Why Save For Retirement In Your 20s?
When you're in your 20s, retirement seems like such a distant goal that it hardly seems real at all. In fact, it's one of the most common excuses people make to justify not saving for retirement.
But anyone nearing retirement age will tell you that the years slip by and that building a sizable nest egg becomes much more difficult if you don't start early. Also, you'll probably acquire other expenses you may not have yet, such as a mortgage and a growing 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) affair.
You're probably also 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 retirement.Compound Interest Is Your Friend
Compound interest is the number-one 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.
For more information, check out Investing 101: The Concept of Compounding.
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 $1000). You now have $1,030.
However, the next year you'll gain 3% of $1,030, which means your investment will grow by $30.9. 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 obviously will be even more dramatic if you invest the money in a stock market fund or other higher earning vehicle.Saving a Little Early vs. Saving a Lot Later
Let's run 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 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.Roth or Regular?
How you invest in your retirement also has important implications for your taxes.
If you invest in a traditional individual retirement account (IRA), you can deduct up to $5,500 from your taxes for that tax year. It will grow tax-free until you withdraw it. However, whenever you withdraw this money, you'll have to pay applicable federal and state taxes on it. If you were to withdraw that $1.17 million all at once, for example, it could cost you a couple of hundred thousand dollars in taxes for that year. One other disadvantage of a traditional IRA: something called the Required Minimum Distribution (RMD). If this still exists when you're 70½, you will be required to remove (and be taxed on) a specified sum every year starting the calendar year after you turn that age.
Alternatively, you could invest in a Roth IRA. You open a Roth with post-tax income, so you don't get a deduction on your contributions (up to the same $5,500 per year). However, when you're ready to withdraw the money you owe no taxes on it – and that includes all the money your contributions earned over all those years. In addition, you can borrow the contributions (not the earnings) if you need to (see How To Use Your Roth IRA As An Emergency Fund). There are income limits on who can have a Roth, but you may be safely below them in your 20s. For more on these differences, see Roth Vs. Traditional IRA: Which is Right For You?
If your employer offers a 401(k), be sure to take advantage of that even before you open an IRA, especially if the company matches your contributions. Many companies offer both Roth and regular versions (see 401(k) Plans: Roth or Regular?).
With certain income limitations, you can contribute to both an IRA and a 401(k) in the same year. For more information, read What are the differences between a 401(k) and an IRA?The Bottom Line
The sooner you begin saving for retirement, the better. When you start early, you can afford to put away less money a month since compound interest is on your side.
There's wisdom to the phrase time is money -- especially when it comes to your retirement. For more, see Five Retirement Warning Signs For Millennials.