Importance of Investing at a Young Age and Best Practices
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 to the process of wealth accumulation.
The first point that needs to be stressed is that compounding interest can be very powerful over time. For example, suppose at the age of 18 you start 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.
You have 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, the time will be upon you before you know it. It pays dividends to start early. Studies show that putting away savings can also improve a person’s confidence, peace of mind and quality of life.
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 2018 is $18,500 if you are under 50 years old. If you are 50 or older, you can contribute an extra $6,000 or $24,500 per year. The key reason to begin investing inside a 401(k) is the growth of the account is tax-deferred. Many employers 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), 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. 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 2018 for an individual under 50 years old is $5,500. Anyone 50 or older can contribute an extra $1,000 for a total of $6,500. This additional contribution is known as a “catch-up” contribution.
If you still have money to invest after maxing out your retirement accounts, 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. 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 assist our clients plan for the distribution phase of their lives. 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.