Young investors today who wish to begin a savings plan face a bewildering array of investment options. There are not only thousands of products and services to choose from, there are almost as many different firms and vendors that market them in various capacities. Fortunately, deciding which types of investments are best is not as hard as it may seem if you're a young person in today's world. Finding the right answer begins with examining what you want to get out of your money both now and in the future.
Saving for Retirement
If you are young, then your greatest financial asset is time. At this point in your life, your primary investment objective for your long-term savings should be growth. Investors in their 20s will have least 40 years over which to accumulate retirement savings. Historical data clearly shows that common stock and real estate are the only two asset classes that have grown faster than the rate of inflation over time. This means that most or all of your long-term savings should probably be placed in some form of equities, such as individual common stocks and stock mutual funds, and perhaps real estate, either in the form of a personal residence or a mutual fund that invests in real estate holdings. It is imperative that you are able to increase your purchasing power in your retirement savings over the course of your life, because you will need every ounce of it that you can muster after you stop working.
Of course, IRAs and employer-sponsored retirement plans are the best places to start when saving for retirement. Employer-sponsored plans often provide matching contributions, and this can give your retirement savings a tremendous boost; a 50% match on the first 5% of your contributions can result in tens of thousands of extra dollars in your pocket at retirement. Most financial experts tell young people to use a Roth IRA instead of a traditional IRA because of the tax-free withdrawals. Roth features are also available in many qualified plans such as 401(k) plans, and these may also be superior to traditional tax-deferred options that are taxable upon withdrawal at retirement. Ultimately, the combination of tax-free growth coupled with the superior returns posted by equities is virtually impossible to beat over time.
Buying a Home
Traditional financial wisdom has usually dictated that a house is one of the best investments you can buy, but whether or not this is true depends upon several variables. The duration of your residence and the current housing market will factor heavily into this issue, as will the current interest rate environment, rental prices and your personal financial situation. If you plan on living in one place for less than five years, then it is probably cheaper to rent in most cases, because, mathematically speaking, it usually takes at least five to seven years to accumulate enough equity in a home to justify buying one versus renting.
Saving for College
If you are still trying to get through school or have not yet started, then there are several other vehicles for you to consider socking money into:
529 Plans - Every state has this type of college savings plan that allows you to put money away until you begin your higher education. The funds can be allocated between various investment choices and will grow tax-free until they are withdrawn to pay for qualified higher education expenses. The contribution limits for these plans are quite high and they can also provide gift and estate tax savings for wealthy donors looking to reduce their taxable estates.
Coverdell Educational Savings Accounts - This type of college savings account is another option for those who want to take a more self-directed approach to choosing their investments. The annual contribution limit is currently $2,000 per year, but it may still be a viable alternative if you want to purchase a specific investment that is not offered inside a 529 Plan.
U.S. Savings Bonds - These are yet another alternative to consider for conservative investors who don't want to risk their principal. The interest that they earn is also tax-free as long as it is used for higher education expenses.
The alternatives for your short-term cash, such as an emergency fund, are pretty much the same regardless of your age. Money market funds, savings accounts and short-term CDs can all provide safety and liquidity for your idle cash. The amount that you keep in these investments will depend on your personal financial situation, but most experts recommend keeping at least enough to cover three to six months of living expenses.
The Bottom Line
The most important decision that you can make as a young person is to get into the habit of saving regularly. What you invest in matters less than the fact that you have decided to invest. The right investments for you are going to depend largely upon your personal investment objectives, risk tolerance and time horizon.