Saving for retirement may not be on your mind when you are in your 20s or 30s, but it should be. The sooner you start saving, the more time you have to grow your money and achieve your financial goals. In fact, if you start saving just $100 a month when you turn 25, by the time you’re 65, you’ll have saved over $630,000 at the average stock market return of 10%. But starting 10 years later will reduce that to a little over $220,000.
Below, find out everything you need to know about the importance of starting early and maximizing your contributions to retirement accounts, like 401(k)s and IRAs. Also, learn the benefits of compound interest and tips for investing wisely to prepare for a laid-back retirement.
What is a retirement plan?
A retirement plan is a strategy that helps you save and invest money for your future income needs when you retire. There are different types of retirement plans, like employer-sponsored plans, individual retirement accounts (IRAs), and personal savings accounts. Each type of plan has its own rules, benefits, and limitations.
The importance of compound interest
One of the main reasons why saving for retirement early is so important is because of compound interest. Compound interest is the interest you earn on both your principal (the original amount) and the interest that accumulates over time. This means that your money grows faster and faster as time goes by.
For example, let’s say you invest $10,000 at an annual interest rate of 10%. After one year, you will have $11,000 ($10,000 + $1,000 interest). After two years, you will have $12,100 ($11,000 + $1,100 interest). After three years, you will have $13,310 ($12,100 + $1,210 interest). And so on.
The interest you earn each year increases as your balance grows, making your total balance grow exponentially.
How to save for retirement
Now that you know what a retirement plan is and how compound interest works, let’s talk about some strategies to save for retirement effectively.
1. Start early
The earlier you start saving for retirement, the better. As we just saw, compound interest can significantly affect how much money you accumulate over time. All else equal (the contribution to your account and growth rate), starting in your 20s instead of your 30s can potentially triple how much money you have available in retirement.
2. Build an emergency fund
Before you start saving for retirement, make sure you have an emergency fund that can cover at least three to six months of living expenses. An emergency fund is a savings account that you can use for unexpected expenses or emergencies, like medical bills, car repairs, or job loss. An emergency fund can help you avoid dipping into your retirement savings or taking on debt when things go wrong.
3. Consider which type of retirement account to set up
As we mentioned earlier, there are different types of retirement accounts, like traditional and Roth 401(k)s and IRAs. Each type of account has its own pros and cons, depending on your income level, tax bracket, and retirement goals.
Generally speaking, a pre-tax account like a traditional 401(k) or IRA is better if you expect to be in a lower tax bracket in retirement than you are now. This way, you can save money on taxes now and pay less taxes when you withdraw the money in retirement.
On the other hand, an after-tax account like a Roth 401(k) or Roth IRA is better if you expect to be in a higher tax bracket in retirement than you are now. This way, you can pay taxes now at a lower rate and enjoy tax-free withdrawals in retirement.
With that in mind, let’s look at the features and limits of the most popular retirement plans you can choose when you’re in your 20s or 30s.
401(k)s, 403(b)s, and 457(b)s
These are the most common employer-sponsored retirement plans. These plans allow you to contribute a percentage of your income to a designated account before paying taxes on it. If you’re in your 20s or 30s, the annual contribution limit for these three types of accounts is $22,500 for the 2023 calendar year.1
In a 401(k), 403(b), or 457(b), your money grows tax-deferred, which means you’ll only pay income tax on the saved amount once you start making withdrawals in retirement.
Some employers also offer contribution matching, which means they will add a certain amount of money to your account for every dollar you contribute, up to a limit. This is essentially free money to increase your savings.
This type of account is similar to the traditional 401(k), except that you fund the account with after-tax dollars. That means that your money grows tax-free instead of tax-deferred, so you won’t pay income tax on retirement.1
An IRA is an Individual Retirement Account. This is another type of retirement plan you can set up on your own, regardless of whether you have an employer-sponsored plan. Similar to the 401(k), there are two types of IRAs: traditional and Roth, with the only difference being that you fund a traditional IRA with pre-tax dollars while the Roth IRA is funded with after-tax dollars. You can save a maximum of $6,500 annually in an IRA in 2023.1
High-yield savings accounts
High-yield savings accounts are good alternatives to retirement accounts like the ones mentioned above. They generate returns on your savings without you moving a finger, although rates are usually lower, and these accounts don’t have tax benefits. However, they’re a smart choice if you’ve already maxed out your other retirement accounts.
4. Max out your 401(k) or IRA
If your employer offers a 401(k) plan, take advantage of it, especially if they match your contributions. If this is the case, you should contribute at least enough to get the full employer match to avoid leaving free money on the table.
It won’t be easy to max out the 401(k) annual contribution limit of $22,500 when you’re in your 20s since it means saving $1,875 every month. However, if you do, and your money grows at a very conservative rate of 8%, by the time you reach age 65, you’ll have a nest egg of $6.5 million.
Of course, with student loan payments averaging $503 per month,2 setting aside another $1,800 for retirement may not be realistic. But you try to max out the amount your employer will match if you can afford it.
The average employer in the U.S. matches contributions up to 3.5% of a worker’s salary.3 So, if your salary is $50,000, you should try to save at least $146 every month. That way, your employer puts up the maximum of $146, and you get $292 deposited monthly into your 401(k). By retirement, you’ll have over a million dollars saved if you start saving when you’re 25, or a little over $435,000 if you wait until you’re 35 to start saving.
If your employer doesn’t offer a retirement plan, you can always open an IRA. In this case, you’ll have to put the full $292 per month yourself to reach the same goal as in the previous example. But if you max it out at the full $6,500 per year, you’ll have almost $2 million by the time you retire.
What to consider when investing
Saving for retirement is not enough; you also need to invest your money wisely if you hope to earn that 8–10% growth rate. Investing means putting your money into assets that can generate income or appreciate in value over time. Investing can help you grow your money faster than saving alone and beat inflation.
However, investing also involves the risk of losing some or all of your money due to market fluctuations or other factors. Therefore, you must be careful and smart when investing for retirement, no matter what your age.
Here are some tips on what to consider when investing:
Your retirement horizon is how long until you plan to retire and start withdrawing money from your retirement accounts. Your retirement horizon affects how much risk you can take and how aggressive or conservative your investment strategy should be.
Generally speaking, the longer your retirement horizon, the more aggressive you can be with your investment. As you get closer to retirement, you may want to shift to a more conservative strategy that reduces volatility and protects your nest egg.
Risk tolerance is how much risk you are willing and able to take with your investments. Your risk tolerance depends on your age, retirement horizon, income, goals, personality, and preferences. If you are starting your investing journey in your 20s or 30s, you can afford to take more risk because you have more time to recover from losses and benefit from long-term growth.
This is the risk that the overall market or a specific sector may decline in value due to economic or political factors. Market risk affects all investors regardless of their individual choices or strategies.
To reduce market risk, you can diversify your portfolio across different asset classes (like stocks, bonds, cash), sectors (like technology, health care, and energy), and regions (like the U.S., Europe, and Asia). Diversification can help reduce the impact of any single event or factor on your portfolio.
This is how much money you pay fund managers, brokers, and financial institutions in fees, commissions, expenses, and taxes for investing your money. Costs can eat into your returns and reduce your net worth over time. To minimize costs, you can look for low-cost investment options like index funds or exchange-traded funds (ETFs) that track a broad market or sector without charging high fees or commissions.
Start saving now; every dollar helps
The sooner you start saving for retirement, the more time you have to grow your money and achieve your financial goals through the power of compounding interest.
However, saving for retirement can be overwhelming, especially when you’re young. Choosing the right type of retirement account, deciding how much to save every month, and choosing which assets to invest your money in are all significant decisions. If you need help, a financial advisor could help guide you along the way. Don’t let this discourage you from starting to save for retirement in your 20s or 30s.
Can I start saving for retirement at 20?
Yes, you can start saving for retirement at any age, but the earlier, the better. Starting at 20 gives you more time to take advantage of compound interest and grow your money exponentially. It also allows you to take more risk and invest in higher-return assets, like stocks or ETFs.
How much should a 20-year-old have in retirement?
There is no definitive answer to how much a 20-year-old should have in retirement, as it depends on factors like income, expenses, lifestyle, inflation, and retirement goals. However, a general rule of thumb is to save at least 5% of your income for retirement every year. If you start at 20, by age 65, you could have about 20 times your annual income saved up for retirement. For example, if you earn $50K a year when you’re 20 and start saving $208.33/mo ($2,500/year) at a conservative 8% annual growth rate, you’ll have almost $1.1M saved by the time you turn 65.
How much should a 30-year-old have in retirement?
There is no definitive answer to how much a 30-year-old should have in retirement, but to reach a goal of 20 years’ worth of income saved by age 65, you’d need to set aside about 10% of your monthly income.