The smartest financial decision you'll ever make

The smartest financial decision you'll ever make
Posted at 4:08 PM, Jul 12, 2016

There’s really only one thing young people need know about money: Save for retirement, starting now.

Yes, at some point you’ll want to pay off your debt, have an emergency fund and buy a home. Right now, though, you’re burning through your most limited resource, which is time. You can’t get make more of it, you can’t get it back when it’s gone, and you have a limited window to harness its power.

One way to illustrate this is with the story of Aadik, Fisayo and Amrita:

  • Fisayo starts contributing $5,000 a year to a retirement plan at age 25 and then stops contributing after 10 years.
  • Aadik, meanwhile, waits until age 35 to start and then contributes $5,000 a year until age 65.
  • Even though Fisayo contributed for far fewer years — 10 years, compared with Aadik’s 30 — his early start means he winds up with more money by the time they’re both 65: about $526,000, compared with Aadik’s $472,000.
  • Their friend Amrita catches on even earlier. She starts contributing at age 21 and stops 10 years later. At 65, she has $689,310 — 31% more than Fisayo and 46% more than Aadik.

These examples assume 7% annual returns, but the result is the same regardless of the return and contribution assumptions. The earlier you put your money to work for you, the more time you have to benefit from the magic of compounded returns. Your returns earn their own returns, which earn still more returns, in a virtuous cycle that accelerates the more time the money has to grow.

The longer you wait, the worse it gets

Another way to illustrate the same point is to take away the tailwind that an early start gives. The less time you have until your goal, the less help you get from compounding. You have to do more of the heavy lifting by saving more of your income.

Let’s say you want to replace 80% of your $60,000 annual income in retirement, including Social Security benefits. The amounts you have to save climb sharply the longer you wait to begin, according to national savings rate guidelines developed by Roger Ibbotson, a retired Yale University finance professor and founder of hedge fund Zebra Capital. (For data geeks: The study uses Monte Carlo simulations and returns forecast by the research firm he founded, Ibbotson Associates, to come up with its numbers.) The guidelines found that:

  • If you start saving at age 25, you’d need to save 12% of your pay.
  • Start at age 35, and the proportion rises to 19.6%.
  • Begin at age 45, and you’ll need to set aside 35%.
  • Wait until age 55, you would have to save a whopping (and completely unrealistic) 79.8%.

A less ambitious goal would be to replace 60% of your income. Even then, the early start gives a decided advantage. You’d need to save 19.4% of your income if you start at 45, or 43.8% if you begin at 55, to match what you’d accumulate by putting aside just 6.4% of your pay every year commencing at age 25.

Why saving is a higher priority than debt

Investment returns aren’t guaranteed, of course, while the returns from paying off fixed-rate debt typically are. That leads some people to prioritize paying off student loans or mortgages rather than saving for retirement.

Here’s what they’re missing:

Your return is lower when you pay off tax-advantaged debt. You can deduct up to $2,500 of student loan interest if you’re single and your modified adjusted gross income is under $80,000, or $160,000 if you’re married filing jointly. That lowers the effective interest rate on federal direct loans from the current 3.76% to just 2.82% if you’re in the 25% federal income tax bracket. You get similar results with a mortgage if you can itemize your deductions. Historically, investors have gotten better returns over time even with low-risk options such as U.S. Treasury bonds.

You get a tax boost from retirement contributions. If you’re in the 25% tax bracket, each $1 you contribute to most retirement plans saves you 25 cents in taxes. If you’re lower-income, the payoff can be even higher. The Savers Credit can cut your tax bill by up to 50 cents for each dollar you contribute.

You should never, ever pass up free money. Most 401(k) plans offer a match, according to benefits research firm Aon Hewitt, and the most common one is dollar-for-dollar up to 3% of a worker’s pay. That’s an instant 100% return on your money. Even smaller matches typically offer 25% to 50% returns. So even if you’re carrying high-rate credit card debt, you should contribute at least enough to get the match before you start paying down those balances.

You lose financial flexibility when you prepay some debts. Your student loan provider won’t send your payments back to you if you need money in an emergency. A retirement fund, on the other hand, can be an important backstop if you face a disaster such as prolonged unemployment or a serious medical emergency. Ideally, you’d leave retirement money alone for a retirement, but a healthy nest egg can see you through a big financial setback.

Not having access to a workplace retirement plan doesn’t let you off the hook. You can open an IRA at a number of discount brokers that have low or no account minimums, low fees and commission-free investment options. (See “The Best IRA Accounts: 2016 Top Picks.”)

One final piece of advice: Once you start saving for retirement, don’t stop. Amrita and Fisayo may have small fortunes set aside after just 10 years of saving, but they — and you — will need a fairly large fortune to afford a truly comfortable retirement. To see how much you’ll need, check out NerdWallet’s retirement calculator.

Liz Weston is a columnist at NerdWallet, a personal finance website, and author of “Your Credit Score.” Email: lweston@nerdwallet.com. Twitter: @lizweston.

The article The Smartest Financial Decision You’ll Ever Make originally appeared on NerdWallet.