Retirement plans aside, not everybody is fortunate enough to begin investing in their twenties. Paying back credit card debt, establishing an emergency fund, and saving for home ownership all take priority over building a stock portfolio.
But if you can start investing, you certainly should. So how do you know when to start? Here is run-down of what the financial priorities in your twenties should look like.
Start with Retirement
Even if you haven’t tackled all of your other financial priorities, think about saving for retirement right away either through your employer-sponsored retirement plan (401k) or an individual retirement account (IRA).
Even if it’s just $200 a year into an IRA, it’s important to get in the habit of setting aside part of your income for the distant future and you won’t have to pay federal income taxes on your contributions.
If you haven’t already, start saving for retirement now.
Pay Off Credit Card Debt
Even in its best years, you won’t earn a return in the stock market that can surpass credit card interest rates. So tally up what you owe, take a deep breath, and knock out that ugly debt.
If you need a hand, our seven steps out of debt series can help.
Get an Emergency Fund
Unlike cash in short-term savings accounts, investments aren’t always liquid, meaning you might not be able to use the assets you have invested in emergencies like if you lose your job or face medical expenses.
Once your debts are paid off, concentrate on building an emergency fund equal to at least three months of your income. In time you will want to grow this to about six months, but three months is a good start.
With high interest rates and access to your money in about 2-3 business days, an online savings account like those from ING Direct is perfect for achieving this goal.
Keep Saving, Start Investing
Once you have an emergency fund established it’s time to start investing!
At first you won’t want to be quite as aggressive with how much you invest as you have been with paying off debt and saving.
Keep saving for upcoming expenses like your home, vacations, cars, even weddings.
Your investing priority should be retirement, and you’ll want to exhaust the ways you can save for retirement before turning to the general stock market.
IRS-set contribution limits in 2007 are $15500 for 401(k)s and $4,000 for traditional IRAs (note that if you max out your 401k, however, your IRA contribution won’t be tax-deductible).
If reach your retirement contribution maximums and are rearing to keep going, congratulations! Then it’s time to start considering buying some securities with an online brokerage.
What About Student Loans?
In most cases, it’s wise to start investing even if your student loans aren’t fully paid-off. Student loans generally have long terms but at fairly reasonable interest rates thanks to federal subsidies. With some aggressive investing you make more than you’re paying on student loans.
You know the importance of saving for retirement early, right? Perhaps you also know that money you put into a 401(k) or individual retirement account (IRA) in your twenties is more valuable than money you contribute down the road thanks to the miracle of compounding interest.
But just how much should you have saved for retirement before your thirtieth birthday? [...]
For many young workers with Fidelity Investments 401k retirement plans, the automatic and often recommended investment choice is the Fidelity Freedom 2040 Fund, a generic mix of large growth domestic and international stocks pre-packaged for the aggressive, long-term investment strategy of somebody aiming to retire around 2040.
While Fidelity Freedom 2040 is not a bad fund (Morningstar gives it three stars and sees strong governance), the International Discovery Fund, currently available to many Fidelity 401k retirement plan participants, is a stalwart choice that should not be overlooked by investors under 30 as an alternative to Fidelity’s cookie cutter suggestion.
The International Discovery Fund boasts a 17.30% 5-year return and beat its peers by over 3%. With numerous energy holdings and a large stake in successful Japanese automaker Toyota, the fund displays an encouraging balance of opportunity and stability.
Perhaps the only pock mark on the International Discovery Fund is its popularity. With just under $7.5 billion in assets under management, some analysts worry if the fund’s strategy can withstand the volume. Don’t be surprised if the fund closes to new investors like its sister fund, Fidelity Diversified International.
What is a 401(k)?
A 401(k) retirement plan is, very basically, an investment account funded by direct withdrawals (called “deferrals”) from your paycheck. The largest benefit of a 401(k) is you do not pay any federal taxes on the money you save, or earn in interest, until you make a withdrawal.
While 401(k) retirement plans are sponsored by your employer and managed by a third party (Fidelity Investments, for example), a 401(k) is a self-directed account. You control how much (if any) money you want to contribute to your 401(k) and your employer automatically takes that money out of your paycheck to deposit in your plan. Your employer may match a certain percentage of the money you contribute to the plan, up to a limit, or may make regular contributions based on your salary whether or not you contribute your own earnings.
Why contribute to a 401(k)?
Just 50 years ago, any decent job offered a pension that guaranteed a percentage of your salary (based upon years of service) between your retirement and the day you died. On top of Social Security, which provided a similar benefit to everybody, most hard-workers could look forward to a relatively comfortable retirement without a second thought. Today, this simply isn’t the case.
Pension plans worked when the average retiree lived for just five or ten more years. Fortunately for us, we live a lot longer today. Unfortunately for employers offering pensions (and employees counting on them), those funds have been eaten up by current retirees. Even more frightening, the federal government has acknowledged the same thing will happen to Social Security. To those working today this is a double slap in the face. While existing retirees’ benefits are coming out of our paychecks each month, the likelihood we will receive similar benefits when we retire is dwindling.
With disappearing pension plans and the erosion of Social Security, young workers have two options: work until you die or save for retirement yourself. For most, a 401(k) retirement plan is the best choice. Why?
Benefits of a 401(k) retirement plan
401(k) plans offer a number of benefits that you would not get through just any investment account. They include:
Tax deferred savings – Your 401(k) account is not subject to federal taxes until you make a withdrawal. That means that your investments grow tax-free for decades. The catch? If you withdraw from your account before retirement the IRS will hit you up for its share – up to 28% plus a 10% early withdrawal penalty if you withdraw before 59 1/2. There are limited exceptions for 401(k) hardship withdrawals and 401(k) loans.
Employer matching – Though not mandatory, most employers provide some sort of matching contribution or profit-sharing contribution to your 401(k) plan. When paired with a regular employee contribution, such contributions can effectively increase your salary by several thousand dollars a year.
Large deferral limits – As of 2006 the IRS allows employees to defer up to $15,000 or 100% of earnings, whichever is less, into a 401(k). Participants age 50 and over can also make “catch-up” contributions up to an additional $5,000 in 2006.
401(k) rollovers – Thanks to the 401(k) rollover; a 401(k) retirement plan is highly portable. As it is unlikely you will work for one employer throughout your career, it is possible to “rollover” your 401(k) into a new company’s plan or an Individual Retirement Account (IRA) without incurring any tax penalties.
Start contributing today!
There is no reason not to take advantage of a 401(k) retirement plan if your company offers one. Read more on Money Under 30 to learn why you must start saving early, learn about unvested money, or use a 401(k) calculator to determine how much you need to save.
A 401(k) vesting schedule is a common way for employers to provide an incentive for employees to stay on-board for more than a year or two. For the uninitiated, 401(k) vesting is when an employer makes a contribution on your behalf into a tax-deferred retirement account on a regular basis, but does not give you complete ownership of the money until you have meet certain requirements. While the money subject to 401(k) vesting earns interest the minute it is deposited, you may not be able to take all of that money with you if you quit before your employer’s allotted period of time. [...]
Thanks to AllFinancialMatters for pointing out this story from MSN Money featuring some average personal finance statistics of people in their 20s. For example, our median net worth is $7,901, but for nearly 25% of us, that figure is negative. We owe more than we own!
These numbers are exactly why I created this site! Immediately upon graduation I fell into the trap of living like an adult even though I was earning like a graduate… A few years later and I am really in the hole. But as the MSN story points out, I am young enough to recover from my mistakes. With some planning and hard work I will be out of debt and have a healthy 401(k) before I turn 30. Obviously this site is all about how we can all do the same, but in a nutshell there are three rules that will be repeated here over and over again!
- Kill Your Credit Cards: High interest credit card debt has to be the first to go. Use all available resources to rid yourself of this debt as soon as you can.
- Save for Retirement: Check out the calculator at AllFinancialMatters showing how much more you will have to save each year if you postpone starting your 401(k) or IRA.
- Live Below Your Means: Once you pay off your consumer debt, you must spend less than you earn to avoid going back in the red! Keep only one credit card for emergencies that must be paid off every month. Create an emergency fund with the money left over each month to fall back on in emergencies. Use this site’s budgeting tool to help track your spending.
Q: I just started my first full-time job but am not eligible for the company sponsored 401(k) until December. What should I do if I want to start saving for retirement now?
A: It’s a great idea to get a head start on your retirement saving even if your employer delays the onset of its retirement benefit. In most situations, a traditional IRA (Individual Retirement Account) is the best solution for young, independent retirement savers. IRA contributions not only grow tax-deferred, but are tax-deductible up to $2,000 per year.
Almost any financial institution (including, most likely, your local bank), can set up your IRA, and many will waive minimum balances if you agree to have monthly contributions automatically deposited into your account. As with opening any retirement planning account, there will be a seemingly daunting variety of investment options available to you. Especially as you just start out, how you decide to allocate your savings is far less important than the act of saving something. If possible, choose a pre-designed aggressive portfolio.
As a young investor you can better tolerate the risks inherent with aggressive investments but stand to be rewarded further down the road.
Once you become eligible for your 401(k), contribute to both. That way you can take advantage of any matching contributions from your employer and the IRA tax deduction.
The Automatic Millionaire Workbook is the follow up to Personal Finance Guru David Bach’s best-selling the Automatic Millionaire. Both books cover the same material, with the workbook providing exercises to evaluate your financial situation and implement your personal plan.
Bach’s anecdotes about his clients’ success stories are motivating and I agree with his concepts, though I think some are better suited for people who have “settled down”. If you’re like me, moving and changing jobs every couple of years, it’s a bit trickier to put all your bills, savings, and investments on autopilot. What worked one month may not the next.
Bach’s advice can be summed up as: find and eliminate your “latte factor”, pay yourself first, make it automatic, and own your home.
Bach has trademarked the “latte factor”, but economists have been onto this principle for years. Basically, tiny purchases you make everyday, such as coffee, cigarettes, or candy bars, seem diminutive, but over time add up to staggering amounts. Eliminating these daily costs is an important step toward long-term wealth.
Pay yourself first is taking money from every paycheck, for retirement and an emergency fund, before you pay a single bill. Making it automatic is the use of payroll deductions or previously-scheduled electronic bank transfers to save and pay debts before you see a single penny in your checking account. I have been using this for a few months and have already been impressed with how much faster I am paying off my credit card. Though the monthly amount I am paying hasn’t changed, I no longer skimp out on a payment some months because something else came up that I used the money for.
Finally, Bach insists that everybody should own their home. Again, it’s hard to disagree with him here, but for many young professionals home ownership is so far away it’s almost laughable. Certainly it is a good reminder of an important long-term goal.
I would recommend both the Automatic Millionaire Workbook or the Automatic Millionaire for anybody looking for a system to simplify the difficult task of getting out of debt and saving for retirement, with the understanding that the younger you are, the less you may be able to implement right away.
Millions of young workers graduate in debt and wonder: When I become eligible for a 401(k) or another tax-deferred retirement plan, should I contribute to the plan even if I could use those funds to pay down debt? [...]
An artlice from Sunday’s Boston Globe (story) got me thinking about the principle of consumption smoothing for the first time since I took Econ 101 about seven years ago. If I remember correctly, it basically states that after reaching a certain age or point in life, our the things we need to buy begin to taper off until they reach a constant annual level. [...]
