Plan for Retirement on Your First Day of Work

Plan for Retirement on Your First Day of Work

At age 21, most people are just beginning their careers. They would be wise to think about retirement at the same time.

Contributions to 401(k) plans, IRAs and other retirement plans tend to be low for those who are just entering the work force. Saving money is not a strength of most 21-year-olds – and they usually don’t have a great deal of money to save.

Early in their careers, young people earn lower salaries, while at the same time they may have high expenses. They often have student loans to pay off and they may be saving for a home. They are probably paying rent, as well as other living expenses, for the first time in their lives.

They are also at a point in life where they probably want to enjoy themselves after spending so many years in school, so expensive vacations, nice cars and good restaurants may be a priority.

But a little frugality early in life can pay huge dividends late in life. Here’s why:

The impact of compounding. As you invest, assuming you continuously reinvest your earnings, compounding can have a dramatic impact on your savings and the earlier you start investing, the more dramatic the impact with be.

Consider a hypothetical example from Fidelity Investments. Assume that you begin contributing $5,500 to an IRA at age 25 and continue to age 70. For the sake of simplicity, we will not take taxes, fees or inflation into account, and we will assume a consistent return of 6% per year.

With annual compounding, the IRA would be worth $1,240,295 by age 70. If all factors remain the same, but you make no contributions to your IRA until age 35, at age 70 it will be worth $649,665.

No matter how little you save, it can help. Fidelity Investments calculated that saving just $50 a month can add an estimated $270 a month to a person’s retirement income. The hypothetical example assumes that the individual saves an additional $50 a month beginning at age 35, continues saving until retirement at age 67 and earns a 7.0% rate of return. The impact would, of course, be even more significant for someone who began saving at age 21.

The rule of 72 provides a way to calculate the impact of compounding on your investments.

To use it, divide your expected annual rate of return into 72. The number you come up with is the number of years it will take for your investment to double in value. For example, a hypothetical investment earning a 10% return every year will double in value every 7.2 years. Do the math with your own investments and you’ll quickly understand the impact of compounding.

Tax advantages. Assuming that you’re contributing to a qualified retirement plan or an IRA, your savings can provide you with significant tax savings today, in the future or both. If you have a 401(k) plan or a similar plan at work, your employer may also provide matching funds.

Investments in traditional qualified retirement plans, such as 401(k) plans, typically are tax deferred. Some IRAs are also tax deductible for many investors. The longer taxes are deferred, the greater the advantage. A 21-year-old can defer taxes for 44 years before retiring at 65. A 61-year-old can defer taxes for only four years before retiring at 65.

If you’re young and you can invest in a Roth IRA or a Roth 401(k) plan, the tax advantages can be even greater. In both cases, taxes are paid up front on the money invested, then the investment grows tax free and can even be passed on to the next generation without being subject to taxation.

Risk is spread out. Young investors typically can afford to be less averse to risk than those who are approaching retirement. Investments in stocks, for example, tend to provide attractive gains over time. If the market turns down, the young investor can wait it out.

In fact, if history is a valid guide, a young person is likely to live through multiple bull and bear markets.

Conversely, for someone who is retired or is approaching retirement and who will need to tap into his or her retirement funds soon, investing heavily in stocks or other risky investments may not be advisable.

Good habits start early.  Another advantage of beginning to save early for retirement is that it establishes good financial habits.  Most people don’t save for retirement when they are young; then they marry and have children and a mortgage and other expenses.  By the time they begin saving for retirement, they may be ready to retire themselves.

Many young people think they cannot afford to save for retirement. In reality, waiting has a much higher cost.

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