Financially

Free Gen Z

Episode 3: 401(k)s and Retirement Accounts

Emma: Welcome to “Financially Free Gen Z”. I'm Emma Barger, a Marketing Specialist at Coulee Bank.

Rachel: And I'm Rachel Munger, a Communications Specialist at Coulee Bank as well.

Emma: In today's episode of our podcast…

Rachel: We will be talking about 401(k)s, IRAs and retirement planning. We're going to be covering the basics of a 401(k) and an IRA. The difference between the two, because that can be kind of confusing. And then the importance of retirement planning even at a young age. We will also hear from Peter Michelson, who will answer all of our questions.

Emma: So starting off, what is a 401(k)? This is something I didn't learn until very recently, but a 401(k) plan is a defined contribution and tax advantaged retirement savings plan that is sponsored by someone's employer. So right now I work for Coulee Bank, so my 401(k) is sponsored by Coulee Bank. An employee signs up for a 401(k), and then they agree to have a percentage of each paycheck paid directly to an investment account. And sometimes the employer may match part or all of the contribution.

Rachel: Yeah. So then what is an IRA? Because there is a difference between the two, even though they are pretty similar. An IRA functions very similarly to a 401(k); however, it's not sponsored by your employer, so it's something you would open up yourself through either a broker or a bank. And IRAs also have some additional rules around them. So there are income limits for IRAs, so if you make over a certain amount of money, you're not able to contribute to those. And then they also have much smaller contribution limits than 401(k)s. So, for 2022 you're able to contribute $6,000 to an IRA or $7,000 if you're over the age of 50. And then in 2023, that's going to increase to $6,500 and $7,500 respectively. So there's much smaller contribution limits, and it's not something that's sponsored by your employer.

Emma: Yeah. And you might also hear tossed around if you're speaking about IRAs or 401(k)s, you might hear the term Roth in there and so there is a little bit of a difference too when it's a Roth IRA or 401(k), which is still a type of tax advantaged individual retirement account that you can contribute after tax dollars to. So in a very basic sense, you can put the money you've already paid taxes on into a Roth IRA, the money will grow, and then when you withdraw that once you retire, you won't have to pay any more taxes on that.

Rachel: Yup. And both 401(k)s and IRAs can be Roth. They can also be traditional and not all employers offer Roth 401(k)s. Some only offer traditional 401(k)s. But the difference between the two is your contributions to a traditional 401(k) or an IRA are made pretax, meaning they're deposited before your income taxes are deducted from your paycheck, reducing your taxable income. However, when you retire and withdraw your funds, you're going to pay taxes then. So with traditional you're paying the taxes later. With Roth, you're paying the taxes upfront, and then you are able to earn tax free on your gains and withdraw tax free at a later date. So in a perfect world, you would use a combination of both Roth and traditional accounts to put aside funds that grow tax deferred for the next years until you retire.

Emma: So I know that a lot of this might be a little bit confusing, so today we're going to be talking to Peter Michelson from Coulee Bank. He is a Retail Banking Manager at Coulee Bank. And thank you so much, Peter, for joining us today and sharing your knowledge with our audience.

Peter: Yeah, absolutely. Thanks for having me on.

Emma: Yeah, of course. So the first question we came up with and one that a lot of people my age I feel like have questions about, is that I am young. My friends are young. A lot of us are Gen Z, We're young and we don't plan on retiring any time soon. So why is it so important that someone like Rachel or I or one of our audience members starts planning and saving for retirement now?

Peter: Yeah, absolutely. It is a good question. And I think one that, like you said, a lot of especially Gen Zers, but young people in general. In general, I know I've had conversations with millennial friends and kind of heard the same question. So it's definitely one that's out there. The very short answer is exponential growth on your savings, and that is accomplished through compound interest.

Peter: You’ve heard the expression an ounce of prevention is worth a pound of cure. The same thing is kind of true when it comes to planning for retirement and putting away those funds and saving them and specifically investing. So I think the best way to answer that question is just to give an example. Let's just say hypothetically, you work a job where you make $50,000 a year, let's say for your entire professional life, you're never going to get a raise, which I would not recommend.

Peter: But simplicity in the example. So you're going to make $50,000 a year. You're going to work for 45 years. You're never going to get a raise. And to make it even more fun, you can only save 5%. So if you do that, let's just say you have a savings account. It's not earning you any interest. Every year you're going to put 5% of that $50,000 that you're making into that account.

Peter: At the end of 45 years, you would have $112,000, which is not nearly enough to retire. Well, you say, all right, I'm going to budget and I'm going to save a little bit more. And so if you bump that savings up to 10%, so now you're saving 10% of the 50,000 for 45 years, your entire career. At the end of the 45 years, you would still only have $224,000, which again, is not going to be nearly enough to retire.

Peter: Instead of saving those, putting that money just in a savings account, if you instead invest that money, it's going to be a very different picture. So take that same scenario. Someone that makes $50,000 a year is never going to get a raise, but instead they're going to put that money into a 401(k) and they're going to deposit not even 10%, just 5% into that IRA, or excuse me, into that for 401(k) for 45 years.

Peter: We have to play with the numbers a little bit, but we're just going to assume a rate of return of 9.3%. And that's sort of a made up number, but it's not a random number according to Vanguard, which is just a mutual fund company. That's the number that they've used as the sort of average benchmark for rate of return.

Peter: So it's, a it's, a fair hypothetical number to use. So if you invest $5000 or excuse me, 5% at $50,000 a year for 45 years, at the end of 45 years, you would have $1.7 million in your 401(k), So $1.7 million versus $112,000 by starting that now is, is really the answer to that question. And that just comes through the compound interest.

Emma: That's awesome. Wow. That really puts it in perspective, I think about how important it really is.

Peter: Essentially, it would be a 93% more than what you would otherwise have because of that 9.3% growth. And then like I said, 9.3 is a nice number to use in theory, in practice. It's, it's kind of all over the place in terms of what that return might be in any given year. But over 45 years is, is enough time to sort of balance out both the peaks and the valleys that come with investing.

Rachel: So, with Gen Z beginning to enter the workforce and possibly starting careers, what are some questions we can ask our employers when it comes to 401(k)s?

Peter: Absolutely. So first you want to just find out that your employer, potential employer does have 401(k) program. Obviously, you're not going to be able to take advantage of it, which you absolutely want to, as we just talked about, if it's not available. So find out that they have one, but then find out when you become eligible for it.

Peter: At some companies, this might be day one, at some companies that might be after 90 days or maybe six months or one year there. But that will be something that will be clearly spelled out that should be able something that they can give you right away at the beginning. The next thing that you're going to want to ask sort of related is what is the company's matching policy?

Peter: Typically, this is going to be laid out at, say, percentage, for example, Coulee Bank there's a 4% matching policy, which means if I deposit, if I opt to save 4% of my paycheck, then Coulee Bank very generously matches that and will also add 4% in. Now, I can contribute above 4%. But that's where that match is going to come.

Peter: So that even if I only contribute 4%, essentially I'm saving 8%, and then a follow up question to that. If your company does have a matching policy, ask when you'll be fully vested, which is essentially just an employee retention practice where you may not be fully vested until three, five or six years. And that just means at that point, even if you leave the company, all of the contributions that that company has made to your 401k would leave with you.

Peter: And then typically it's just prorated down from that. One other thing that this gets a little bit into the weeds, but is, is worth knowing is just finding out a little bit about who the plan provider is for your company's 401(k), and then you can ask, you know, what made your company select that provider versus another one?

Peter: What level of information and what level of transparency you as an individual have in order to sort of choose investment options within that 401(k). Typically that's going to be things like higher or lower growth, which are sort of directly proportional to how risky those investments might be. And so just the more choices that you have, the better in terms of being able to have an investment strategy that makes sense for you and where you are in your career and your retirement goals.

Rachel: Yeah, I remember something from our plan provider here at Coulee Bank. They came and they gave a talk to everybody. When you're signing up for your for one case and stuff and one thing they mentioned that I had never thought of is that when you're kind of younger, you're going to go for the typically the more high risk profiles, and then as you go later in later in your career and closer to retirement, you're going to opt for more of those safer options just because there's less time for the market to correct itself before you're retiring. So that was something interesting that I didn't know because I tend to be like really safe and I don't like to take risks. So I was in the safer option and they recommended like no, with your age, you should probably switch to the more high risk.

Peter: Mm hmm. Yeah, absolutely. That's something that usually they'll say, you know, in your twenties and thirties, you want to be you don't have to say riskier. You can say higher growth opportunity, which then obviously implies the inverse as well. And then, yeah, when you're in your forties and moving into your fifties, then obviously you want to move to a more moderate growth, but then also only moderate levels of risk.

Peter: And then as you approach retirement age, depending on when that is for for you personally, you'll want to move to something more conservative where at that point, the bulk of the money that you're going to earn is already in there. And if you're still growing it at a more conservative rate, that's fantastic. But really, at that point, yeah, what you're looking for is to not lose any of it through market fluctuations at that point, just because you don't have that time to course correct before you retire.

Emma: And so, Peter, you mentioned a little bit about how the age people retire might be a little different. And I know in your figure, you mentioned 45 years of work and also that $112,000 is not necessarily enough to retire. So what would you say is the average age people retire and about how much money would someone have to save to be able to retire?

Peter: Yeah. So let's tackle the first part of that question first. And what age do people typically retire? On average, people retire between about 62 and 65 years old, typically women are closer to 62, and men are closer to 65. Then sort of maybe the textbook answer is Social Security considers full retirement to be at 67 years old. But when it comes to tapping into funds that you've set aside for retirement, so things like your IRA, your 401 (k), those are available to take normal distributions, which is just what withdrawals from those programs are called at 59 and a half without penalty. So there are reasons, obviously, which we'll get into in the second part of the question. But in general, it's going to be late fifties into the sixties.

Emma: Okay.

Peter: But really, when you retire comes down to the second half of the question how much money you need to retire. Obviously, if you are at an age where you would like to retire, but your retirement fund isn't quite where you want it to be, maybe you need to stick around for an extra year or two, depending on how that goes and hopefully you've made those decisions and sort of forecasted that out a little bit further out that it doesn't have to be a last minute, as it were, decision.

Peter: But what you want to think about is what your retirement income needs to be and for how many years you need that retirement income. A general rule of thumb is to plan to live at 80% of your pre-retirement income per year, and that 80% figure assumes that you're probably going to be getting some Social Security and some other programs that are going to be offsetting going from 100% income paid from an employer to 80% income paid from your retirement savings.

Peter: Now, there's also the question of if you want to retire early. Usually in that regard, the magic number is 25 years of income saved. So if we use that example from before of somebody that makes $50,000 a year, 25 years worth of that is going to be $1.25 million, which sounds like a lot of money. But again, in that example that I gave where if you're saving at that interest rate and at that level of savings for 45 years, you could get to 1.7 million.

Peter: So even if you're not quite saving for 45 years, it's still very possible to get to that, That in that example, to get to the 1.25 million, which then would allow you to withdraw $50,000 a year, which would be 4% of that total for 25 years. And that isn't to say that when you got to the end of 25 years that you just have $0 in there because remember that 1.25 is still going to be earning interest even if it is at a more conservative rate.

Peter: And so with the market and with interest rates where they are right now, it wouldn't be unthinkable at all to think that you could maintain that 4%, which means that essentially you could have the $1.25 million take out 4% a year, but then your interest is gaining 4% a year. And so you're not actually eating into your your quote unquote savings and you're really just living off of the the interest.

Peter: And that's why a lot of times you'll hear that number referred to as your nest egg, because it is is something it implies that growth even after you you start to tap into it. So that's a little bit of a longer answer. And obviously that's going to be different to each individual. But thinking about 4% per year or thinking about that, you need to be at 80% of your income from what you're making right now at a job to when you would be retired. Those are both good numbers to work with.

Emma: It's nice to put in perspective a little bit. I think that helped a lot. So thank you for that.

Peter: Yeah, absolutely.

Rachel: Yeah. So this is obviously such a big topic and lots of numbers, lots of things to consider. If a young adult has questions about planning for retirement or is interested in learning about the different options that are out there for saving and investing. Where would you recommend that they go for advice and resources?

Peter: Yes. Yes. This is something I think there is sort of a growing awareness of. Oh, this is this is something that I need to be thinking about. And as you identified that the earlier you start thinking about it, the better because of that. Again, that exponential growth of you start that clock on 45 years when you're 20 as opposed to starting it when you're 30 or 35, that's going to make a huge difference over the course of your career.

Peter: And for that reason, I think there is a lot of really good information out there, especially online. And before I go further on that, I do just want to say one note. Even when I was doing some some research for this podcast, I noticed that there really are two sorts of fields or subsets of people that are putting this advice out there.

Peter: And the first one, I would call it not quite get rich quick, but sort of people that were sort of positing a lot of shortcuts to savings and shortcuts to investment and retirement accounts. And I found some not very good information. And some of those are things that either fall into the category of excessive risk, which, Rachel, like you said, you know, you want to be conservative and received advice that, hey, you can be a little bit more high risk, high growth.

Peter: But even in that, there's going to be there's going to be limitations. But really, in general, if you're if you're looking at someone and you're seeing advice from someone online, just ask yourself if this is someone that is clearly a professional and someone that does have a track record of over years, maybe not just getting lucky or hitting on on something once or twice, but something someone that has made a career out of a string of of sound financial decisions.

Peter: So I will shout out my personal favorite that I think checks this box really well is a gentleman by the name of Brian Preston, better known as the Money Guy. So if you've if you've spent any time on financial Tik Tok or Instagram or YouTube, you've probably seen some of his content. He has a YouTube channel, a podcast and a website, and he has really, really good information.

Peter: And I think he does a nice job of sort of breaking down difficult concepts, making them sort of easy to understand and digestible, but then also very practical in terms of what he suggests as far as assessing where you are, figuring out where you want to be, and then practical steps that can help you get from point A to point B.

Peter: So I would definitely recommend the Money Guy. One other source that has been useful to me, sort of as I've figured this out for myself, is a gentleman by the name of Rob Berger, who wrote a book called “Retire Before Mom and Dad”. I can't say that I'm crazy about the title of the book, but the the concepts that he breaks down are incredibly helpful, and he really spends a lot of time focusing on that idea of the compounding