Your college days are history, and you just landed your first real job. Congratulations! Now, listen up. You have a golden opportunity to start your financial life on the right foot -- and it doesn’t involve buying lottery tickets. The secret to becoming rich is really quite simple: Spend less than you earn, save the difference, and let the magic of compounding do the rest.
Albert Einstein called compound growth the eighth wonder of the world. To illustrate, imagine that you invest $2,000 a year for 20 years and it earns an average of 8% per year. Over 20 years, you would have invested $40,000, but due to the magic of compounding, your pot of money would actually be worth close to $100,000. Just imagine how much more you could accumulate by investing a larger amount over a longer period of time.
Here’s a quick rule of thumb called the Rule of 72. Divide the rate of interest earned -- in this case, 8% -- into the number 72. The result -- nine in this case -- is the number of years it will take your money to double without investing another dime.
Before you start wondering where you can find a savings account that pays 8% -- you can’t. But you can invest your money in the stock market, which over the long term has returned an average of nearly 10% a year. With decades to go before you’ll need the money for retirement, you can afford to ride the ups and downs of the stock market. And if the market falls, don’t panic. It just means stocks are on sale and you can scoop up more shares at lower prices, which will pay off big when the market rebounds and each of those shares is worth considerably more.
Save at Work
If you’re lucky, you’ll have the chance to save for your future through a payroll-deduction plan at work. The most typical form is a 401(k) plan -- named after the section of the tax code that authorizes it. If you get a job at a school or hospital, you might have a similar retirement-savings plan called a 403(b) plan, or if you are employed by a state or local government, you might have access to a 457 plan. The federal government’s version is called the Thrift Savings Plan, or TSP.
Regardless of their different letters and numbers, all of these tax-deferred retirement savings plans are essentially the same: You contribute money directly from your paycheck to an employer-provided retirement account and the money escapes state and federal taxes, meaning there’s more money in your account to benefit from the magic of compounding. Say you’re in the 25% tax bracket and you contribute $1,000 to a retirement plan. Your 401(k) balance grows by $1,000, but your take-home paycheck is reduced by just $750 because if you didn’t contribute to the account, you would have paid $250 in taxes on that $1,000.
Increasingly, employers are automatically enrolling new employees in their 401(k) plans. You can opt out, but don’t. With the money coming directly out of your paycheck, chances are you’ll never miss it.
If you don’t have access to a retirement savings plan at work, don’t think you’re off the hook. You can set up an IRA on your own at a bank, a mutual fund company, such as Fidelity or T. Rowe Price, or an online discount broker, such as Charles Schwab or T.D. Ameritrade. You can contribute up to $5,000 to an IRA in 2012, and you can arrange for a direct transfer from your bank account to an IRA every time you get paid.
At your young age, you may want to consider establishing a Roth IRA. Although there’s no upfront tax break as there is with a traditional IRA, the money can be withdrawn tax-free in retirement and you can withdraw your contributions (but not earnings) tax-free and penalty-free at any time.
Help from the Boss
There’s a good chance that if you have a 401(k) plan at work, your company will kick in some money to your account. Typically, employers will make matching contributions up to a certain percentage of your pay. For example, if you earn $50,000 per year and your employer contributes 50 cents for every dollar you contribute up to 6% of pay, you would have to contribute $3,000 to capture your employer’s $1,500 match. Fail to contribute at least $3,000 -- that’s only $250 per month -- and you’re walking away from free money. And once the year is over, your opportunity to capture that year’s match is gone forever.
But don’t stop there. Ultimately you should aim to save 15% of your gross income -- including any employer match -- to amass enough savings for a comfortable retirement decades from now. And by contributing 6% of pay and capturing your employer’s 3% match in the above example, you’re more than halfway there.
Commit to a simple plan called “Save More Tomorrow.” Each year, boost your 401(k) contribution by one or two percentage points, and earmark a bit of future raises for long-term savings. (Some employer plans will allow you to do this through an automatic-escalation feature.) Before you know it, you’ll be on your own personal path to riches -- and it won’t hurt a bit.
How to Invest
You are young and have decades to invest before you need to tap your savings. You’re a perfect candidate to direct the bulk of your savings to stocks, which historically have produced higher returns than more conservative bonds or the paltry interest you can earn on money market funds. Ideally, you want to spread your risk over several categories of stocks because you never know which sectors will do well and which ones will lag. Divvy up your money among several types of mutual funds listed in your 401(k) plan’s investing menu. Most 401(k) plans offer Web-site-based asset-allocation tools to help you decide how much to invest in big and small U.S. companies as well as companies in developed and emerging foreign countries.
And this is important: You can sign up for automatic rebalancing, which forces you to sell some of your winners and to buy more of the underperforming shares to bring your asset allocation back in line with your original allocation. It’s a great way to exercise one of the essential premises of smart investing: Buy low and sell high, rather than letting your emotions stampede you into selling losing investments when they tank and following the herd to buy the latest hot stock at inflated prices.
Or, if your plan offers a target-date fund -- one that has a date in its name, such as 2055, which may be near the date you plan to retire -- you can direct all of your money into that one fund. Professional managers will do the rest, dividing your money among age-appropriate investments and gradually dialing down your risk as you grow closer to your retirement age.
Roll It Over
While this may be your first real job, it almost certainly won’t be your last. And as you hop around among different employers, make sure you don’t let your hard-earned savings seep through the cracks. Because retirement savings are portable, you can take them with you when you leave a job, roll them over to an IRA or cash them out. (Or, if you have a balance of at least $5,000, you can leave the money in your former employer’s plan).
Caution: Cashing out your 401(k) -- even for well-intentioned purposes, such as paying off a big credit card bill -- is both shortsighted and costly. Say you have $10,000 in your 401(k) when you decide to take a new job. Let’s assume you’re in the 25% federal tax bracket, you pay 5% in state income taxes and you’re 30 years old, meaning you’ll also be hit with a 10% early-withdrawal penalty. You’ll lose $4,000 of your $10,000 balance to taxes and penalties, and you’ll rob your future self of nearly $163,000. That’s how much the $10,000 earning 8% per year would be worth in 35 years.
The bottom line: The sooner you start saving, the more financially secure you will be. Years from now when you look back on your younger self, wouldn’t you rather say: “I’m glad I saved” rather than “I wish I had”? Procrastination is very expensive.