Why your 20s are the time to save
Your retirement finances will look a lot better if you start saving sooner rather than later.
This post comes from Bob Sullivan at partner site Credit.com.
Graduation season always brings an equal mix of hope and anxiety about the future: hope for what young, bright minds unleashed into the world might do, and anxiety that they will find a decent job. One part of the future that is rarely part of any graduation party chatter, however, is retirement. And that's a shame. Because young adults in their early 20s are in a unique and quite temporary situation to set up a comfortable, long-term future. In fact, thanks to the "miracle" of compounding interest, here's an oddity you probably won't believe until I prove it:
Someone who saves for retirement from age 20 to 30 and stops has more money at retirement --- MUCH more -- than someone who saves from age 30 to 65.
The relationship between money and time is a funny thing, and it's often hard to get our heads around. This one is so hard to believe on its face I'm going to restate it: A college grad who saves through her 20s, and stops at 30, is better off at retirement than someone who starts saving at 30 and puts aside funds for the next 30 years or so. That means when you are giving graduation gifts this season, consider doing the nerdy thing: instead of giving your niece or nephew a check they will blow on a vacation with friends, make a deposit into an individual retirement account for them instead.
OK, here's what's going on. Financial advisers sometimes call this phenomenon the Parable of the Twins. Liz Weston, in her book "Deal with Your Debt," offers this version of the story. One twin puts aside $3,000 every year in a Roth IRA starting at age 22, and stops at 32. She never adds another penny. Her brother starts saving $3,000 annually at 32, and continues until age 62.
Assuming an average 8 percent return annually, the twin sister wins easily. When both turn 62, she has $437,320, compared to her brother's $339,850, even though she contributed far less of her own money than her brother ($30,000 vs. $90,000).
Somewhere in the back of your mind, you've seen a chart that shows the incredible value of compounding interest over time -- or the pain of compounding fees or mortgage interest over time. This is why most people spend more than double the price of their home on their mortgage, for example. The longer the time horizon, the more severe the impact of compounding interest.
Perhaps you've heard about the rule of 72, which gives you quick math to learn how long it will take for an investment to double. Let me simplify that for you and rough out that, earning 10% annually, your money will double about every seven years. Let's look at how important the value of an extra round of doubling can be later in life:
- 23: $10,000
- 30: $20,000
- 37: $40,000
- 44: $80.000
- 51: $160,000
- 58: $320,000
- 65: $640,000
This simple chart shows you at a glance how punishing the Parable of the Twins can be to the foolish brother. Add seven extra years at the end of a retirement strategy, and you add one more round of doubling -- in this rough example, you add $320,000. Even someone who starts later and tries to pile on the cash to catch up has a tough time making up for that lost, last doubling of the money.
It's very hard to get a 23-year-old interested in saving for retirement, of course. Data bears this out. A study by Aon Hewitt in 2010 found that workers under age 30 average 5.3 percent contributions to their 401k plans, as compared to 6.8% by workers 31-45 and 8.4 percent by older workers.
Most people encounter the Parable of the Twins when they are older, and it fills them with regret. Here's the bad news about the story. Naturally, saving money for retirement at any time is a good idea. Hearing this math might inspire you to redouble your savings efforts. It doesn't matter. There is no fountain of youth, and there is no way to make up for time lost NOT saving for retirement in your 20s.
So, as you pick out a graduation card and think about what you plan to give to the young, hopeful, anxious graduate in your life this season -- do what you can to help her be the wise twin. You might not be the most popular uncle at the party, but you'll probably have a nice guest room to visit in your old age.
More from Credit.com
2) Pay off your debts as fast as you possibly can. If this means living in a crappy studio apartment and eating ramen everyday for a couple of years, do it. If you want to buy a car, get a reliable beater. Get insurance for $25/month from Insurance Panda. Forget about buying a house until your debts are paid off.
3) Once you are out of debt, stay out of debt. The only exception to this rule is a vehicle and a house. If you want to get a nicer car, buy used and be able to pay it off in a year or 2.
4) If you are going to stay in the same spot for at least 10 years, buy a house, preferably with at least a little bit of usable land. An acre is good, 5 acres is better. Take the amount you are pre-approved for and cut it in half - that's how much you should spend on a house. Come to the table with at least 20% down and make a couple of extra mortgage payments every year. If you're going to be transferred or relocate every 5 years, forget about buying a house and rent instead.
6) Develop multiple revenue streams. Do contract work. Start a business on the side. Invest in a business as a silent partner. Raise chickens, breed dogs or grow apples. Build websites. Buy and sell antiques. Acquire rental property. Sell something that generates residual income. Learn to play the currency markets or trade stocks. Do whatever you can to generate income from multiple sources.
7) Grow these multiple revenue streams to the point that they generate enough consistent and reliable cash flow to replace your current income.
8) Make as much as you can. Save as much as you can. Give away as much as you can.
9) Retire!- the sooner, the better. Be sure you understand that "retirement" doesn't necessarily mean you stop working, it just means having the freedom to do what you want to do, when you want to do it.
When my son was 16 and had his first job, I opened a Roth IRA for him. He just graduated from college and has over 30k in this account. Based on the example above if he does not add another dime at age 65 he would have roughly 2.25M.
Parents you need to think ahead for your teens and give them the gift of future financial security.
Exponential growth is not that hard of a concept to understand for anyone halfway competent at math. The big issue is the education system has been taken over by liberals who are too busy telling kids they can be whatever they want to be rather than bracing them for the cold cruel world that really exists...
The rule of thumb I always use to convince my younger cohorts to start saving is that having 30,000 invested aggressively by the time you are 30 should be worth about a million dollars at age 65 with no further contributions. If you get serious early, $30k by 30 is a very achievable goal...
I think if more people understood just how easy it is to get ahead over the long term by investing early, there woulb be many fewer people attending college today... $30k at 30 could lso be $15k by 23. If you skip college and eneter the workforce straight away while minimizing expenses, that's also an extremely achievable goal. Once you've hit those milestones, any further contributions are basically just ticking down your retirement date...
Copyright © 2014 Microsoft. All rights reserved.
Fundamental company data and historical chart data provided by Morningstar Inc. Real-time index quotes and delayed quotes supplied by Morningstar Inc. Quotes delayed by up to 15 minutes, except where indicated otherwise. Fund summary, fund performance and dividend data provided by Morningstar Inc. Analyst recommendations provided by Zacks Investment Research. StockScouter data provided by Verus Analytics. IPO data provided by Hoover's Inc. Index membership data provided by Morningstar Inc.
ABOUT SMART SPENDING
LATEST BLOG POSTS
When it comes to holiday shopping, a bargain is a bargain no matter what time of year it is.
VIDEO ON MSN MONEY
BLOGS WE LIKE
MUST-SEE ON MSN
- Video: Easy DIY smoked meats at home
A charcuterie master shares his process for cold-smoking meat at home.
- Jetpacks about to go mainstream
- Weird things covered by home insurance
- Bing: 70 percent of adults report 'digital eye strain'