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As many of my listeners know, I am a huge proponent of saving diligently and investing as early as your first paycheck in order to potentially experience the magic of compounding.
If you skipped saving and investing in your 20s, don’t worry. You’re definitely not too old to begin investing. Getting started now gives you plenty of reasonable paths to help build a multi-million dollar nest egg by retirement.
If you’re working and saving and have been afraid of the stock market, wake up! Put the past behind you, especially considering you have a long time to work within your favor.
1. Start With Your 401(k)
A 401(k) is the first place most people should save for retirement. It has a high annual contribution limit. Contributions get swept into the account directly from your paycheck—before taxes—like magic. And, perhaps best of all, many employers will match your contributions—at least, up to a cap. That’s free money you won’t find through other offerings.
Here’s the payoff: Let’s pretend you make $50,000 and begin saving at age 30. Let’s also make a few reasonable assumptions. Let’s say you get 2% annual salary increases, save 10% each year towards your 401(k), collect a 3% match from your employer, and get a 6% average annual return on your investment. This alone will net you a little over $1 million by age 67. If you make more, save more, and invest more—all the better.
2. Supplement With A Roth IRA
Once you’re capturing that full 401(k) match, you should take a second look at your 401(k)’s investment options, taking particular note of the plan’s administrative fees. If your plan is too costly, you’re better off directing any additional contributions to the second-best place for your retirement savings, an individual retirement account, such as a Roth IRA.
As I noted above, with a 401(k), your contributions go in pretax, which means they’re taxed when you withdraw them in retirement. With a Roth IRA, your contributions go in after-tax, which means you invest, pay no tax when you make withdrawals in retirement, so your money grows tax-free in a Roth IRA—which is really nice.
This tax diversification is why it’s a good idea to combine a 401(k) with a Roth IRA if you meet the income eligibility rules for a Roth.
The downside is that IRA contributions have lower caps than 401(k)s. That limit is just about 1/3 of the allowable 401(k) contribution. So, if you max out your IRA contribution, go back to your 401(k) until you hit the higher ceiling.
Consistently saving $5,500 in your Roth IRA each year beginning at age 30 with a 6% return will give you about $740,000 at age 67. But remember, we called this a supplement, and that’s $740,000 you can draw on tax-free in retirement, over and above your 401(k).
3. Time Is On Your Side
Young people have a long-time horizon before retirement, which means they can worry less about short-term stock market volatility and stay invested for the long run and potentially experience the higher long-term returns associated with stocks without worrying about bonds. So, while in your 20s and 30s, focus your investments on stocks and stock mutual funds. But do not get greedy or cocky! Be prudent, don’t bet the bank on speculative stuff. Diversify, ignore market volatility, do not rush in to buy or sell, but hold your investments over time. And for the stocks that pay dividends, I’d strongly suggest you enroll in automatic dividend reinvestment, where as soon as your dividends are paid out, they are used to buy additional fractional shares of the stocks you own. This also works for ETF’s and Mutual Funds and is a great way to help build your wealth.
Let’s say you played it safe in your 401(k) and earned an average annual return of 4% through some combination of bonds and other investments, whereas it was possibly 6% with stocks. That risk aversion would trim your $1 million down to about $740,000. Therefore, while you’re young, consider increasing your stock exposure in your portfolio.
4. Seek Inexpensive Diversification
Investing becomes less risky if your investments are diversified, which means “no, you should not dump all your available cash in your favorite IPO”. Here’s one trick to diversification: consider using index and exchange-traded funds, so-called ETFs.
A Standard & Poor’s 500 fund, for example, tracks the S&P 500. The performance of the fund virtually mirrors the performance of the index, less the fees you pay for the convenience of the fund.
The wide assortment of stocks in index funds makes you somewhat diversified. To diversify even further, you can put together several funds, for example, one that gives you exposure to international stocks and one or two that invest in small and medium-sized U.S. companies.
With diversification, your overall portfolio return may or may not improve, but it should be less volatile, which means you’ll get more sleep than if you’d bet your retirement on one individual stock.
5. Take Off The Retirement Blinders
Retirement is the universal long-term goal, but it’s often treated as the only goal. You also need to save and invest for other things in your 30s such as a down-payment for a house or vacations or college for your kids.
The trick is to prioritize these goals. Retirement should come first, but you can divert money into these other goals by saving more when you get a raise, stashing away windfalls, and taking advantage of changing expenses. Let’s say you pay off your car or student loans, instead of kicking your restaurant spending up a couple of notches, put those payments into a savings account or a 529 college savings plan.
If you invest as little as $200 a month and fortunately experienced a 6% return annually from the time your child is born until he or she turns 18, you’ll end up with about $75,000, which should help with college expenses. So between spending rationally, saving for retirement, saving for your house, and being prudent in your thinking, you should have enough to take you comfortably through the rest of your life.
Investing involves risk and investors should carefully consider their own investment objectives and never rely on any single chart, graph, or marketing piece to make decisions. The information contained herein is intended for information only, is not a recommendation to buy or sell any securities, and should not be considered investment advice. Please contact your financial advisor with questions about your specific needs and circumstances. There are no investment strategies, including diversification, that guarantee a profit or protect against loss. Past performance doesn’t guarantee future results. It is not possible to invest directly into an index. Equity investing involves market risk, including possible loss of principal. All data quoted in this piece is for informational purposes only, and author does not warrant the accuracy, completeness, timeliness, or any other characteristic of the data. All data are driven from publicly available information and has not been independently verified by the author.
ETFs will fluctuate with changes in market conditions and are not suitable for all investors. In many cases, ETFs have lower expense ratios than comparable index funds. However, since ETFs trade like stocks, they are subject to brokerage fees and trading spreads. Therefore, ETFs are not effective for dollar cost averaging small amounts over time, and likewise any strategy using ETFs must account for these additional costs. ETFs do not necessarily trade at the net asset values of their underlying holdings, meaning an ETF could potentially trade above or below the value of the underlying portfolio.
To qualify for the tax free penalty free withdrawal of earnings, a Roth IRA must be in place for at least five tax years, and the distribution must take place after age 59 ½.
The concept of compounding interest assumes that the earnings are compounded and reinvested. This does not take into consideration any tax implications and their effect on the investment. The scenarios mentioned herein are not representative of past or future performance but are provided for illustrative purposes only. Actual results will vary. This type of plan does not ensure a profit or protect against loss in declining markets.