Knowing the about the various types of IRA and 401K savings plans is one thing, but knowing when, how much, and what plan to use first is challenging. Most investors know the plans they can put money in, but deciding when and how much is enough to make many people not invest anything at all. Often people decide when to start saving to retire well into their 30s and 40s, and end up not being able to capitalize on the compound interest earned by starting young.
When to start saving to retire has an incredibly simple answer – now or yesterday. The younger a person can start, the better off they will be when it comes time to retire. The beauty of compound interest is that starting just a few years earlier can help a person set aside considerably less, but still come out ahead at retirement.
For example, if a person’s goal was to save $1 million by the time they reached age 60 they would obviously understand that if they waited longer, they would have to save more each year to get to their goal. But just how much more? Assuming an 8% rate of return (pretty standard average over the long term for the stock market), a person starting at age 15 would need to save around $2,250 per year; a total of $101,250 out of pocket over the years. If that same individual were to wait until age 25 to start saving, he or she would have to set aside $5,200 per year ($182,000 total) to hit the same goal. Waiting 10 years costs nearly $82,000. Waiting until age 40 would set them back $20,250 per year ($405,000 total). In essence a person who wants to wait until their career is flourishing before they start to save for retirement will end up investing 4 times as much, to meet the same goal, as the person who started earlier in life (you can find an easy to use compound interest calculator here).
Trying to time the market (buy low, sell high) almost always ends in disappointment. In order to minimize the risks of buying at exactly the wrong time, experts advise dollar cost averaging. This means putting in the same amount of money, at regular intervals. Suppose an investor is buying a stock or fund that ranges from $5 to $10 in price (ignoring sales charges and expenses). If the investor contributes $100 per month on the first of every month, they will be buying 20 shares when the price is at a low, and 10 shares when it is as a high. If the price is at $5 per share 6 months out of the year, and $10 per share 6 months of the year, the investor will essentially be buying their shares for an average of $7.50 each. They will be averaging out how much they spend per share by capturing both the highs and the lows of the market. See another example here.
Many people wonder how much they should invest. There really is no set rule, but working backward from retirement date, assuming a rate of return and a goal, the investor can determine how much is needed to go into their account each month. The bottom line is, pay yourself first. Set aside as much as possible into an emergency fund and retirement account, and then pay all the bills.
The most important place to put money is into a qualified account. Getting the tax breaks are fantastic for helping compound returns. Make sure to put in enough to each plan to get the employer match. There is no sense in letting essentially free money go to waste. Once the match has been met, an investor should contribute as much as they can to a Roth IRA. The tax implications of the Roth, especially those in a low tax bracket now, cannot be beat. Finally, once the qualified plans have been maxed out, a non-qualified account should be used.
By realizing at the beginning of your career that now is when to start saving to retire, starting early and making regular contributions you can see your retirement savings accounts take off. Each year it may not look too different, but over time the account will continue to grow and flourish, in the end resulting in a healthy retirement account that was not too painful to build.