When you’re a young adult (age 22-30) just starting your career, you’re facing a number of decisions for perhaps the first time in your life—where to live, whether to rent or buy a house, finding a job that suits your skills, how to get the grocery shopping done, and paying for all of the bills that come with your newfound independence.
One thing that you might not be thinking about at such an early age is investing. Yes, you know that one day you’ll want to retire, but that day is far into the future. At the moment, there may seem to be bigger things to worry about, and more important things to do with your money. However, there are small steps you can take now that will provide big payoffs down the road.
Understanding how investing early pays off can help spur you to action now even when you think there’s plenty of time to act later. And being knowledgeable about your different options (What are the different retirement plans available? Should I invest or pay extra on my student loan?) can help set you up for success from the moment you first step out into the “real world.”
The Power of Compounding Interest
Compounding interest is the key to building wealth over time. It’s easy to say, “You should start investing early.” When you’re young, it can be tempting to just focus on the short-term, but an example should help make clear just how important starting early is. Even little steps when you’re young can pay off in a big way. So, let’s take a look at a little step you can take.
Let’s assume that you’re 22, and you invest $2,000 at the end of the year, doing that for a total of five years. That’s just $10,000 over a five-year period, which may seem like a lot until you realize what that can do for you down the road. Assuming an average annual return of 9% (over the last 50 years, the S&P 500 Index (“S&P 500”) has averaged just over an 11% annual return), by the end of the year you turn 65, that initial $10,000 investment will have grown to $344,910.59.
You might think that’s too young to start planning for something so far into the future, but what if you wait to start saving for retirement? Waiting until you’re 30 to start investing (and just doing the same $2,000 a year for the first 5 years) still sees your money grow, but to only about $173,098.99 by the time you’re 65. That’s still a good return but delaying for 8 years cuts the amount of money you would have at retirement in half.
What if you wanted to end up with that same $344,910.59 that you could get by starting investing at age 22? If you waited until you were 32 ½ years old, you would need to invest $2,000 at the end of every year until you’re 65 years old to end up with that same amount.
Investment Options
When you’re first starting out, there may be a number of investment options that you encounter. Below, we will examine some of the most common retirement options, along with the advantages and disadvantages of each.
401(k)
A 401(k) plan is an employer-sponsored retirement plan. You designate a percentage of your paycheck to be put into an investment account for retirement. Oftentimes, employers will match part or all of that contribution. For instance, if your employer offers to match the first 3% that you contribute to a 401(k), you should contribute at least that amount. If you contribute 3%, your investment doubles right from the start!
The contributions to a 401(k) are pre-tax, meaning you’re not taxed on the money you contribute. It’s only when you take the money out at retirement that you pay taxes on it. One disadvantage to a 401(k) is that if you make withdrawals before retirement age (except for limited reasons), you will pay an additional penalty on the withdrawal. And at some point during retirement (the minimum age changes periodically), you will be required to take a required minimum distribution (RMD), whether you need it or not.
IRA
An individual retirement account (IRA) is similar to a 401(k), except it can be set up by an individual as opposed to an employer. In order to contribute to one, you must have earned income (as opposed to income from dividends or interest), and the amount you can contribute is less than that of a 401(k). You can buy individual stocks in an IRA, while your investment options for a 401(k) may be limited to mutual funds or ETFs.
Contributions to an IRA can be deducted from your income taxes, with the money growing tax-deferred until you take it out at retirement. Like a 401(k), there is a penalty if you make a withdrawal before retirement age, and you will also be subject to taking RMDs when the time comes.
Roth IRA
There are a couple of important distinctions between a Roth IRA and a traditional IRA. While both require earned income, contributions to a Roth IRA are made with after-tax dollars. That is, there is no current-year tax benefit to contributing to a Roth IRA. Also, unlike a traditional IRA, you are not required to take an RMD during retirement.
Like a traditional IRA, contributions and earnings in a Roth IRA grow tax-free. However, withdrawals from a Roth IRA are also tax-free (assuming certain conditions are met). If you’re in a low tax bracket, contributing to a Roth IRA may provide you with the biggest benefit because a current tax deduction may not save you as much as you will save down the road when taking money out.
Student Loan Debt Repayment
When you’re just starting out, it can feel daunting to have people telling you that you should be investing if you’re paying off student loans. Because every situation is different, it’s important to sit down and take an objective view of your situation. If carrying student loan debt is something that weighs on you, paying it off as quickly as possible may make sense for your peace of mind, even if there may be better options of what to do with your money. But for those who are looking at what makes the most sense financially, there are a few things to consider.
Federal loans generally have lower interest rates than private loans, but regardless of what type of loan you have, it’s worth looking into whether you can refinance the loan at a lower rate, allowing you to pay off the loan faster or free up money for other financial goals. When you look at the rate you’re paying on your loan, you should ask the question, “Is the rate on the loan or the rate I could get investing higher?” Whichever one is higher is the one that your money should be going towards.
How would that play out in real life? Assume you have $20,000 left to pay on your student loans at an interest rate of 5% over the next 10 years. Your payments would be $212.13/month, and over 10 years, you would pay a total of $25,456.
If you made extra payments so that you paid your loan off after 5 years, you would pay $377.42/month and end up paying a total of $22,645, saving you $2,811 in interest.
But let’s look at what would happen if, instead of paying extra each month towards the loan, you took that money and invested it instead. Assuming you take the extra $165.29/month and earn an annual return of 9%, that amount would grow to $12,466.86 after 5 years. You could then pay off your remaining loan balance ($11,240.97) five years early, having made $1,225.89 (before taxes) in the process. That may not seem like much, but you’ve taken the right steps to be on solid financial footing.
How to Get Started
When you’re a young adult facing a lifetime of financial decisions ahead of you, it’s important to start strong. By working with a professional financial adviser, they can help keep track of your financial situation and give you clear, objective advice to ensure that your financial goals are met. Find someone that you’re comfortable with and let them help guide you on your financial journey and avoid some of the common pitfalls out there.
About Chase Investment Counsel
Chase Investment Counsel is a family and employee-owned boutique wealth management firm that offers personalized investment services. Our clients include career professionals, those nearing or in retirement, and families experiencing financial transitions such as generational wealth transfer, widowhood, divorce, or sale of a business. Chase’s active, disciplined investment management team is focused on selecting individual stocks and bonds targeted to each investor’s specific financial goals and risk tolerance. Established in 1957 in Charlottesville, VA, Chase Investment Counsel manages more than $300 million in assets.