Retire young: Get on track

Starting a savings plan in your 20s could put you on the right track for an early retirement. Just make sure you've got the right mix, says Money Magazine's Walter Updegrave.

By Walter Updegrave, Money Magazine senior editor

NEW YORK (Money) -- Question: I'm 25 years old and I would like to retire in my 50's. I already contribute to my 401(k), but I'd like to fund an IRA as well. How do I do that? - Steve Henry, Lakeland, Florida

Answer: First, let me say that you're thinking along the right lines. If you're going to call it a career in your 50s, you're going to need beaucoup bucks. So you better start revving up the old savings engine now.

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Indeed, in the Money Magazine Retire Early cover story I wrote earlier this year, the estimates the story lays out for how much money you would need to retire at 60 are formidable enough, let alone calling it quits before that age.

For example, someone who's 40 years old and makes, say, $50,000 a year, should already have about three and a half times his or her annual salary, or $175,000 socked away in retirement accounts by that point to have a decent shot at turning an early-retirement dream into reality.

And that assumes our 40-year-old will continue saving like a demon over the following 20 years. Naturally, you won't need as large a nest egg if you'll continue to work in some way (part-time, temporary or whatever) or if you'll be collecting a company pension.

But you're definitely going to have to set aside more than you would if you retire at a later age, if only because your savings are going to have to support you for a longer time (not to mention the fact that you'll likely have to buy private health coverage until Medicare kicks in at 65).

Funding your 401(k) to the max is your first step toward building a retirement kitty that can support an early exit. But that alone may not be enough.

Your 401(k) could have relatively low contribution limits, or your employer might not have the most generous matching program. Or maybe there will be periods when you're between jobs and not able to contribute at all. Which is why I think it's virtually a given that anyone who wants to retire early will have to supplement his or her 401(k) with an IRA.

This year, you can contribute up to $4,000 (people 50 or older can throw in an extra $1,000), and next year you can put away as much as $5,000. After that, the maximum contribution rises with inflation in $500 increments.

Unfortunately, many people who perhaps could take advantage of this opportunity to ramp up their retirement savings effort don't. A report by AARP earlier this year found that while nearly 80 percent of taxpayers are eligible to make contributions to an IRA, only about 11 percent do so.

I'm sure some of those who don't take an advantage of an IRA just don't have the extra bucks to save after contributing to their 401(k). But I'm also sure there are plenty of others who don't have a 401(k) at work but never get it together to fund an IRA.

And I can't help but think that there are also many people maxing out their 401(k) who could also afford to funnel some more money into an IRA but just don't get around to it. That's too bad. Because if you get started early and contribute every year, you can be talking about serious money by the time you're ready to call it a career.

Let's say that you put away $4,000 for this year and add $5,000 every year for the next 25 years (for simplicity's sake, we'll ignore the fact that you'll no doubt invest more as inflation pushes up the contribution limit). If you earn an annual 8 percent return, you would have nearly $400,000 by the time you're 50.

When it comes to IRAs, you've got two basic choices: a traditional deductible IRA or a Roth IRA. If you do the traditional IRA, you can deduct your contribution from your taxable income. Your contribution plus all your gains escape tax until you withdraw them, preferably in retirement.

With a Roth IRA, by contrast, you get no upfront deduction, but your withdrawals are tax-free, provided they meet certain requirements. You've also got to meet some eligibility standards to contribute to these accounts. For details on those standards, click here.

And for a calculator that can quickly tell you whether you're eligible for a traditional or Roth IRA or both, click here. (There is a third choice, a nondeductible IRA. But as I mentioned in a recent column, I don't think it's a worthwhile option except as a way to get into a Roth in the future if you're now ineligible.)

So which should you do, a traditional deductible IRA or Roth? A Roth has several advantages , a number of which I outlined in a column last year. To my mind at least, these advantages generally make a Roth a better bet if you think you'll be in the same or higher tax bracket in retirement than you'll be in today, which I think is a pretty good possibility for a young person with decent career prospects who is also saving diligently for retirement in a 401(k).

That said, though, doing either type of IRA is better than doing neither. So don't get too hung up on which you should do. The most important thing is that you fund some type of IRA as soon as possible and do it as many years as you can.

The mechanics of contributing to an IRA are pretty straightforward. You can open an IRA account either in person by phone or online at virtually any investment firm (a brokerage house, mutual fund firm, a bank) and start funding it immediately. You can also usually arrange for automatic deductions from your checking account into your IRA.

As for what type of investments should go into your IRA, I'm a big proponent of keeping it simple. I suggest going with low-cost mutual funds, such as the ones in the Money 70, Money Magazine's list of recommended funds.

If you really want to keep costs down, go with the index funds on our list. Ideally, you want to build a portfolio of funds that's appropriate given your age and tolerance for risk.

Or, if you prefer a hands-off solution, you can invest in a target-retirement fund, a type of fund that gives you a fully diversified portfolio of stocks and bonds that's appropriate for your age and that becomes more conservative as you approach retirement. (For guidance on how to build your own portfolio, click here. For more on how target retirement funds work, click here).

One final note: Depending on how early in your 50s you retire, you'll want to take care that you don't end up paying a 10 percent early-withdrawal penalty in addition to regular taxes on 401(k) and IRA withdrawals (or, in the case of a Roth IRA, possibly paying tax and penalty on what otherwise would be tax-free withdrawals).

The cover story I mentioned earlier has a section that deals with this issue. As a practical matter, you'll also want to accumulate some savings in taxable accounts during your career, so you're not completely dependent, before or after you retire, on money in 401(k)s, IRAs and the like that have restrictions on how you can tap them. (See editor's note at bottom)

To sum up, if you're serious about retiring early, I suggest you open up an IRA today, contribute to the max and then continue plowing as much money as you can into your 401(k) and IRA each year. I can't say that following this strategy will guarantee you'll be able to retire comfortably in your 50s. But I can say that you'll have a hard time reaching your goal if you don't.

-Editor's note: The section above on early-withdrawal penalties and restrictions was added to the original story. Top of page

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Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer LIBOR Warning: Neither BBA Enterprises Limited, nor the BBA LIBOR Contributor Banks, nor Reuters, can be held liable for any irregularity or inaccuracy of BBA LIBOR. Disclaimer. Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.