When you're in your 20s and someone says you should start saving for retirement, your first thought is probably, that's a long way off, and you've got plenty of time to start saving. The reality is that time passes more quickly than you realize, and the best time to start is in your 20s if you want to have a financially comfortable retirement.
In the first place, if the goal of saving for retirement doesn't motivate you, here's another way to look at it. Don't think of saving as putting money aside for a retirement savings account; think of it as wealth accumulation or building your net worth.
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After all, what is your goal? Do you want to arrive at age 40 in a completely different financial situation with a ton of credit card debt and no money in your savings account? Of course not. You're going to need another source of retirement income in addition to your Social Security payments.
Here's why you should begin your wealth accumulation plan in your 20s and how to do it.
Setting Up a Budget
The first step on the road to accumulating wealth and reaching your financial goals is to create a plan. If you follow the strategy of adding to your savings if there's any money left at the end of the month, you can be fairly certain there'll never be any money left, and your investments will never grow.
Accumulating wealth and saving for retirement is best when started in your 20s, and you have more time to at to savings.
To solve this problem, analyze your monthly living expenses and make the investment in your retirement savings a fixed amount and part of your budget, just like paying the rent, utility bills and student loans and building up an emergency fund. You can start small and gradually increase the amount each year.
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For example, suppose you have $5,000 in gross monthly income. Start by investing just 1 percent, or $50, each month in your retirement account and make that contribution mandatory, just like paying your other bills. You can even set up these contributions as automatic withdrawals from your checking account.
If you begin this strategy while in your 20s, it will become a habit and part of your financial lifestyle.
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The Advantages of Compound Interest
Compound interest performs magic on investments and is the best reason to start early in life with your savings plan. Simply put, compound interest is the process of earning interest on the interest you earned on the principal balance in a savings account.
Suppose you have $1,000 in an account earning 6 percent per year. At the end of the first year, you'll have $1,060 in the account.
At the end of the second year, you'll have $1,123.60. The reason is that you earned another $60 on the original balance and $3.60 on the interest ($1,060 + $60 + $3.60 = $1,123.60).
Suppose you're 25 when you start investing $50 per month, and you're earning 6 percent compounded monthly, and you continue with the same amount until age 65. With the magic of compound interest, you would end up with $100,122.41 with a cumulative investment of $24,000 (480 months times $50).
Now suppose instead of keeping the amount of the investment constant at $50 per month, you increase the amount of contribution by only 5 percent each year. Your investment at age 65 would be $207,453.64.
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Types of Retirement Plans
These are the most common types of tax-deferred retirement plans.
Traditional IRA: Contributions to a traditional individual retirement account (IRA) are made with pretax dollars and are deductible on your income tax return, but you have to pay tax on withdrawals in retirement. Income on your investments accumulates tax-free. Currently, the IRS imposes a contribution limit to a traditional IRA of $6,000 for single taxpayers.
Roth IRA: Contributions to a Roth IRA are made with after-tax dollars, so you don't pay tax on distributions in retirement.
401(k) plans: If your employer offers a 401(k) plan, it makes sense to take full advantage of the contributions to this plan, particularly if your employer offers any percentage of matching funds.
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Types of Investments
If you're not familiar with the various types of investments, you should consult a financial planner. But if you have an investment strategy and want to make the decisions yourself, these are the major kinds of investment options that you can use to create an investment portfolio with your desired asset allocation.
Stocks: While you're young, you can invest in riskier stocks, depending on your risk tolerance. Even so, you'll probably want to invest in the major large-cap companies like American Express, Home Depot, Microsoft and Walmart.
Bonds: Bonds of major corporations will have a lower interest rate return, but they are more secure and less volatile than stocks.
Mutual funds: If you're not comfortable selecting your own individual investments, put your money into mutual funds or exchange-traded funds. You can find funds that are conservative or aggressive. A safe approach is to invest in a Standard & Poor's 500 Index Fund, which represents 500 of the largest companies in the stock market and will give you a broad diversification of assets. Over a period of years, stocks have historically provided a return in the range of 10 percent.