappuccino at Starbucks each day. Not a huge sacrifice for potentially having hundreds of thousands of dollars when you retire. They key is starting early, which gives the Millennials a huge advantage over Generation X and the baby boomers. Take a look.
Let’s assume that Dylan is 25 years old and saves $5 a day or $1,825 a year, which he contributes to a Roth IRA. Let’s also assume that Dylan was able to save $1,825 a year until he reached the age of 70. Not a very unrealistic assumption. Let’s also assume that Dylan was able to average 7% annually on his investments, which is actually below the average S&P 500 return since its inception through 2014, which is close to 10%. Let’s further assume that the tax rate stayed static at 25%. Based on the facts, Dylan would have $557,997 in his Roth IRA at age 70, versus just $419,498 had he made the investments personally.
Now let’s take Susan, who is 45 years old, and has not yet started saving for retirement. If she was able to contribute $5,000 a year to a Roth IRA until she reached the age of 70, then, assuming the same 7% rate of return as Dylan and the same 25% tax rate, Susan would have $338,382 in her Roth IRA at age 70, but only $253,787 if she made the investments personally.
As you can see, from a retirement standpoint, Dylan is much better off than Susan because he started contributing at a young age. Dylan’s Roth IRA contributions equaled $82,125, whereas Susan’s contributions equaled $125,000; yet, because her Roth IRA funds has less tax deferral power behind it, her Roth IRA was close to $219,000 less than Dylan’s. Now, even if Susan earned a 9% rate of return on her investments instead of 7%, that would only increase Susan’s Roth IRA to $461,620, still almost $100,00 less than Dylan’s.
The Millenniums or Generation Y folks are certainly the most savvy and well informed generation ever, but if they just added the concept of “tax deferral” to their vocabulary to go along with Tweet, Face-time, or photobomb, they could also end up being the richest generation.