When bills and other short-term financial goals dominate your budget, retirement contributions tend to fall by the wayside. How can you possibly focus on retirement when you have all of these other expenses?
Plus, is it really necessary to get started now? You probably have decades to go before retirement. Considering how little you can put toward your retirement account, it can’t possibly matter that much, right?
Actually, it does matter.
Even when you earn a minimal income, it’s important to start saving for retirement for two different reasons.
Reason 1: The eighth wonder of the world
“Compound interest is the eighth wonder of the world,” Albert Einstein allegedly said. “He who understands it, earns it. He who doesn’t, pays it.”
Einstein, or whoever actually did say that quote, is right on the money. Compound interest is the single best reason it’s important for you to start saving for retirement today instead of waiting until you consider yourself in a more financially comfortable situation. It’s also the reason it feels like it takes forever to pay off any debt.
The simplest way to explain compound interest is that you’re building interest on your interest.
Here’s how it works: Let’s say last year you invested $100 into your retirement account and earned a 7 percent return. You now have $107. This year, you will continue earning interest on the $107 in your account rather than just the initial $100 you invested.
If you earn a 10 percent return this year on that $107, you’ll add $10.70 to your investment. Therefore, next year you’ll earn interest on $117.70.
That increase just keeps snowballing. The best strategy, of course, is to continue to add to your investment in addition to earning compound interest, which brings us to the point of why it’s important to start early and be consistent.
Reason 2: Time
Apparently Einstein didn’t have a clever quote about the importance of time when investing, but it is one of the biggest assets you have in your investor arsenal. The longer your time horizon is the bigger impact your compound interest can have on your money. And you can better weather the ups and downs of the market.
By investing early, you’re giving your money a chance to do a lot of the heavy lifting for you. Ultimately, you’ll need to put much less money away today. Trying to double down on how much you contribute in the future is difficult and doesn’t always mean you’ll actually catch up to what you would have had you started earlier.
Ways to save when your budget is tight
“Okay, I get it!” you might want to scream. It’s important to save for retirement, but that’s much easier said than done.
Here are a few strategies:
- Employer-matched retirement plan: Taking advantage of an employer-matched retirement account is the easiest way to put aside a little money and get way more bang for your buck! For example, if your company matches your contributions up to 3 percent, then you need to contribute 3 percent of your salary to get the full match. Getting the match also provides a guaranteed return on your investment.
- Small, incremental increases: Suddenly contributing a high percentage of your salary may feel like too big a jump, so start with something small and increase it every quarter or semi-annually. It’s not wrong to just start by contributing 0.5 percent and then gradually increasing it by half a percent until you reach your desired contribution rate. Contributing something is always better than contributing nothing.
- Forced savings for the self-employed: Being self-employed means you have to save for retirement on your own. I do it at the same time I set aside money for taxes. A good rule of thumb is to save at least 30 percent of each paycheck for taxes. Personally, I save 45 percent of each paycheck. That way I always have ample money to pay my tax bill, and the leftover money goes into a SEP-IRA.
The final question: how much do I need to retire?
That’s, quite literally, the million-dollar question. There’s no one-size fits all answer to how much you’ll need, but it’s important to figure out the bare minimum required to pay for your annual expenses and the lifestyle you want in retirement.
Once you have a rough estimate of your annual expenses, you can start to do the math on how much you need based on when you want to retire. Generally, people use the 4 percent withdrawal rule – which theorizes that if you can live off 4 percent of your nest egg annually, you won’t run out of money in retirement.
For example, 4 percent of a million dollars is $40,000. So, if you can live off $40,000 a year, then a million dollars may be enough for you in retirement. However, your risk tolerance may dictate a lower withdrawal rate, or if you want to retire before age 65 or 70, you might want more saved to ensure you won’t outlive your money.
Source : TaxAct Blog