Young Workers Not Saving Enough in Tax-Advantaged Plans
Apparently, youth isn't the only thing wasted on the young. So too are tax breaks.
Several recent studies show that the vast majority of young workers are failing to sign up for myriad tax-advantaged accounts, potentially leaving hundreds if not thousands of dollars of benefits on the table.
While the vast majority of eligible baby boomers participate in their 401(k)'s, fewer than a third of workers under 25 are contributing to these employer-sponsored retirement plans. Even worse, only 4 percent of young workers are maxing out on their workplace retirement plans, according to a recent survey by the tax information service CCH.
Ironically, these accounts are more important to young workers than to older Americans. That's because the majority of younger workers aren't covered by an old-fashioned guaranteed pension. Moreover, every dollar that 20-somethings save will be more valuable over the course of their lives than the same dollar will be for older workers. That's because young workers have more time to invest their savings and then let that money grow, tax deferred.
Sadly, there seems to be little urgency among young Americans to remedy this situation. For instance, even though there's still time to put money into an individual retirement account for the 2006 tax year–you have until the April 17 filing deadline this year–a paltry 19 percent of young workers say they plan to fund a traditional or Roth IRA this year. In fact, the majority of 18-to-24-year-olds don't even know whether they qualify to fund various types of IRAs, according to CCH.
The good news is, as workers get older, their financial awareness improves. But there's some bad news, too: Even among 25-to-40-year-olds, only around 2 in 5 are contributing to a tax-advantaged IRA, according to a survey by the brokerage Charles Schwab.
Why? Many cite a lack of money or awareness to take advantage of these plans. Yet "with a few minor adjustments, younger investors can make the necessary changes to ensure they are doing everything they can to save for the future," says Rande Spiegelman, vice president of financial planning for the Schwab Center for Investment Research.
Young workers aren't simply turning their backs on tax-sheltered retirement plans. They're failing to utilize other benefits as well. For example, only 10 percent of 18-to-24-year-olds are taking advantage of healthcare flexible spending accounts (FSAs) at work. These accounts allow workers to set aside money on a pretax basis from their paychecks to cover various out-of-pocket healthcare costs throughout the year.
By utilizing these FSAs, you are in essence getting the government to help you pay for an assortment of routine expenses, including copayments for doctor visits, eyeglasses, over-the-counter medicines, and other uninsured healthcare costs. Think of it this way: If you were to spend $100 in over-the-counter drugs using an FSA account, it might cost you only around $70, depending on your tax bracket. That's because this account is funded with a portion of your paycheck before it's taxed.
Unfortunately, only around 4 percent are contributing the maximum amount allowed into these tax-advantaged FSAs.
So what should young workers do?
Make sure you're aware of all your tax-related benefits. A simple way to do that is to visit your company's human resources department to learn whether you're eligible for a 401(k), FSA, or other tax-deferred savings vehicle. Also, visit the websites of major investment firms like Fidelity, Charles Schwab, or T. Rowe Price to see if you qualify for various types of individual retirement accounts.
If you're getting a tax refund this year, use the money to fund an IRA. It's tempting to spend tax refunds, especially since households often consider this "found money." But in reality, it's not found–you earned it throughout the year. So why not take your hard-earned tax refund and invest it for your future? Many financial services firms now make it extremely simple to open and fund an IRA. In fact, Schwab has created what it calls its "15-minute IRA," which you can open online in minutes.
Take full advantage of your company-sponsored 401(k). In this age of do-it-yourself retirement savings, 401(k) plans have become a worker's primary savings and investment vehicle. Yet the average generation Y worker (ages 18 to 25) has saved only around $3,200 in an account. The good news is, the government is gradually increasing the maximum amount that workers can contribute. This year, the federal limit for annual contributions to a 401(k) stands at $15,500, up from $15,000 last year.
Think about using a so-called target-date retirement fund in your 401(k). Many workers aren't contributing to a 401(k) because they haven't a clue how to invest money. But the majority of 401(k) plans now offer workers access to a so-called target-date fund. These are single-fund solutions that will make sure you're always invested in the proper mix of stocks and bonds. These ready-made investment packages aren't just easy to use–they're also quite effective. According to a recent study by Hewitt Associates, workers who utilize these investment options–instead of managing their own collection of mutual funds–end up earning bigger returns than do-it-yourselfers.
At the very least, take full advantage of any company matching contributions. Many companies give workers a match on their retirement savings. Often, for every $1 you put in, your employer will kick in 50 cents up to around 3 to 6 percent of your salary deferrals. That's an immediate 50 percent return on your investment, with no risk.
Use any annual raises to increase your contributions to your 401(k). It's not enough to simply participate in a 401(k). You have to save adequately inside it. According to the Schwab Center for Investment Research, workers in their 20s should be setting aside at least 10 percent to 15 percent of their paychecks for retirement savings. Yet the majority of young workers don't save anywhere near that amount. Among gen Y workers who are participating in a 401(k), the average savings rate is just 5.6 percent, according to Hewitt. A simple–and somewhat painless–solution is to increase your savings rate every time you get a raise. That way, you never have a chance to see the raise in your take-home pay. And if you never see the extra income, you probably won't miss it.