On the surface retirement planning in your 20s can seem almost counter-intuitive. After all, you’re young and you have so many other things to do in your life – why start preparing for the end of your life now? But in reality, your 20s are the very best time to start retirement planning.
The sooner you can begin saving and investing money for retirement, the more money you will accumulate and easier the effort will be. Bonus: it will take more aggressive saving, but if you start in your 20s you will have the best chance of achieving early retirement.
How to Get Started
There are so many options today that retirement planning is easier to start and to maintain than most people think. The easiest way is to participate in an employer-sponsored plan, such as a 401(k) or a 403(b) plan. Under these plans you can allocate a certain percentage of your salary to your retirement plan.
Many employers also offer a company match. Under a typical match arrangement, the employer will match 50% of your contributions up to, say 6% of your salary. That would mean that 9% of your pay is going into your retirement plan each year – 6% from your own salary, and 3% from your employer.
Even if you don’t have an employer plan, or if you are self-employed, you can still open an individual retirement arrangement (IRA). Under an IRA you can contribute up to $5,500 each year into your account. You can even have an IRA account in addition to an employer-sponsored plan.
Best of all, the money that you contribute to your 401(k) or 403(b) plan will be tax-deductible under a traditional plan. And a Traditional IRA will be tax-deductible as well, but there are limitations if you are also covered by an employer plan.
Whatever plan you choose, the most important step is getting started. Even a relatively small amount of money contributed each year can make a huge difference in how much money you can accumulate. By saving just $3,000 per year, beginning at age 25 and assuming an average annual rate of return of 8%, you will have $1,053,586 by the time you’re 65. If you do nothing else in your life to provide for your retirement, you will still have a substantial amount of money – and that can open up a lot of options.
Action item: enroll in your employer 401k plan or open an IRA today.
How to Establish Investing Goals
It can be difficult to establish retirement goals when you’re only in your 20s, but as with all plans it’s always best to start with the end in mind. Make a rough estimate of how much money you think you’ll need for retirement – start with an estimated income figure. How much money do you think you’ll need to live on by the time you retire?
You probably already have an idea what it cost you live based on your current experience, and that’s a good starting point. If you are currently earning $40,000 per year, and you decide that’s how much money you will need for retirement, you can use that as a basis for calculating how much money you’ll need to produce that kind of income.
There is a retirement convention known as the “safe withdrawal rate.” It holds that if you withdraw 4% of your portfolio each year, you will never exhaust the amount of money in the portfolio. This is because by investing money in the stock market over the very long term, you can generally expect a rate of return of about 8%. If you are withdrawing 4% per year for living expenses, another 4% is going back into your portfolio. The portfolio is never exhausted!
If $40,000 is your number, then you will get it from the $1 million portfolio ($1 million X 4% = $40,000). As we showed in the previous section, you can reach the $1 million mark by age 65 by putting away just $3,000 per year beginning at age 25.
These are just examples, so feel free to play around with the numbers. A good retirement calculator will enable you to run various scenarios to see how much money you need to have saved up for retirement, based on your current income and projected future needs.
Asset Allocation in Your 20s
At every stage in life you need to have a portfolio of various assets – a portfolio allocation. That will be the percentage of various assets that you will hold in your plan. It typically contains a mix of stocks, fixed income securities and cash assets, and that mix will change throughout your life.
Stocks are the growth assets – they are the investments that are most likely to enable you to reach your retirement goals. Fixed income investments are mostly about capital preservation. By holding a certain percentage of these assets you reduce your risk of loss when the stock market is falling. In addition, it enables you to hold some assets that you can later use to invest in more stocks after a market slide.
Cash is for liquidity, and you can think of it as your investment operating capital. It’s the place to put proceeds from the sale of stocks, ETF’s and mutual funds, and where you hold them until you’re ready purchase more.
If you’re in your 20s, the emphasis in your portfolio should be on stocks. You have a very long investment horizon, which means that not only are you in the best position to take advantage of the long-term growth prospects in the stock market, but you also have plenty of time to ride out and recover from any market downturns.
A sample portfolio in your 20s might consist of 90% stocks, and 10% in fixed income investments and cash. There are “target date funds” offered by various investment firms that will actually set up your portfolio based on the target date of your retirement.
These funds can take the guesswork out of building your own retirement portfolio, or they can serve as a model for your own efforts.
There is a wealth of information available about retirement planning, and particularly for people in their 20s. That’s really the best time to get started, because it offers you the best opportunity to prepare for retirement without straining your budget. And don’t forget that you have a much better shot at early retirement than you will in the future. You’re young and you have the time.
Already past your 20s? Check out the next in the series: Retirement Planning in Your 30s – Financial Goals for Your Thirties.