Retirement funds and ramen noodles: Saving smarter in your 20s
It seems everyone wants a piece of your paycheck when you reach your 20s.
There are school loans to repay, rent checks to write and professional wardrobes to purchase—all on a ramen-noodle budget. Add to that any credit card debt accrued while searching for employment and it's easy to see why long-term savings often take a backseat to more immediate financial needs in young adulthood.
"It can be hard to focus on something that's decades in the future, so it helps to show them how dramatic a difference it makes when they start saving in their 20s versus their 30s or 40s," said Gil Armour, a certified financial planner with SagePoint Financial.
Indeed, he noted, the decision to sock even a sliver of your salary away in a tax-favored retirement account when you're just starting out can have a profound effect on the size of your future nest egg.
A 25-year-old, for example, who makes $40,000 and contributes 10 percent of his salary to a 401(k) plan annually will amass $3.9 million by the time he retires at age 67. That figure assumes a 50 percent employer contribution match, a 5 percent estimated salary increase rate annually and an 8 percent investment rate of return.
Using all the same parameters, that same person would have $2.5 million—or $1.4 million less—if he had started saving at age 30.
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Ultimately, though, it's not how much you earmark for retirement when you're young that makes the biggest impact. It's the ability to save on a consistent basis.
Ken Waltzer, a certified financial planner and president of Kenfield Capital Strategies, said good financial habits right out of the gate can all but eliminate the biggest risk of retirement: outliving your money.
"If I look at my clients, the ones who have the most money today in retirement, it's not the people who earned the most," he said, noting one of his clients is a schoolteacher with more than $1 million in the bank. "It's the people who saved the most."
Pay yourself first
The best system for building a comfortable nest egg is to "pay yourself first," said Armour at SagePoint Financial.
"If they can prioritize their dollars by setting up a system where they put money aside for their future before they can spend it, they could end up with a really nice nest egg," he said.
Automated deposits into your 401(k) or a traditional individual retirement account (IRA), for example, are a great way to take the sting out of saving, Armour said.
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Not only are contributions made on a pretax basis, which reduces your taxable income, they also disappear from your paycheck before you get a chance to spend them, which helps you learn to live within your means.
As a young adult, you may not be able contribute the maximum amount to your 401(k), which is $17,500 for 2014, but all employees, regardless of age or income, should at least contribute enough to get the full benefit of their employer match if one is available, said Roger Oprandi Jr., a certified financial planner and senior vice president of Vega & Oprandi Wealth Partners.
"If you work for a company that offers a 401(k) match, take full advantage," he said. "That's free money, and too often young people leave that money on the table."
"If you work for a company that offers a 401(k) match, take full advantage. That's free money."
The upside potential of saving while you're young, of course, is predicated on the benefit of compounded interest, in which you continually earn interest on the money you save and on the interest that money earns. With a time horizon of 40 years or more, even a small amount of savings can snowball into a sizable sum.
But that benefit is lost if you invest too conservatively, warned Oprandi. He pointed to the example of one of his younger clients, a medical school student who invested exclusively in stable value funds because he feared market risk. Oprandi helped him reallocate to a more balanced portfolio.
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"The statistics are overwhelmingly in favor of starting sooner, but you must invest that money age-appropriately," he said, adding that inflation chips away at purchasing power every year. "Don't put those dollars into a money market account or a certificate of deposit, which is too conservative for someone with a longer time horizon until retirement."
Retirement savers in their 20s, Oprandi said, should have 80 percent to 100 percent of their portfolio invested in equities (stocks).
Waltzer at Kenfield Capital Strategies agreed, noting that many of his youngest clients, who watched their parents endure the Great Recession, are too gun-shy for their own good.
He recommends 20-somethings use their employer-sponsored 401(k) plans to save first, but then separately open Roth individual retirement accounts funded with after-tax dollars. The benefits of a Roth IRA for young adults, he said, are almost too numerous to name.
For starters, a Roth IRA is additional savings that you can't touch without penalty—which helps keep your hands out of the cookie jar. The earnings in a Roth IRA also grow tax-free, even upon withdrawal, and there's no requirement to begin taking minimum distributions at age 70½ , as there is for a traditional IRA. Thus, money in your Roth can continue earning interest.
"Roths are really good vehicles for young investors because the longer your time horizon is, the more valuable the tax deferral is," Waltzer said.