How to get started saving for retirement in your 20s
I get asked this question from time to time from younger individuals just starting their career who may not know the best way to begin saving for their retirement. When looking at this question I think it’s important to review your current income needs, future goals, flexibility and tax benefits. When you begin to ask yourself these questions it’s going to open up the answers are you’re searching for. It may not be as clear-cut of answer as you may be looking for, but it should give you a better understanding of how much you can save as well as what types of accounts you should utilize.
When you’re in your 20s money can be tight. You’re often times adjusting to the new expenses of being independent and balancing actually having some sort of social life. However, the key to being able to save at a young age is to not inflate your standard of living too much too fast. Being able to maintain your current standard of living while also saving for your future is going to be somewhat of a difficult task at times.
So let’s assume that you have a stable job in the field you are trained to work. The easiest place to begin saving for your future retirement should be your company provided retirement plan, assuming they offer one. The reason why your company’s retirement plan makes the most sense when you’re first starting out is because they more than likely offer some sort of matching contribution for the amount you put into it. This presents a great opportunity to accelerate your savings simply because the money your company matches to your retirement plan is essentially free money to you (it’s your “benefit” of being an employee working for them).
Most companies often times choose to avoid nondiscrimination testing by the IRS by opting for the safe harbor regulations. Companies that use a safe harbor plan must either:
Make a dollar for dollar matching contribution for all participating employees, on the first 4% of each employee’s compensation (this is the most popular option), OR
Contribute 3% of the employees compensation for each employee, regardless of whether the employee chooses to participate in the plan
So assuming your employer ops for the more popular option of 4%, every dollar you contribute up to 4% is essentially doubled; meaning you contribute 4% and they also contribute 4%. You can see why this option makes a lot of sense as your first step towards building a retirement savings.
Now you may be telling yourself that this is great I can contribute to my 401(k) and get the full match from my company and while I only have to save 4% in reality I’m saving 8%, but all of these funds are locked away until I retire. This becomes a problem for many individuals because they have short-term financial goals that may require funding in the next 1-10 years. So now you’re thinking I want to save for my future but I also want to have money on hand when I need it to maybe buy a house, purchase a new car or some other goal you have in mind.
Keeping flexibility in mind you may want to diversify your savings into additional accounts that you have more immediate access to. Some options you may want to consider would be:
checking and savings account (think 3-6 month emergency fund)
a taxable brokerage account
Or possibly a Roth IRA
Personally, I think your first goal should be to build up your emergency fund. Now that can take a few different forms, but I think it is extremely important to work out to at least a three-month reserve. Once you have an emergency fund established then you can start working towards saving in maybe a taxable investment account.
Taxable investment accounts definitely have their pros and cons; however, if you’re looking for flexibility this gives you an option to be invested and potentially earn a higher rate of return on the money you have saved versus letting it build up in your checking or savings account and earn near to nothing. The flexibility that this provides is that you now have a midterm savings bucket that you can pull from for when you need to fund your goals that may occur in the next 10 years.
From a general standpoint, an example which would save the short-term and long term goals would be as follows:
Establish a 3 to 6 month emergency fund
Contribute to my companies provided retirement account up to the full match
Save leftover funds into a taxable investment account.
So there you have it my quick and dirty guide to begin saving while you are in your 20s. Please feel free to email me with any questions at ScottHaley@PreludeFinancial.com.