Tips for Saving for Retirement in Your 20s

Who thinks about retirement in their twenties? You should. You’ll reach retirement with enough money to live comfortably if you’re 20-something and you start saving now and you save consistently. You'll have enough money to do the things you never had the time to do during your working years. But first, you need a strategy.

Benefits of Starting Early

Young people might believe that they are at a disadvantage when saving for retirement because they're just starting out and may make a modest income. However, there are some distinct advantages, particularly if you start saving early.

Power of Compounding

Saving early and often, even in small increments, can add up to significant gains in the long term because of the power of compounding. Compounding is the process of earning interest on interest from an investment. Below are two examples that show investing with and without compounding.

Investing a Lump Sum Amount for Retirement

Let's say that you're 25 years old and you invest $2,000 for 35 years, and the investment earns 5% per year.

• In year one, you'd earn $100 ( .05 * $2,000) in interest
• By year 35, you would have earned $3,500 ($100 * 35) in interest for a total balance of $5,500

However, if each year you reinvest the $100 earned, you'd also earn interest on the $100 in interest. In other words, in year one, you'd start with a $2,000 investment, but at the start of year two, you'd be investing $2,100.

• By year 35, you would have earned $9,032 in interest for a total balance of $11,032
• Compounding added an extra $5,532 versus the $3,500 in interest without compounding
  

Investing in Monthly Increments

If you're in your 20s and start saving early, you don't need to invest a lot of money initially. Instead, you can opt for a smaller initial investment but contribute a portion of your salary each pay period. Let's look at an example below of a 25-year-old saving for retirement.

• In year one, you invest $500
• Each year for 35 years, you earn 5% in interest
• Each month, you contribute $100 to your savings plan for a total of $1,200 per year
• By year 35, you would have contributed $42,500
• The total compounded interest would be $68,642
• Your total balance would be $111,142 in 35 years

The key to building retirement wealth is to start saving early, even if you can't save a lot of money at the start. Remember, you can always increase your contribution amount later as you earn more income due to raises or job advancements.

You can also add an extra amount each year if you receive a tax refund. In short, use your youth to your advantage by letting the power of compounding work in your favor.

Starting Earlier vs. Later

It might appear that it would be easier to delay saving for retirement until your income is higher and contribute at that time. However, this strategy reduces the power of compounding.

Delay Saving for Retirement

Let's use the same example, but instead of starting at age 25, you start saving at 35 years old. As a result, there are only 25 years until retirement at age 60.

• In year one, you invest $500
• Each year for 25 years, you earn 5% in interest
• Each month, you contribute $100 to your savings plan for a total of $1,200 per year
• By year 25, you would have contributed $30,500
• The total compounded interest would be $28,466
• Your total balance would be $58,966 in 25 years

By waiting ten years to save for retirement, your total retirement balance would be $52,176 less than had you started saving at age 25 ($111,142 - $58,966).

In other words, you would have 47% less money saved for retirement by waiting until age 35 versus starting early at 25.

Playing Catch Up

If you start saving for retirement later, at age 35, you can still reach the same total balance you would have achieved had you started at age 25, but you have to increase your monthly contributions.

Assuming the same initial investment of $500 and interest of 5%, you would need to contribute $191.10 per month for 25 years to achieve a balance of $111,142 by age 60. In other words, you'd need to increase your monthly contributions by $91.10 to achieve the same total balance than had you invested $100 per month at age 25.

By saving early, you allow compounding to do some of the heavy lifting when saving for retirement.

Retirement Planning Strategies for Your 20s

Retirement planning will include investing your money in various types of mutual funds, exchange-traded funds, or bonds. A fund is essentially a basket of securities. When investing over the long term, different mixes of assets can help you achieve diversification, meaning all your eggs or money isn't in one basket.

Diversifying reduces some of the risks of losses by spreading your money across various sectors or industries. This process is called asset allocation. The charts below show five types of investing strategies and asset allocations.

Enroll in a 401(k) Plan

If you're in your 20s and saving for retirement, a 401(k) is one of the best wealth builders available to you. The 401(k) is based on section 401(k) of the Internal Revenue Service (IRS) tax code. It allows you to invest money into an account earmarked for retirement without paying taxes on the gains until you reach retirement age. A 401(k) plan is only available through an employer. Your contributions are withdrawn from your paycheck based on a percentage of your income. The company may match your contributions up to a certain limit.

For example, a company might match 50% of your contributions up to 6% of your pay. In other words, you would receive 3% each year deposited into your retirement account by your employer as long as you contribute 6%.

As a result, it's important to take advantage of the benefits that a 401(k) offers and contribute enough to qualify for the full employer match if your company offers a 401(k) with this type of arrangement.

You can also start your own 401(k) under your registered company name if you're self-employed.Another benefit of a 401(k) is that the yearly contribution limit is higher than most retirement accounts. For example, in 2022, you can contribute up to $20,500 per year into a 401(k).

Start an Individual Retirement Account (IRA)

IRAs have many of the same rules as 401(k)s, but their contribution limits are lower. For 2022, you can only contribute $6,000 annually, or $7,000 if you’re 50 or over, but there are also distinct advantages. You can invest in almost any stock, bond, ETF, or other traditional investment.

IRAs don’t have to go through your employer, either, which gives you a lot more control over how your money is invested. You can also invest in both an IRA and 401(k).

Other Tips for Saving for Retirement in Your 20s

Pay Off Debt

It can be challenging to save extra money for retirement while you're paying thousands of dollars in high-interest credit card debt over several years. Paying off high-interest debt is a sound financial strategy, especially since many credit cards charge more than 20% interest.

Emergency Fund

Unexpected life events can set you back financially. If you need cash fast, you can't withdraw from your retirement accounts without paying a stiff penalty in most cases. You might be able to borrow from your 401(k), but you have to pay that money back. As a result, it's important to establish an emergency fund to cover unplanned expenses such as a car repair or temporary unemployment. Keeping three to six months of living expenses is a good strategy.

Invest Aggressively

You may experience market downturns during your lifetime and before you reach retirement. They can send your retirement account into free fall, but that's no reason to panic. Experts recommend investing at least 80% in stocks in your early 20s because you have 30 or 40 years to recover from those short-term stock market downturns. In other words, since you have a long-term time horizon for retirement saving, you can afford to increase your risk tolerance when you're young.

Make Saving Automatic

It’s easier to stay disciplined when saving happens automatically. Ask HR for paperwork on how to set up automatic withdrawals from your pay that will go straight to your 401(k) or IRA each month. If you can afford it, contribute a significant amount, especially while you're not supporting a family.

Be Proud of Yourself

Aggressive retirement savings in your twenties will mean a super impressive balance long before you retire. Keep an eye on your account and watch it grow and multiply. Be proud of your accomplishment, and let it motivate you to save even more.

Nothing beats the effect of compounding gains. The simple passage of time makes you richer and richer. Wealth in later years means security. A lifetime of good choices will allow you to carry out your financial dreams.

Frequently Asked Questions