We have all heard how important it is to start saving for retirement at a young age; but what exactly does that mean? A lot of young working people will sock money away in a savings account and think they are doing the right thing. While having cash for a rainy day/unexpected life event is very important, it is not at all how to save for retirement or save for a big purchase (i.e. down payment on a mortgage/new car). The secret behind it all is something called “compounding interest”. Compounding interest is something that happens over the course of many years and is hands down the best strategy to obtaining financial freedom.
For starters, it is important to understand what kind of account you are funding. Ideally, funding both a qualified account and non-qualified account is important. Qualified accounts are tax-advantaged retirement accounts such as Traditional IRAs, Roth IRAs, and 401ks. The beauty about these accounts is that they can grow either tax-deferred (such as a Traditional IRA) or tax-exempt (i.e. Roth IRA), however they cannot be tapped until a later age without penalty. Qualified accounts also come with contribution limits so one cannot put in an indefinite amount. Although you will pay tax on earnings upon sale of investments within non-qualified accounts, the good news is that the funds are available for withdrawal at any time with no age restriction.
We understand young workers may not be able to fund both kinds of accounts early in their careers, therefore, we recommend funding the qualified accounts (retirement) first, followed by the taxable, non-retirement accounts.
Click here to learn a little more about Roth and Traditional IRA’s (qualified/retirement accounts).
The next step is to determine what kind of asset allocation aligns with your ‘Risk Tolerance Level’. We recommend consulting an investment expert, like DWM, to help determine your risk level profile (e.g. defensive, conservative, balanced, moderate, or aggressive) and the funds you should be invested in. Assuming your risk tolerance lands you in a “balanced” portfolio, you should expect a targeted long term rate of return of 6 to 8% per year. This may not sound like an enormous annual rate of return, but after compounding interest over a long investment time horizon, one is capable of achieving impressive portfolio numbers.
Now for the magic of compounding interest, what it can mean for your future, and why it is so important to start early for young workers. The best way to explain this is through an example:
If you contribute $5,500 to a Roth IRA (the max a Roth allows each year) starting at 22 years old and average 7% return per year until retirement at age 65, the $236,500 total contribution will turn into $1,566,121.
Compare that to socking away $5,500 into the same type of account, invested in the same exact funds, starting at age 40: Your account will grow to $372,220. This is still great and much better than not investing at all, but it would be a lot nicer to grow an account to over 1.5 million dollars versus less than 0.4 million dollars going into retirement.
An accepted estimate in the financial planning world is something called “The Rule of 72”. This is a quick and simple math equation that estimates how many years it will take to double an investment, given a certain annual rate of return. If we assume a 7% rate of return, we would divide 72 by 7 to come to a final answer of 10.24. So, with an annual return of 7%, it will take you a little over 10 years to double an investment. Therefore, a 25 year-old has the potential to double his/her invested money every 10 or so years from your early 20’s until retirement (4x over).
This means one would need to more than quintuple your annual income if you wait until age 40 vs. starting at 22 to make up for not putting away the $5,500 the 18 years prior (~$1.25 million) you technically missed out on.
Click here to see what amount you can achieve if you started putting $5,500 away today.
Another big misconception with saving young is “maxing out a 401(k)”. Many young workers will say they are maxing out their 401(k). However, simply putting away the 3-4% a company matches is not at all maxing out a 401(k), in fact, it is barely scratching the surface. As of 2017, the maximum employee contribution, per year to a 401(k), is $18,000- this is maxing out a 401(k). Let’s say a 25 year old makes $50,000 per year and is contributing 4% to his/her 401(k) that the company is matching. This 4% is only $2,000 per year and the match only becomes yours after it vests. It is important to understand your companies vesting schedule because in some cases it can take six years or more for that to actually be considered your money.
Another important step to saving/investing correctly is analyzing the investment menu within your 401(k). This involves studying the funds offered within a 401(k) and identifying an appropriate asset allocation target for yourself in-line with your risk tolerance. It is also important to look at the underlying fees within the funds of the 401(k). If you are in a large cap equity fund charging 70 basis points but there is another large cap fund that charges only 9 basis points, it can make a big difference over 20-30 years. Here at DWM, we do a 401(k) analysis for all clients because we understand the importance a few basis points can have on an individual and their family over the course of a lifetime.
We have all heard our millennial generation and future generations will never be able to retire because of different theories on social security and how rare pensions are today. This could not be further from the truth. We simply need to take our savings just as seriously as our expenses and we may be capable of not only retiring, but comfortably retiring and being able to leave a legacy for future generations. While a lot of millennials believe they are going to invent the next pet rock and become overnight millionaires, it might be a good idea to start saving the correct way because slow and steady does indeed win the race.