You need to start saving for retirement when you are in your 20’s. I know retirement can seem far away and sort of an abstract concept when you’re 25, but by taking action and saving for retirement now, you’ll be setting yourself up for financial success later. You don’t want to be living like broke 20 something forever do you?
So why is it so important to start saving now? The short answer, compound interest. At this point, the only experience you’ve probably had with compound interest is about your debt and why it just seems to take forever to pay off. Imagine compound interest, working for you instead of against you.
How Compound Interest Works
Compound interest allows you to earn interest on not only your original investment but also what you’ve earn in interest. For example, if you invest $1,000 and earn 10% in interest you will have $1,100 by the end of year one.
By not contributing anything more and just keeping the $1,100 invested, by the end of year two you will have $1,210. You earn more because you are also earning interest on the $100 in interest you earned the year before.
Compound interest builds on itself making it easier to grow your wealth. The sooner you start saving, the more money you can earn through compound interest because the more time it will have to build up.
The Difference Between Saving in Your 20’s and Trying to Catch Up in Your 40s
You may be thinking that sure compound interest is great, but you can’t afford to save right now, so you’ll just work hard later to catch up. Think again! Saving now still nets you more money than playing catch up later.
For example, let’s say when you are 22 earning $35,000 a year you start contributing $100 towards your 401(k). Let’s also say that your company offers an employer match of 100% up to 5% of your contributions. So automatically you double your money, having $200 put towards your retirement. If you want to retire at 65, you’ll have 43 years of saving. Estimating a return of 7%, by contributing just $100 with employer match you’ll have saved $594,663.
If on the other hand, you wait to start saving for retirement when you are 40 you will only have 25 years to save before hitting 65. To help catch up, you decide to contribute $250, to keep it simple we’ll assume a 100% employer match so that a total of $500 gets contributed towards your retirement each month. Using the same return of 7%, even contributing more than double, you would end up with $379,494.23, a difference of $215,168.
Compound interest is your best friend when it comes to saving for retirement, so buddy up to it in your 20’s and make that friendship last a long time. If you want to play around with the numbers yourself, Investor.gov has a great calculator.
If it Sounds Like a Lot, Either Way, Don’t Forget About Inflation
While there is a big difference in what you’ll have saved if you start in your 20’s versus trying to play catch up in your 40’s you may still think that either way you’ve saved a lot of money. However, you have to also factor in inflation. Just as $5 doesn’t go as far now as it did the 1970’s, $5 in the 2050’s will likely not get you nearly as much as it does now.
If you don’t have enough saved, due to the cost of inflation, you could end up running out of money. You also shouldn’t count on Social Security to cover the gap because if inflation is high, social security may not be enough. You also don’t know if these programs will continue to exist when you get to the age of retirement.
Why You Still Need to Save Even When You Feel Like You Can’t
You may think that it is impossible to save for retirement when you are broke and while it can be a challenge, it’s not impossible. If you contribute just enough to max out your employer match, you are automatically doubling your money which can make a big difference in your overall return. Because when it comes to compound interest, every little bit counts and given enough time, it can add up to a big amount.
Additionally, if your retirement account is a tax-deferred retirement account, contributing $100 won’t decrease your paycheck by $100. Since the contribution is pre-tax, it lowers how much you are taxed over all.
For example, let’s say you get a bi-weekly paycheck of $1,500 before taxes. Let’s also say taxes account for 35%, so your take home pay is $975. You decide to contribute $100 of each paycheck to your retirement account. This means you are taxed as if you made $1,400, with taxes at 35% your take home pay would be $910. While you contributed $100 towards your retirement, you only saw a $65 difference in your take home pay.
It is a lot easier to learn to live without $65 in each paycheck then to figure out how to make ends meet when you run out of money at 75.
It may mean you go out to eat less or skip takeout coffee or that you pack a lunch. You can find $65 to give up in your 20’s to financially prepare yourself for retirement.
Hopefully, from the examples, you can see how much it is worth to start saving for retirement in your 20’s. If the cold hard cash isn’t enough to convince you then hopefully the future cost of inflation and the realization that $100 contribution may not mean a $100 deduction in your paycheck will help you realize you NEED to start saving for retirement in your 20s. Don’t cheat yourself, make the most of compound interest now when you’re younger to make sure you’re rolling in the dough when you’re older.