At this stage of your life, your most valuable asset isn’t youthful vigor or a full head of hair. It’s time. Because you’re decades from retirement, contributions to a 401(k) or other retirement plan will have years to compound and grow. Even a modest contribution now will pack a much greater wallop than a significantly larger contribution when you’re in your forties and fifties.
If you start socking away $200 a month in a retirement account from the moment you land your first full-time job at age 22, within ten years you’ll have a stash of more than $37,000, assuming your investments grow 8% a year. In 20 years, you’ll have more than $122,000, and by the time you reach age 67, your nest egg will be worth $1.2 million.
Stuart Ritter, a certified financial planner for T. Rowe Price, recommends investing 15% of your salary toward retirement. That may seem like an unreachable goal for young people with other demands on their paycheck. If you’re pulling in $30,000 a year, for example, that’s $375 a month. But with tax breaks associated with employer-sponsored retirement plans, plus a possible employer match, you can reduce your actual out-of-pocket contribution. Even a smaller contribution will give you a serious head start on saving, so you’ll have a bigger stash that can grow for decades — plus more wiggle room to deal with the competing demands on your paycheck later on.
Enroll in the 401(k). Most major companies that offer 401(k) plans match a percentage of your contributions. Typically, these matches range from 25% to 100% of your contribution, up to 6% of your salary. Even if the match is at the low end, that’s an immediate 25% return on your investment, says Ted Sarenski, a certified public accountant in Syracuse, N.Y. “You’re not going to get that kind of return anywhere else.”
In addition, the money that you contribute to your 401(k) is excluded from taxable income. Once you take the tax break into account, a 6% contribution “only feels like 4%,” says Sheryl Garrett, president of Garrett Planning Network.
Fund a Roth IRA if you don’t have a 401(k). Many small employers don’t have the money or manpower to offer a 401(k) plan at all, let alone one with a company match. That means you have to create and manage your own retirement plan.
For most young workers, the best choice is a Roth IRA, Sarenski says. Contributions aren’t tax-deductible, but you can withdraw them anytime tax-free. And as long as you wait until you’re 59 1/2 to take withdrawals, earnings are tax-free, too. (Funding a Roth is a good idea even if you are contributing to an employer’s 401(k) plan; read on to find out more.)
You can invest up to $5,000 in a Roth in 2012. That doesn’t mean you need $5,000 — or even $1,000 — to get started. Some mutual funds and brokers, including Schwab, will waive minimum investment requirements if you sign up for an automatic investment program.
Pay off student loans — in good time. Don’t pay off federal student loans more quickly than necessary, Ritter says. The interest rate — between 3.4% and 6.8% for loans issued after 2006 — is fixed and relatively low compared with the rates many borrowers get on private student loans, and up to $2,500 of the interest is tax-deductible.
Resist cashing out a 401(k). When you leave a job, you have several options for your 401(k) plan. You can leave it with your former employer, roll it into an IRA, roll it into your new employer’s plan (if your employer permits such rollovers) or ask your former employer to cut you a check.
You may be tempted to choose the last option, but in most cases, that’s a bad idea. Your employer will withhold 20% of the amount withdrawn to cover income taxes. And because you’re under 55, you’ll also have to pay a 10% early-withdrawal penalty on the entire amount. Plus, you’re jettisoning any growth you’ve earned, which sends you back to square one when you start saving again. Workers who cash out their 401(k) plans reduce their retirement income by up to 67%, according to an analysis by the Employee Benefit Research Institute.