You’re a recent college graduate. Now that you’ve started your first job, you’re probably wondering how to spend some of that new salary. A vacation? A car?
Maybe you should be thinking instead about saving for retirement. That’s right. It’s time to put money away — ideally 10% to 20% of your annual take-home pay — and come up with a saving strategy that works for you.
It’s all about using the secret weapon of young savers and investors, which is time. Money compounds, but it really grows if you start early and give yourself time to save and grow a real retirement.
To quote the billionaire investor Warren Buffett, “Life is like a snowball. The important thing is finding wet snow and a really long hill.”
Ready to climb that hill? Here’s a look at some great Warren Buffett snowball savings vehicles:
Your workplace 401(k): If your employer offers a 401(k) plan with a matching contribution, take it. Sign up for a certain amount to be automatically deducted from your paycheck before taxes so you never see that money and, in theory, never miss it. Your employer will then match that amount, partially or in full. Either way, it’s free money. The sooner you start contributing, the more you’ll have in your nest egg.
While the employer match is probably the biggest reason to sign up for a 401(k), it’s not the only one. The money you save grows tax-deferred. When you do begin taking withdrawals, you’ll be taxed at your ordinary income rate. And if you ever find yourself involved in a bankruptcy or a lawsuit, that retirement plan is off-limits to creditors.
What a 401(k) doesn’t always provide is a wide range of investment options. Since your employer is in charge, you have to go with whatever funds are on offer. You can, however, research the funds — your retirement plan administrator probably has a website — and calculate which is most affordable in terms of fees and in line with your own investment goals.
A personal IRA and Roth IRA: An individual retirement account (IRA) lacks the matching funds of an employer-sponsored 401(k), but it’s convenient and typically offers a greater variety of fund choices. As with a 401(k), you don’t pay taxes up front. But you do pay taxes on earnings when you take distributions.
Another useful savings tool is the Roth IRA. Unlike a regular IRA, a Roth has income limits. If you make too much money, you can’t open one. You also pay taxes on your contributions, but your money grows tax free. When the time comes, you don’t pay taxes on the money you withdraw.
There’s a limit to how much you can contribute to either plan. In 2015, you can squirrel away up to $18,000 in a 401(k). Contributions for IRAs are limited to $5,500 if you’re under 50, and $6,500 if you’re 50 or older.
There are also rules governing when you can actually get your money. If you tap into your 401(k) before the age of 59 ½, you’ll pay a 10% early withdrawal penalty, along with taxes due. The same rule — as well as a rule about distributions, contributions and age — applies to a regular IRA. Those constraints don’t exist for Roth IRAs.
Magic of Compounding
Compounding, or interest earning interest, is why IRAs and 401(k)s have proven to be such ideal savings tools. Over time, the magic of compounding can turn a small deposit into a robust stockpile.
Say you put $5,000 into an IRA this year at an average rate of 8%. You’d earn $400 in interest. The following year, you would earn interest on $5,400. Even at a lower average rate of 5% or 6%, you’d eventually end up with more than $1 million tax-free in your retirement account 50 years down the road.
With IRAs, you can open one through any large financial institution: your bank, a brokerage house or a mutual fund company. Participation in a 401(k), on the other hand, is set up through your employer.
Just watch out for fees. Plan management fees can range from 0.5% to 0.85%, although some drift higher, and those fees nibble away at your savings. Index funds are passively managed and carry lower fees than actively managed funds.
Even if you’re just out of college with your whole life ahead of you, there’s no better time than the present to start putting money aside and building a financial safety net for the future.