Each decade of adult life brings unique challenges and incentives when
it comes to saving and planning for retirement. In a series of exclusive
articles, the 401Kafé is examining strategies for successful retirement
investing from the 20s to the 70s and beyond.
Each month we'll look at a different age group. Up this month: the 20s.
Whether you've already started retirement investing or aren't sure where to start, believe it or not, the best possible age to begin this critical investment is in your 20s. Starting to save when you're young puts you way ahead of the game.
The very best friend a twenty-something investor has is time. Being a financial whiz, lucky in the markets, or a trust fund baby might help too, but investing for retirement in your 20s offers two essential tools for accumulating the most assets possible: compound interest and long-term gains.
A wedding or a snowboard?
Jennifer Smith lives a half-hour from snowboarding heaven, in the mountains surrounding Lake Tahoe. At 22, she is practiced on the slopes and practical when it comes to money. She has a natural aptitude for accounting and business; but what really helps is that she knows what her goals are.
She is so goal-oriented, in fact, that she put off her wedding for two years to avoid going into debt. One goal she had was to purchase a new snowboard. But when it came down to buying a wedding dress or the snowboard, she compared their costs and put off the nuptials. Also, her fiancé Eric wanted to buy fishing gear.
"Part of the reason we put (the wedding) off was because neither one of us was looking forward to going into debt," she said. "We decided to wait until both of us were at a place where we wanted to spend the money." (For the record, she and Eric are now happily married.)
"Part of the reason we put (the wedding) off was because neither one of us was looking forward to going into debt."
|- Jennifer Smith, 22.
Jennifer has had a clear vision of her financial goals, especially retirement planning, since taking an economics class in high school. She bought shares of her first mutual fund at 18, and credits her economics teacher as a positive influence on her financial awareness.
"He showed us that if we invest early, we could be millionaires by age 60," Jennifer said.
Although her instructor relayed the power of compound interest, Jennifer learned about long-terms gains through personal experience.
"I did pretty well with my fund, and made a gain of about 25% in a year, but in the end I was disappointed because the fund didn't do well relative to its peer group," she said. "I pulled the money out to pay for a semester of school, but I'll never do that again, because now I realize the fund's value only grows if it's there for the long-term."
She acknowledges the tuition money was necessary, but says she later regretted cashing out her fund to pay short-term expenses.
"I read an article that talked about the 'time value of money' after I liquidated the account. I never forgot that, how the time value of money is the most important thing. The money in my fund, when I cashed out, was basically a wash."
Jennifer received money equal to what she originally invested, but feels even money is a loss because of the lost opportunity for compound interest. Despite an investor's knowledge of how important compound interest is in contributing to retirement assets, situations can arise that demand liquidating these accounts. Continuing education, time spent between jobs while figuring out what career path to choose, or mounting credit card debt can tempt twenty-something investors to cash in their retirement funds.
There are steps you can take to help you "ignore" your retirement assets. If you forget they are there, you won't be tempted to spend them.
|"Ignore" Retirement Assets By:
- Contributing the maximum allowed into a 401(k) plan or IRA, where it is hard to get at.
- Planning and sticking to a budget that includes an emergency-only cash account, vacation savings account, etc.
- Making sure you're covered by disability, car, homeowner or renter, and health insurance.
- Saving automatically, using payroll deduction plans and the company match.
- Planning to meet college expenses in advance (avoid using retirement money!)
Jennifer allotted her account as a short-term investment, and used the liquidated shares' value for tuition, but remembers the up-and-down market of 1997 as what really led to her mutual fund cold feet. The experience of cashing out when she had even money instead of taking a gain only solidified the long-term strategy she now holds. Cashing out is something she is determined not to repeat with her next growth fund.
Jennifer intends on re-establishing assets allotted for retirement and long-term gains upon her graduation from college this spring. Currently without a 401(k) plan, the first thing she wants to do after starting a new full-time job is contribute the maximum to her company's 401(k) plan, and open an IRA account.
401(k)s and Roth IRAs
The combination of a 401(k) plan and a Roth IRA offers both taxable and nontaxable income at retirement. The Roth isn't tax deductible at the time you contribute to it, but can be a good bet for twenty-something investors because the money grows for years and offers tax-free income upon retirement, if they follow the rules. And 401(k) plans are essential retirement vehicles, since you contribute pre-tax dollars into the account, which enables two things:
- A lowered annual tax bill, due to reporting less gross income.
- Accumulation of your own assets, plus free money offered through the company match.
Ted Benna, the creator of the 401(k) plan, advises investors in their 20s to contribute at least 5% to 6% of annual income into a 401(k), in order to receive the company match, but says 10% of income is the goal to strive for.
"We should be realistic that investors in their 20s have things other than retirement they want to spend their money on, but they should try for 10% of their pay."
This could be the minimum that investors ever contribute. Benna says the figure doesn't go down from there, and said that in their 30s, investors should save a minimum of 15% of income for retirement.
How can twenty-something investors be aware of these and other recommendations, that may not be in the broad media, which best suit their investing story?
A considerable amount of investment news and research is out there, and not seeking professional investment advice is something Sharon A.C. Kayfetz, CFP, a financial planner based in San Ramon, California, says is common for people in their 20s.
"You wouldn't log on to the Internet for a half-hour and then perform open heart surgery on yourself; there are experts out there to help you." The same is true for financial planning, she said.
"You wouldn't log on to the Internet for a half-hour and then perform open heart surgery on yourself; there are experts out there to help you."
|- Sharon A. C. Kayfetz, CFP.
In addition to thinking they can do all their retirement planning on their own, another obstacle that twenty-something investors face is a tendency to overspend.
"They want to spend, spend, spend," says Kayfetz.
Kayfetz also points out that investing for retirement encompasses individual issues that research done on one's own can't address: income and tax implications, and qualitative measures such as goals and risk comfort level.
An example of asset allocation for a 20-year old found in the media might miss the boat by not taking certain factors, like risk tolerance, into consideration. Younger doesn't necessarily mean the investor is comfortable with aggressive investments.
"Comprehensive planning includes not only a budget but looking at tax issues, and whether an investor is conservative, moderate, or aggressive," said Kayfetz. Cookie cutter planning is not in the investor's best interest."
Calculate the potential of your investments
To calculate your own, current 401(k) investments' possible results upon retirement, click here.
The calculator is adjusted for an annual 3.5% pay increase as well as inflation.
Travel or retirement savings?
Carl Harrison, 29, hasn't worried too much about retirement planning - he's preferred to spend his extra money on travel. Carl worked at the Stanford University bookstore for 6 years, and reads and travels extensively, visiting friends scattered up and down the western American coast.
About to embark on an extended stay in southern Oregon, he jokes about how his lifestyle doesn't lend itself well to retirement planning. "I am basically the case study of what not to do when planning for retirement," he said.
"I am basically the case study of what not to do when planning for retirement."
|- Carl Harrison, 29, who loves to travel.
Carl did contribute to a 401(k) plan through his job at the bookstore, but he cashed it out three years ago, a move he now regrets.
"One thing I do know, is don't liquidate your 401(k) plan," he said, noting that he now has no retirement savings at all.
When he cashed it out, his 401(k) was valued at about $2,000. For the two years he participated, he deducted 4% of his pay, and used the 100% company match.
"I didn't plan on liquidating it, but the money really came in handy. I paid some bills, but now I wish I still had it, for what it would be worth."
How much would Carl have today, if he hadn't cashed out?
The power of compounding
Based the ending $2,000 value of Carl's 401(k), over the past 3 years with no contributions and assuming a 10% return, his investment would now total $2,662.00. And the power of long-term gains? Assuming the same factors, no annual contribution and a 10% return, over 10 years Carl's account would have totaled $5,187. By the time he turned 65, Carl would have $74,808.69 - with no further investment!
Carl did consult a financial planner when he was participating in the 401(k), to review how good it was.
"The agent was really strong on the 401(k), and said it was good because the plan was designed to be balanced, to give the most, and safest, returns. What I've realized, though, mostly through my own reading, is that compounding over time is the most important thing," said Carl.
Carl is right. Asset allocation is very important, but compounding does the bulk of the work in funding your retirement, regardless of what's contributed by market performance or your investment mix.
"Start early, and don't watch. Eighteen months is not long-term."
|- Sharon A. C. Kayfetz, CFP.
"100% (in) equities" is a good choice for people in their 20s, says Tony Custodio a senior analyst for mPower, an Internet-based retirement and financial advisory firm and the publisher of this web site. His rationale: "This age group has the longest time horizon, which helps investors ride out volatility, and average returns for equities are between 10% to 12% - based on 30 to 40 years."
"Start early, and don't watch," Kayfetz confers "Eighteen months is not long-term."
Ignore retirement assets, not retirement
Depending on what your retirement goals are, and depending on the planning you do so that you "ignore" assets allocated for retirement, you can fund the longest time you won't work -- retirement. College may have been expensive but the time involved is short compared to retirement. Discipline, planning, market trends and lifestyle may all account for how your retirement fund does, but none of these can compare with how much compound interest contributes, or with leaving assets alone so they can gain in value, over 10, 20, and 30 years.
Short on discipline, long on time?
Invest for retirement by resolving to not touch these assets for the long-term, and use a plan that automatically deducts contributions. A 401(k) or similar employer-sponsored plan will do this for you. You can also arrange an automatic deduction for your IRA. Allocating money automatically to investments helps save it for retirement before you get a chance to spend it.
If you start out by making saving a habit in your 20s, it will be easier to keep throughout life.
Want to accumulate even more? Take advantage of free money by contributing enough to your 401(k) to get your company's match.
There are also immediate tax advantages when contributing to a 401(k) in your 20s. You will be able to claim less income at a time when your deductions (children, mortgage, spouse, etc.) may be minimal
Spend your golden years in hotels, not hostels
The earlier retirement investments are made, the greater the potential payoff. The most valuable commodity twenty-something investors have is time. Regular investments started early should boost the amount you're actually socking away. If you're investing for retirement in your 20s, your two best friends should outperform all other investing factors, including market performance.
Look at it this way. If traveling is one thing you'd like to do when you retire, saving early could mean the difference between staying in comfortable hotels or bare-bones hostels when you're 70.