When you’re in your 20s, retirement seems so far off that it hardly feels real at all. In fact, it’s one of the most common excuses people make to justify not saving for retirement. If that describes you, think of these savings instead as wealth accumulation, suggests Marguerita Cheng, CFP, CEO of Blue Ocean Global Wealth in Rockville, Maryland.
Anyone nearing retirement age will tell you the years slip by, and building a sizable nest egg becomes more difficult if you don’t start early. You'll also probably acquire other expenses you may not have yet, such as a mortgage and a family.
You may not earn a lot of money as you begin your career, but there’s one thing you have more of than richer, older folks: time. With time on your side, saving for retirement becomes a much more pleasant—and exciting—prospect.
You’re probably still paying off your student loans, but even a small amount saved for retirement can make a huge difference in your future. We’ll walk through why your 20s are the perfect time to start saving for those post-work years.
- It's easier to save for retirement when you're young and may have fewer responsibilities.
- You can map out your retirement plan, but if you don't have the know-how, an investment advisor can help prioritize your goals.
- Compound interest, which is the interest earned on your initial savings and the reinvested earnings is a great reason to start saving early.
- You can invest post-tax dollars in a Roth IRA, while pretax dollars can build a traditional IRA.
Know Your Goals
The sooner you start saving for retirement, the better it will be down the road. But you may not be able to do it yourself. It may be necessary to hire a financial advisor to help you out—especially if you don't have the know-how to navigate the process of retirement planning.
Make sure you set realistic expectations and goals, and make sure to have all the necessary information when you meet with an advisor or start mapping out a plan on your own. A few things you may need to consider during your analysis:
- Your current age
- The age when you plan to retire
- All income sources including your current and projected income
- Your current and projected expenses
- How much you can afford to set aside for your retirement
- How and where you plan to live after you retire
- Any savings accounts you have or plan to have
- Your health history and that of your family to determine health coverage later in life
While you may not be able to predict certain life events like divorce, death, or children, it's important to keep these in mind when you plan for retirement.
Compound Interest Is Your Friend
Compound interest is the best reason it pays to start early with retirement planning. If you’re unfamiliar with the term, compound interest is the process by which a sum of money grows exponentially due to interest more or less building upon itself over time.
Let’s start with a simple example to get down the basics: Say you invest $1,000 in a safe long-term bond that earns 3% interest per year. At the end of the first year, your investment will grow by $30—3% of $1,000. You now have $1,030.
However, the next year you’ll gain 3% of $1,030, which means your investment will grow by $30.90. A little more, but not much.
Fast forward to the 39th year. Using this handy calculator from the U.S. Securities and Exchange Commission’s website, you can see that your money has grown to around $3,167. Go ahead to the 40th year, and your investment becomes $3,262.04. That’s a one-year difference of $95.
Notice that your money is now growing more than three times as quickly as it did in year one. This is how “the miracle of compounding earnings on earnings works from the first dollar saved to grow future dollars,” says Charlotte A. Dougherty, CFP, founder of Dougherty & Associates in Cincinnati, Ohio.
The savings will be even more dramatic if you invest the money in a stock market mutual fund or other higher-earning vehicles.
Why Save For Retirement In Your 20s?
Saving a Little Early vs. Saving a Lot Later
You may think you have plenty of time to start saving for retirement. After all, you are in your 20s and have your whole life ahead of you, right? That may be true, but why put off saving for tomorrow when you can start today?
If you have access to an employer-based retirement plan, take advantage of it. Most employers will match some of your contributions, so you'll benefit from having an extra boost to your savings. And with pretax deductions, you won't even notice your money is being put away.
You can also put money aside outside of your employer. Let's consider another scenario to drive this idea home. Let’s say you start investing in the market at $100 a month, and you average a positive return of 1% a month or 12% a year, compounded monthly over 40 years. Your friend, who is the same age, doesn’t begin investing until 30 years later, and invests $1,000 a month for 10 years, also averaging 1% a month or 12% a year, compounded monthly.
Who will have more money saved up in the end?
Your friend will have saved up around $230,000. Your retirement account will be a little over $1.17 million. Even though your friend was investing over 10 times as much as you toward the end, the power of compound interest makes your portfolio significantly bigger.
Remember, the longer you wait to plan and save for retirement, the more you'll need to invest each month. While it may be easier to enjoy your 20s with your full income at your disposal, it will be harder to put money away each month as you get older. And if you wait too long, you may even need to postpone your retirement.
What to Consider When Investing
The types of assets in which your savings are invested will significantly impact your return and, consequently, the amount available to finance your retirement. As a result, a primary object of investment portfolio managers is to create a portfolio that is designed to provide an opportunity to experience the highest return possible. Amounts that you have saved for short-term goals are usually kept in cash or cash equivalents because the primary objective is usually to preserve principal and maintain a high level of liquidity. Amounts that you are saving to meet long-term goals, including retirement, are usually invested in assets that provide an opportunity for growth.
If you manage your investments instead of using the services of a robo-advisor or professional, it is important to understand that there are other factors to consider. The following are just a few:
The investments that provide the opportunity for the highest rate of return are usually the ones with the highest level of risk, such as stocks. The ones that provide the lowest rate of return are usually the ones with the least amount of market risk.
Your ability to handle market losses should be factored in when designing your investment portfolio. If the amount of market risk associated with your portfolio causes you undue stress, it may be practical to redesign your portfolio to one with less risk, even if it is determined that the amount of risk is suitable for your investment profile. In some cases, it may be practical to ignore a low level of risk tolerance if it is determined that it negatively impacts the ability to provide your investments with sufficient growth.
Generally, the level of discomfort one experiences with risk is determined by one's level of experience and knowledge about investments. As such, it is in your best interest to, at a minimum, learn about the different investment options, their market risks, and historical performance. Having a reasonable understanding of how investments work will allow you to set reasonable expectations for your return on investments, and help to reduce the stress that can be caused if expected returns on investments are not achieved.
Your targeted retirement age is usually taken into consideration. This is usually used to determine how much time you have to regain any market losses. Because you are in your twenties, it is presumed that investing a large percentage of your savings in stocks and similar assets is suitable, as your investments will likely have sufficient time to recover from any market losses.
Individual Retirement Account (IRA)
How you invest in your retirement will determine how much income you'll have in retirement but also how you are taxed.
If you invest in a traditional individual retirement account (IRA), you can contribute or deposit up to $6,000 per year for the 2020 and 2021 tax years. As a benefit, you also get a tax deduction, meaning you can subtract your annual IRA contribution from your taxable income when you file your taxes. As a result, you pay less in taxes. Also, the money within an IRA grows tax-free until you withdraw the funds in retirement.
Whenever you withdraw this money, you’ll have to pay applicable federal and state taxes on it. It's supposed to be used as an annual retirement income supplement. If you withdrew the whole lot at once, you'd owe a bundle in taxes.
One other disadvantage of a traditional IRA is something called the required minimum distribution (RMD). If this still exists when you’re 72, you will be required to withdraw a specified sum every year and pay income taxes on it. Previously, the RMD age was 70½, but following the December 2019 passage of the Setting Every Community Up For Retirement Enhancement (SECURE) Act, the RMD age is now 72.
Alternatively, you could invest in a Roth IRA. You open a Roth with post-tax income, so you don’t get the tax deduction on your contributions. However, when you’re a retiree and withdraw the money, you owe no taxes on it—and that includes all the money your contributions earned over all those years. Also, you can borrow the contributions—not the earnings—if you need to before you reach retirement.
However, there are income limits on who can have a Roth and those limits also depend on your tax-filing status (i.e.married or single). If you file taxes as a single individual, you can't make contributions to a Roth if your income exceeds $139,000 in 2020 and $140,000 in 2021.
If your income is below those levels, your contribution might get phased out or get reduced. For the 2020 tax year, the income phase-out range for singles is $124,000 to $139,000, while for 2021 contributions, the income phase-out range is $125,000 to $140,000.
For married couples who file a joint tax return, the Roth income phase-out range for 2020 is $196,000 to $206,000, and for 2021, it's $198,000 to $208,000. This means that you can't contribute to a Roth if your income as a couple exceeds $206,000 in 2020 and $208,000 in 2021. If you're in your 20s, you're probably safely below the income limits.
401(k) Retirement Plan
If your employer offers a 401(k) or a Roth 401(k), be sure to take advantage of it before you open an IRA, especially if the company matches your contributions. A 401(k) withdraws money from your paycheck and direct deposits those funds into a retirement account, which is then invested in stocks and bonds. Companies often match a certain percentage of your salary, such as 3%, as long as you contribute to the plan as well.
You can contribute to both an IRA and a 401(k) in the same year. However, there are contribution limits for 401(k)s. For 2020 and 2021, you can contribute up to $19,500 per year into a 401(k) or a Roth 401(k).
And put your savings on auto-pilot, says financial planner Carlos Dias Jr., founder of Excel Tax & Wealth Group, in Lake Mary, Florida. “Money deposited straight into your retirement account can’t be spent elsewhere and won’t be missed. It also helps you maintain discipline with your savings.”
Invest in a Savings Account
A savings account from your local bank may not get you a great rate, but you can deposit and withdraw as much as you want—when you want. Every bank has its own rules, though, which means some may require a minimum balance or restrict the number of withdrawals before they charge. But, unlike registered retirement accounts, there are no tax deduction benefits with a savings account. In other words, any interest earned on the savings is taxed in the tax year that it was earned.
The other benefit of having a savings account is convenience. You can use a savings account for whatever you need, whether for short-term expenses or longer-term needs. You may be saving to purchase appliances for your home, a trip, or a downpayment on a car or home—which is when a savings account will come in handy.
The Bottom Line
The sooner you begin saving for retirement, the better. When you start early, you can afford to put away less money per month since compound interest is on your side. “For Millennials, the most important thing about saving is getting started,” says Stephen Rischall, co-founder of 1080 Financial Group. “Compounding interest benefits those who invest over longer periods the most.”