Saving money can be such a chore and one that can seem unattainable with your budget. We get it! Between all of life’s expenses and wanting to have a little fun, saving money can quickly fall to the bottom of the priority list, especially when you are young. It’s easy to fall into the habit of saying, “I’ll do it tomorrow!”
We assume that once we get the job of our dreams, we can start saving and make up for lost time. But here’s the thing—while that dream job might come, there’s no way of predicting the future and any other factors that might get in the way of you saving and catching up. Let’s explore the ins and outs of how investing works to better understand the why, where, how, and what it all means.
Let’s dive deeper!
The truth is WHEN you start saving and investing actually outweighs how much you save, thanks to something called compound interest.
Understanding Compound Interest
What exactly is compound interest?
You may have heard the saying, “Compound interest is the eighth wonder of the world.” Here’s what that means: Regardless of your financial situation, compounding interest is your friend, especially when you have time on your side. Compound interest is the return earned on your money at the end of every compounding period. Each time interest is calculated and added to your account, the larger balance results in even more interest earned than before.
In other words, think of compound interest like a snowball—it just keeps growing and picking up momentum as time goes on. To show you the power of investing early, take a look at the following scenarios. All three scenarios assumed a 9% annual investment return. The only difference is when and how often they saved:
- Amy invests $100/month beginning at age 18. At age 28, she stops contributing but her money remains invested. She has saved for 10 years and contributed $12,000 in those 10 years. At age 58, when she retires, her account balance is $290,811
- John (same age as Amy) doesn’t start investing until age 28. John invests $100/month until age 58 when he retires. He has saved for 30 years and contributed $36,000 in those 30 years. His account balance at retirement is $185,920
- Danny (same age as Amy & John) also starts investing $100/month at age 18 but unlike Amy, he does not stop making contributions until he retires. He has saved for 40 years and contributed a total of $48,000 in those 40 years. His account balance at age 58 is $475,254
As you can see, John had to invest almost three times as much as Amy, and Amy still ended up with a higher balance at retirement all because she started saving sooner than John. Amy saved for just 10 years while John had to save for 30 years. This is the power of compound interest: the investment return that Amy earned from her 10 early years of saving had more time to snowball.
Of course, Danny, who started saving early and continued saving the longest, was the one who ended up with the highest balance at retirement. While you may be amazed by Danny’s balance, what is actually truly remarkable is the simple strategy he used to attain his wealth. He invested early and he remained consistent.
So now that you know why you need to start investing ASAP, let’s talk about where to get started. The answer is simpler than you might think.
Where to Invest
Where should I invest my money?
The best place to start investing is in “tax-advantaged” accounts. This includes common retirement accounts such as 401ks, Roth IRAs, or Traditional IRAs. By investing in these types of accounts, not only are you taking advantage of compound interest but since taxes are “deferred”, there is more money in the account to compound. Typically, with how investing works in a regular taxable account, such as a brokerage account, you are required to report and pay taxes on any returns annually.
With “tax-advantaged” accounts, such as retirement accounts, the IRS lets you postpone having to pay taxes on earnings until you take the money out. However, there are limits to how much you can contribute to these types of accounts. Here are the 2020 contribution limits for 401ks, Roth IRAs, and Traditional IRAs:
- Roth IRA: $6,000
- Traditional IRA: $6,000
- 401k: $19,500
How to Determine What Retirement Account to Use
When deciding which type of retirement account to use, your first step should be to check with your employer to see if they offer a 401k. Here are four considerations on how investing works with or without a 401k option at work.
- Some employers will sometimes match your contributions to the 401k plan up to a certain amount. Neglecting to contribute enough to get your full match amount is like leaving free money on the table.
- If your employer does provide a 401k but doesn’t provide a match, look to see whether the plan offers low-cost investment options. If they don’t, you can open your own retirement account, either a Roth IRA or a Traditional IRA, at most financial institutions.
- If your employer doesn’t provide a 401k, open either a Roth IRA or a Traditional IRA.
- If your income is below $139,000/year, consider using a Roth IRA before a Traditional IRA.
What’s the Difference Between a Roth or Traditional IRA?
Understanding how investing works in either a Traditional or Roth IRA comes down to when and how you get the tax break.
With a Roth IRA, you cannot deduct contributions but your withdrawals at retirement are not taxed. On the other hand, contributions to a Traditional IRA are tax-deductible in the year that you make the contribution. You are then taxed when you take the money out of the account. So, how do you choose between the two?
The answer depends on whether you think you will be in a higher or lower tax bracket in the future. If you are currently in a low tax bracket (as most young people are), then it makes sense to use a Roth IRA and pay the taxes now. This way, when you’re in a higher tax bracket, you can take the money out tax-free.
If you anticipate being in a lower tax bracket at retirement, then use a Traditional IRA. This will allow you to take advantage of the deduction now and pay the taxes when you take the money out (and are in a lower tax bracket).
Once you have maxed out “tax-advantaged” accounts, you can move on to opening a brokerage account. While brokerage accounts are taxable each year, it is an option for any remaining money you wish to invest.
How much should I invest?
As a general rule of thumb, you should aim to save and invest 10-15% of your yearly income toward your retirement. Sure, that might be able to buy you a nice vacation or a whole lot of Starbucks, but your future and financial security will thank you. And, as we saw from the scenarios above, investing early and being consistent is key to building wealth.
What types of investments should I select?
There’s no doubt that the world of investing can be overwhelming. There are a lot of options to choose from. While a financial advisor can definitely help you choose the investments that make the most sense for your situation, the truth is that no one can predict how future investments will perform. Instead, consider the factors that are in your control such as when you start investing and selecting investments with low fees.
The most popular investments for those just starting out include stocks, bonds, mutual funds, and exchange-traded funds (ETFs). Stocks are one of the most commonly talked about types of investment options for millennials in recent years. It is easier than ever to invest in individual stocks as a result of apps such as Robinhood that target younger investors. However, stock-picking can be complicated and time-consuming. If you want to avoid these complications but still invest in stocks, consider low fee stock index funds or ETFs.
Time horizon is the amount of time that you have to invest. Ask yourself, when will I need this money? If your investment time horizon is more than 15 years away (like retirement, for example), nearly all of your investments can be placed in stock index funds or ETFs. If your retirement is a little closer (5-15 years), you will need to consider a combination of stock and bond funds.
Need the money in less than five years? The best option for you is to hold onto the money in cash or cash-like vehicles, such as a high-interest savings account or money market account.
Understanding the Importance of Investing Now
It is true that the younger you are, the more time you have until you have to worry about retirement. But on the other hand, you also have more time to earn compounded interest. We hope the above info about how investing works inspires you to act now. Why wait? Start reaping the benefits of compounding interest! A little can go a long way.