With the uncertain status of Social Security in the next 30 years, relying solely on the government to provide income after retirement could have devastating effects. Although retirement may loom more than four and a half decades away for an undergraduate student, saving for retirement, like all investment strategies, garners the biggest rewards when started in advance.
Investors should err on the conservative side and not factor in Social Security payments into their retirement portfolios, but they should plan to live exclusively on their capital assets and savings.
"Personally, I look at it as gravy," Finance Prof. Patrick Dennis said. If Social Security is "around in 30 years, which it probably will be in some form, it will buy an occasional dinner out or some new clothes."
Instead of banking on monthly Social Security checks, employees first entering the job market should opt to invest in a 401(k) plan, available through the employer.
As tax-sheltered vehicles, employees can contribute portions of their income into 401(k) plans, which are not taxed until funds are withdrawn upon retirement.
For example, if an employee makes an annual salary of $40,000 and contributes $5,000 of that to a 401(k) plan, that $5,000 currently becomes exempt from taxation, pushing the employee's taxable income down to $35,000.
In addition, that money earns interest on itself, garnering further tax-free compounding interest benefits. Of course, taxation still occurs upon withdrawal, but the government taxes retirement savings appropriately - not as capital gains but as regular income.
"The time value of money is the critical element," Dennis said. "So start saving early. If you're going to save money for retirement anyway, take advantage of the tax benefits 401(k) plans offer."
Many companies often will match employee contributions, say $0.50 for every $1 invested, often in the form of corporate stock. The U.S. government caps contributions at $11,000 annually, although companies may have lower limits.
By stipulating a given amount deducted from a paycheck, retirement-conscious investors can put their plan on autopilot, allowing deposits and corresponding interest to grow over time.
As for the investment side, employees can choose from a menu of options, ranging from growth stock funds to bond funds, income stock funds and stock in the employee's company itself. The University offers faculty a choice between Fidelity and Vanguard mutual funds.
However, Dennis advised against investing in the firm's stock, as many Enron employees learned. As Enron stock plummeted, so vanished the retirement savings of hundreds of employees who did not diversify their investment to hedge against such dramatic losses.
For an investor wanting more freedom than a 401(k) offers, individual retirement accounts allow an employee to invest in stocks, mutual funds or bonds.
Although IRA contributions are limited to $3,000 per year and generally do not have tax-free benefits, they are ideal for employees whose company has a mandatory waiting period before being able to contribute to a 401(k) plan or if an employer does not offer retirement plans at all.
"It's not a choice between either a 401(k) or an IRA," Finance Prof. Karin Bonding said. "You can have both."
Employees wanting to hold an IRA should choose a Roth IRA. Because IRA deposits already have been taxed from a paycheck, there is no further taxation penalty upon withdrawal at retirement.
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Instead of investing in a Roth IRA, employees can opt for a traditional IRA, which is not taxed. However, traditional IRAs only benefit people with low incomes, typically less than $36,000.
"While you might make that in your first year out of college, as your career advances, you'll probably make above the limit," Bonding said. "So you can't use it in the manner for which it was originally designed."
Because IRAs operate separately from employers, an investor can open an account at any time to benefit optimally from compounding interest principles.
"If you get money when you graduate, set up a Roth IRA," Bonding said. "It's really worthwhile to do it early because you can end up with a phenomenal amount of money."
Employees working for non-profit agencies will invest in a 403(b) plan, which actually differs little from the more mainstream 401(k) option. 403(b) plans work in tandem with 457 plans to set aside additional funds for retirement.
As a general rule of thumb, an employee should expect to save at least 70 percent of their current income upon retirement.
For example, an investor who lives on $40,000 annually should have at least $28,000 each year of retirement for living expenses. If that investor retires at 65 and lives until 85, he will need a total of $560,000 in today's dollars. But because inflation eats away the purchasing power of the dollar, that amount will be insufficient four decades from now. Factoring in an average inflation rate of 3 percent, an investor should plan on $1,228,834.
Factoring in inflation, coupled with an average 9 percent investment growth rate of return, a 22 year old starting a retirement plan will need to contribute $2,787 annually. That amounts to $232.25 per month, a very manageable amount.
Like all investing, the best strategy is to start sooner rather than later. Students unfamiliar with investing must educate themselves to help build a secure financial future, well beyond the immediate horizon.
"The average American only saves 1 to 2 percent [of their income] per year, which is horrific," Dennis said. "The more and the earlier, the better."
"The sooner students take care of their [retirement plans], the better they'll be off later on," Bonding added. "Whether they take a class or read a book, they really should become educated because finances don't take care of themselves. You have to do it"
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