I’m in College. Should I Start Saving for Retirement?

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It is never too early to start saving for retirement. In fact, the sooner you start, the less you will need to save in the long run. This means more money in your pocket to spend on non-retirement over your lifetime, and if you want to retire early rather than working to 65 or 70 like so many Americans, this is your golden ticket.

The Power of Compounding Interest

As a millennial, you have the greatest retirement tool: time. It’s a commodity that you can’t get back as you get older and one many boomers would be jealous of. The earlier you start investing, the more time you’ll have to let compounding work for you. You add less now but have more later. Use a retirement calculator to determine your savings goal, a compounding tool to see the numbers, then create a plan and stick with it.

It can be difficult for a young person to save big money during and right after college, considering many students only work part-time or not at all while in school. Entry-level salaries may also not provide a big savings cushion, and high levels of student loan debt, too, can eat into a young person’s savings.

However, let’s assume for illustrative purposes that Christine saved $600 per month in college for 5 years, from the time she turned 18 until she turned 23. She saved $1,000 per month for 7 years after college when she began working, from 23 until she turned 30. Then she stopped saving and left the money in her account, where it continued to accumulate interest at an annual rate of 5% until she retired at age 65.

Now let’s compare her to Jason, who didn’t start saving until after college on his 24th birthday, when he got his first “real” job. He put away $1,000 per month for 13 years, until he turned 37. He also left the money in his account, where it continued to accumulate interest for 28 years at a rate of 5% per year until he turned 65.

Over that 13-year period, Jason contributed about $156,000 and Christine contributed about $120,000. Christine saved $36,000 less than Jason, but she wound up with about $21,000 more than Jason had saved for retirement.

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If Christine chooses, she can stop contributing at age 30 and have more money in her pocket for other goals (if she has determined that this retirement amount at age 65 is sufficient). Jason, on the other hand, is saving in his 30s when other constraints like starting a family or mortgage payments may make it difficult to save for retirement.

Christine can use that money from age 30 to 36 to travel, save for a house or add to her retirement account to help it grow even more. The latter would very easily contribute to the possibility of her retiring earlier than 65, creating a more secure retirement and helping to ensure that she will not need to work due to poor planning. The point is, she has more options – saving earlier has created the financial freedom to let her live the life that she wants.

How to Super-Charge Your Savings

These results can be further enhanced by utilizing an employer match in a deferred plan such as a 401K to reduce your actual weekly out-of-pocket contribution to your retirement account. Plus, it’s free money (as long as you meet your company’s vesting requirements).

The bottom line is, saving is like a muscle; it takes discipline, much like going to the gym. Start slow and early and keep building, and you lessen the chance that you may face the painful task of trying to catch up later in life.

You can consider consulting a Certified Financial Planner (CFP®) for comprehensive advice on calculating your retirement goal amount and strategies to support savings for this and other life goals. (Full disclosure: I am a CFP®.) And as you work toward those goals, you can see how your habits are affecting your credit by viewing two of your credit scores, updated each month, for free on Credit.com.

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Can You Use Your IRA to Pay for College?

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Families or individuals sometimes want to tap retirement assets in an Individual Retirement Account (or IRA) to pay for educational expenses. This has become even more attractive recently, as the rules governing both traditional IRAs and Roth IRAs have been changed to allow withdrawals for qualified higher education expenses.

The tax treatment of the funds used to pay for college varies based on whether the assets being used for college expenses are in a Roth IRA or a traditional IRA. But as long as the amount of the withdrawal does not exceed the cost of higher education costs for that year, the withdrawal will avoid the 10% additional penalty.

Higher education costs are defined as any postsecondary education that is eligible to participate in student aid by the U.S. Department of Education, along with the tuition, fees, books and supplies that come with attending.

The Difference Between Using Roth or Traditional IRA Funds

With a Roth IRA, the principal portion, or amount you put in, can be withdrawn tax-free and penalty-free at any time for any purpose. A key benefit of Roth IRAs is that distributions are not taxed as earnings until the entire principal balance is withdrawn. That means you can take out as much as you put in, tax-free, to pay for college and withdraw the earnings portion tax-free when you turn 59-and-a-half.

By way of example, imagine having $100,000 in a Roth IRA on your child’s first day of college, $65,000 of which is principal and $35,000 of which represents earnings over the period that you have been contributing to the Roth IRA. You would be free to use that entire $65,000 towards college expenses before needing to worry about any tax consequences. And then you would still have $35,000 remaining that could be used for retirement purposes.

Note, however, that any withdrawals that exceed the total contributions are attributable to earnings and will be taxable for those under age 59-and-a-half. Therefore, if you withdraw $75,000 of the $100,000 from the example above to pay for college expenses and you are under 59-and-a-half, then the $10,000 of earnings withdrawn would be taxed as ordinary income on the following year’s tax return.

In the event you choose to withdraw moneys from a traditional IRA to pay college expenses, the full amount of the withdrawal will be taxed as ordinary income, assuming that you are under 59-and-a-half and that all your contributions to the traditional IRA were made on a pre-tax basis.

To use the same example from above, imagine you have contributed $100,000 to a traditional IRA. Whatever amount you take out of the IRA to pay for college expenses is taxable, no matter whether you take out $10 or the full $100,000 in the IRA. Therefore, whatever amount you withdraw will be taxed as ordinary income on the following year’s tax return.

When it’s time to prepare your taxes, any amount that you withdraw from a Roth or traditional IRA will be documented to you from the custodian on a 1099R, and are required to be reported on Form 5329 with your tax return.

Know the Tax Implications Up Front

Tapping retirement assets to pay for college expenses can provide an alternative to taking out costly student loans or paying college expenses in cash. You should ensure, however, that you understand up front what the tax implications will be, so you can avoid an unexpected, and most likely hefty, tax bill. If you do intend to withdraw assets from a traditional IRA or amounts in excess of your contributions to a Roth IRA, then consider either making quarterly estimated tax payments or adjusting your withholding to account for these distributions.

Another consideration from a planning perspective is that the $5,500 (for those under 50) or $6,500 (for those over 50) IRA contribution limits apply, no matter whether you plan to use moneys in an IRA for retirement purposes or to pay for college expenses. Therefore, if you decide you like the thought of using an IRA to save for college, make sure to factor the IRA contribution limits into your planning.

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