When you’re starting your career in your 20s, the last thing on your mind may be the end of your career and the retirement that comes after. But thinking about retirement now can ensure your financial security in the future.
The earlier you start investing, the better – even if you’re only saving a small amount. Typically, having a long-time horizon means you have time to weather the ups and downs of the markets.
What’s more — and this is critical — the earlier you invest, the more time you’ll be able to take advantage of compound interest, the returns you earn on returns that help supercharge your ability to save. Compound interest is the reason small amounts of money saved and invested now can go further than much larger amounts of money saved later. The more time you have, the more returns compound interest can deliver.
Related: What is a 401(k)?
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Compound Interest Example
Imagine you are 25 with plans to retire at 65. That gives you 40 years to save. If you save $100 a month with an average annual return of 6% compounded monthly at age 60, you would have saved about $200,244.
Now, let’s imagine that you waited for 30 years, until age 55 to start saving. You put $1,000 a month into your retirement savings account. With an average annual return of 6% compounding monthly, you’d only have about $165,698 by the time you’re ready to retire, far less than if you’d started saving smaller amounts earlier.
The lesson? The longer you wait to start saving for retirement, the more money you’ll have to save later to make up the difference. Depending on your financial situation, it could be difficult to find these extra funds when you’re older.
Though it may not sound fun in your 20s to start putting money toward retirement, it may actually be easier in the long run.
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How to Start Saving for Retirement in Your 20s
If you’re new to investing, starting a retirement fund requires a little bit of planning.
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Step 1: Calculate how much you need to save
Opening a retirement account begins with setting a goal. Consider your target retirement date and how long you’ll expect to be retired based on current life expectancy. What kind of lifestyle do you want to lead? And what do you expect your retirement expenses to be?
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Step 2: Choose a savings vehicle
When it comes to where to put your retirement savings, you have a number of options. The average interest rate in a savings account in November 2021 was 0.06%. For better returns, many retirement savers opt to use an investing account, such as a taxable brokerage account or tax-advantaged retirement savings account instead.
Keep in mind that investments in equities or other securities are riskier than savings accounts, which allows for the possibility of better returns. Still, young investors can typically take on additional risk since they have time to recover after a market decline.
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Step 3: Start investing
Once you’ve opened an account your investment strategy depends on age, goals, time horizon and risk tolerance. For example, the longer you have before you retire, the more money you may consider investing in riskier assets, such as stock, since you’ll have longer to ride out any rocky period in the market. As retirement approaches, you may want to re-allocate more of your portfolio to less risky assets, such as bonds.
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Types of Retirement Plans
If you’re interested in opening a tax-advantaged retirement plan, there are three main account types to consider: 401(k)s and traditional and Roth IRAs.
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1. 401(k)
A 401(k) is an employer sponsored retirement account, meaning you invest in it through your workplace, if your employer offers it. You make contributions to 401(k)s to pre-tax funds (meaning contributions lower your taxable income), usually deducted from your paycheck. Your 401(k)s will typically offer a relatively small menu of investments from which you can choose.
Employers may also contribute to your 401(k) and often offer matching contributions. Consider saving enough money to at least meet your employer’s match, which is essentially free money and an important part of your total compensation.
Some companies also offer a Roth 401(k), which use after-tax paycheck deferrals.
Individuals can contribute up to $19,500 each year in their 401(k) in 2021 and $20,500 in 2022. Those age 50 and up may be able to make an extra $6,500 in contributions.
Money invested inside a 401(k) grows tax-deferred, and you’ll pay regular income tax on withdrawals that you make after age 59 ½. If you take out money before then, you could owe both income taxes and a 10% early withdrawal penalty.
You must begin making required minimum distributions (RMDs) from your account by age 72.
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2. Traditional IRA
Traditional IRAs are not offered through employers. Anyone can open one as long as they have earned income. Depending on your income and access to other retirement savings accounts, you may be able to deduct contributions to a traditional IRA on your taxes.
As with 401(k) contributions, you’d owe taxes on traditional IRA withdrawals after age 59 ½ and may have to pay taxes and a penalty on early withdrawals.
In 2021 and 2022, traditional IRA contribution limits are $6,000 a year or $7,000 for those age 50. Compared to 401(k)s, IRAs offer individuals the ability to invest in a much broader range of investments. These investments can then grow tax-deferred inside the account. Traditional IRAs are also subject to RMDs at age 72.
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3. Roth IRA
Unlike 401(k)s and traditional IRAs, savings go into Roth IRAs with after-tax dollars and provide no immediate tax benefit. However, money inside the account grows tax-free and it isn’t subject to income tax when withdrawals are made after age 59-and-a-half.
You can also withdraw your principal (but not the earnings) from a Roth at any time without a tax penalty. Roths are not subject to RMD rules.
Contribution limits are the same as traditional IRAs.
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Investing in Multiple Accounts
Individuals can have both a traditional and Roth IRA. But note the contribution limits apply to total contributions across both. So, if you’re 25 and put $3,000 in a traditional IRA, you could only put up to $3,000 in your Roth as well.
You can also contribute to both a 401(k) and an IRA; however, if you have access to a 401(k) at work, you may not be able to deduct your IRA contributions.
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Retirement Plan Strategies
The investment strategy you choose will depend largely on three things: your goals, time horizon and risk tolerance. These factors will help you determine your asset allocation, what types of assets you hold and in what proportion. Your retirement portfolio as a 20-something investor will likely look very different from a retirement portfolio of a 50-something investor.
For example, those with a high-risk tolerance and long-time horizon might hold a greater portion of stocks. This asset class is typically more volatile than bonds, but it also provides greater potential for growth.
The shorter a person’s time horizon and the less risk tolerance they have, the greater proportion of bonds they may want to include in their portfolio. This graph offers a look at some portfolio strategies and the asset allocation that might accompany them.
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The Takeaway
Even if you don’t have a lot of room in your budget to start investing, putting away what you can as early as you can, can go a long way toward saving for retirement. As you start to earn more money, you can increase the amount of money that you’re saving over time.
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