Preparing for Retirement in Your 30s

The Challenge

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Alicia, 32, is a lifelong resident of Texas and works in sales for a communications company. Although she just recently changed employers, she has worked in the same field for five and a half years.

Most, but not all, of her pay comes through commissions. With the job change, she has spent two months in training and that's two months she hasn't been collecting commissions. But her commission income kicks in next month, and she expects to quickly be back to more customary monthly income levels.

Given the unpredictability of commission income, it is important to have an adequate savings cushion and a good handle on monthly expenses. Alicia has both of these bases covered. She closely evaluates her spending and makes conscious decisions on discretionary spending. As a result, she routinely saves $1,000 to $1,500 per month and has accumulated an emergency savings cushion of more than one year's worth of expenses in a dedicated savings account earning 0.7%. Additionally, she has the equivalent of nearly three months' expenses in her checking account. She also has $2,000 sitting in cash in an online brokerage account.

Her obligations: Alicia has $26,000 in student loans she consolidated after graduation at a fixed rate of 4.54%. She pays $199 each month, the minimum required. Due to her income, she is no longer eligible to deduct the interest from her taxes. She has $7,500 remaining on a car loan through her local credit union with a low fixed-interest rate of 2.65%.

There is also an outstanding credit card balance of $2,000 she plans to pay off with her first commission check. She put expenses on her credit card for a couple of months after the job switch because she wanted to conserve cash until the commission checks resumed. Alicia says she "probably won't use the credit card again" once it's paid off, as she views credit cards as just for emergencies. Instead, she typically uses her debit card -- 20 or more times per month -- for expenses.

Alicia rents an apartment, having recently moved closer to work, and she's not considering buying a home in the foreseeable future. She says such a step may be 10 years away.

Her retirement plan: Alicia has a $30,000 401(k) balance at her former employer she plans to roll over to her new employer's plan. Her investment allocation is a little off, something that should be rectified sooner rather than later. She does not have an individual retirement account, or IRA.

Her new employer's 401(k) plan doesn't have an employer match during the first year of employment, but afterward they'll match two-thirds of her contributions up to 10%. She has signed up to begin contributing 10%, and this will be enough to maximize the employer match once it kicks in next year. Any matching funds from her employer won't be fully vested for five years.

Her company also offers a pension program that is fully funded by the company. Participation begins after one year, and she'll be fully vested after five years. Benefits begin at age 65 or with a reduced amount at age 55. If Alicia stays with her employer, then over time this could be another leg on the retirement savings stool.

Her dreams: She has been considering starting a small business on the side but has been reluctant due to the $10,000 to $15,000 initial commitment.

Alicia is worried about not having enough in retirement for her age, and she's seeking the Money Makeover to help figure out how she can be on track to retire by age 67.

Key Issues:

  • Plenty of emergency cash, but holding a $2,000 credit card balance at 14.9%.
  • Allocation of existing 401(k) balance needs some tweaking.
  • She doesn't have an IRA.
  • All taxable assets are held in cash and not earning optimum yields

The Solution

Alicia is in great shape, but there are a few things she should do to enhance her current and future financial security. She can begin by tapping some of the savings to pay off the credit card balance now. This will save her about $25 in interest expense compared to waiting until next month for the initial commission check.

Change investment allocations: Alicia's current 401(k) balance is entirely invested in equities, which is fine for a retirement account at her age. After all, she may not tap this account for 30 years or more. The investment allocation needs some tweaking, however. She has no international exposure, and she is underweighted toward large-company stocks, with just 12% of her account dedicated to them. With expense ratios of more than 2%, the large-company stock funds in her former employer's 401(k) are very expensive, especially for mutual funds holding stocks of large companies. A broad index fund such as a Standard & Poor's 500 index fund would be a lower cost alternative, either in the current plan or her new employer's plan.

Alicia doesn't currently have an IRA, so she should open a Roth IRA and tap her savings to fully fund a $5,000 contribution for tax year 2011. The Roth IRA won't give her any tax deduction on her contributions like the 401(k) but will permit tax-free withdrawals of all future growth. This Roth IRA can be used to round out her overall asset allocation by adding such tax-inefficient investments as commodities and real estate investment trusts, that may not be available in her new employer's 401(k).

In addition to tapping the savings to pay off the credit card and fund a Roth IRA, an additional option would be to use the cash that exceeds 12 months' worth of expenses to invest in an exchange-traded fund, or ETF, or a mutual fund that holds dividend-paying stocks. The yield is considerably higher -- and the tax rate lower -- than cash and many bonds, yet she'd still have one year's worth of runway before having to access the money in the event of a job loss.

Maximize retirement accounts: There are several possible uses for the additional cash she's still able to put aside every month. She can choose to deploy this money in one or more of the following ways: accumulate $5,000 for next year's Roth IRA contribution, save up for her eventual business venture, further increase 401(k) contributions or make additional taxable investments.

Eligibility to make a $5,000 Roth IRA contribution for 2012 opens up Jan. 1. Her annual 401(k) contribution limits are $16,500 -- provided her employer permits her to defer that much -- so there is the possibility of substantially increasing her deferrals. And starting the side business is very doable at some point in the next couple of years, so setting aside some cash to meet that goal is also a worthwhile pursuit.

Search for better yield: In terms of emergency savings, Alicia is currently earning 0.7% in her savings account, but there are a couple of opportunities to increase her take without sacrificing safety or access to the money. The first option would earn an additional $135 annually by parking one year's worth of expenses in one of the high-yield online savings accounts listed at