Arguably the most fundamental lesson that can be taught in personal finance is the importance of saving and investing at a young age; it is vital in the process of wealth accumulation.
The first point that needs to be stressed is that compounding interest is your friend and it can be very powerful over time. To give you a simple example, suppose at the age of 18 you started saving $100 a month ($1200 per year) until retirement at the age of 65. At age 65, you would be a millionaire with an investment account worth $1,046,369 (using a 10% annual return). To put things even further in perspective, if you put away another $10 on top of that, your account would be worth $1,151,006. Instead of the $10, if you earned another 1% return annually, your account would be worth $1,461,296. Finally, if your interest was compounded quarterly instead of annually, your account would be worth $2,580,587. You can clearly see that even a small amount of money set aside and invested on a compounded basis ends up giving you a rather large retirement account at age 65.
Sure, you aren’t making as much money when you are younger, but it is important to understand that small amounts go a long way. You also have much less financial responsibility at a young age. As you get older, there is a longer list of bills to pay, people to support, and other financial obligations. Although most young people usually don’t think ahead to their retirement years and most think that they have plenty of time to save for the future, the time will be upon you before you know it. It pays dividends to start early. There are studies that show putting away savings can improve a person’s confidence, peace of mind and quality of life. Although it’s a pretty simply concept, we want to stress the importance of investing at an early age and its affects on wealth accumulation.
The question that remains for young folks is where and how should I invest my money?
The first place to start is your 401(k) account. The maximum contribution for 2014 is $17,500 if you are under 50 years old. If you are 50 or older, you can contribute an extra $5,000 or $23,500 per year. The key reason to begin investing inside a 401(k) is the growth of the account is tax-deferred. Put another way, $1 contributed to a tax-deferred account will reduce your take home pay by $1 less your marginal income tax rate because you are not paying tax on the contribution amount. Some employers also will match your contribution up to a certain amount. This is essentially free money that you are throwing away if you don’t contribute. Hence, the minimum you should invest is up to the percentage the employer will match.
If you find yourself maxing out your 401(k) and still have money left over and are under certain income thresholds, or if your employer doesn’t offer a 401(k) to contribute to, you should consider contributing to an individual retirement account (“IRA”).
There are two types of IRA’s to choose from – traditional and Roth. Contributions to a traditional IRA are made normally with pre-tax dollars although there are some exceptions to this rule. The account grows tax-free until withdrawals are made. At the time of withdrawal, the funds are taxed at your marginal income tax rate in affect at the time of withdrawal. On the other hand, contributions to a Roth IRA are made with after-tax dollars. The account grows tax-free and withdrawals are tax-free! In many cases, making contributions to a Roth IRA at a young age makes good financial sense as you will likely be in a lower income tax bracket than when you are older. When it comes to IRA’s, the max contribution limit in 2014 for an individual under 50 years old is $5,500. Anyone 50 or older can contribute an extra $1,000 to the original $5,500. This additional contribution is known as a “catch-up” contribution.
If you still have money to invest after maxing out your retirement account and/or your IRA, you can establish a taxable account. The money contributed goes in on an after tax basis. Any sales in a taxable account that result in a gain are taxed at capital gain rates. For most people, capital gain rates are lower than marginal income tax rates.
Another key aspect of building your savings throughout your working career is to maintain some balance between the three types of accounts (tax-deferred, Roth and taxable). Many individuals max out their tax-deferred retirement account year after year while working and retire with a very large retirement account, but little savings elsewhere. While it’s always good to save, having the majority of your savings in a tax-deferred account when you get to retirement has its own set of challenges. Another key aspect of contributing to all three types of accounts while working is that each type of account has different return characteristics and tax efficiencies. At THOR, we are strong believers in asset location and we look to find the best vehicle for every investment we purchase. We also help our clients plan for the distribution phase of their lives. We do this by helping our clients understand the tax implications of making tax-deferred contributions while working versus having the ability to tactically and tax efficiently withdraw money from their savings in retirement. Given the complexity of the income tax code and the potential financial implications of withdrawing money, THOR believes it is important to plan carefully before reaching retirement age.