If you are young you have, set before you the greatest opportunity to get ahead financially you will ever have. The only problem is you need to start working towards it right now. Even if it’s small steps because the danger of not doing so is made plain in this example….
Who do you think would have more money by the time they turn 65?
A 20 Year Old who put $5,000 into a 401k that they never contributed to afterward.
Or a 40 Year Old who saves $250 a month into a 401k until he is 65.
One made a single contribution, and one saved diligently every month for 25 years.
Ending Balances:
20YR - $364k
45YR - $295k
Despite not saving a dime past 20 years old the person who started earlier had $69,000 more than his late-starting counterpart. Again this goes back to the opportunity set before us, an opportunity to get ahead. Even if you are farther along your journey, getting started at 30 is better than 40. starting at 40 better than 50 and so on.
Now you may be wondering what are the things I should be learning and thinking about. Well in this brief letter we will cover a handful of ideas that you will find useful in getting started answering that most important question.
401k
I mentioned a 401k earlier and it’s where we will start. I imagine the vast majority of my audience has heard of a 401k and how important it is to retirement. This is great to hear but means nothing without knowing the heck this 401k thing actually is.
Simply the 401k is a special kind of tax-advantaged savings account. Unveiled over 40 years ago it was designed to help people save for retirement and ultimately lead to the death of the pension plan, tragic.
Most employers offer this and if yours does it is certainly something to take advantage of. Why? You may ask. Well…
Taxes are something we all dislike very much, so what if there was a way to avoid paying them, at least for a little while? Well, that is one big advantage of the 401k. You put your money into this account before you pay taxes on it. It’s the first deduction on your pay slip, whatever amount of money you choose, put away into an account where you won’t have to pay taxes for many years.
Often times your employer will even match your contributions up to a certain amount. Let’s say you contribute 5% of your paycheck to this 401k, your employer may give you an extra 5% on top of your 5%. Of course, this changes from company to company so it’s important to check what amount your employer will match up to.
This employer-matched tax-sheltered account does come with a catch, however. In order to withdraw penalty-free, you have to wait until you are 59 1/2 years old. If you want to withdraw before that you will pay a 10% penalty on the money in the account. And when you start withdrawing money you will have to pay taxes on it.
If you want to avoid paying taxes in retirement then there is an account for you too.
Roth IRA
The Roth IRA is not usually something offered by an employer but through a standard brokerage. This account is the mirror of the 401k. It allows you to grow your contributions tax-free but those additions will be made after you pay taxes on the money. This comes with the added benefit of not needing to pay taxes in retirement.
But basically, it’s the same idea. You make contributions using after-tax money until you turn 59 1/2 at which point you can take money out of penalty, and tax-free.
And this is where a little thinking is required. A 401k is good for those who make a lot of money when they are younger and can save a lot. A Roth IRA is good for those that don’t make so much in their younger years instead of building large income streams into retirement. But no matter what having one of these is far better than having neither.
Retirement is just one aspect of planning for the future, however. Let’s say you have a child and would like to set them up for success later on.
529
An idea to consider is enrolling in a 529 account. This account, much like a Roth IRA allows you to contribute after-tax money into a tax-sheltered account that grows until your child is ready to go to college. Again this is going to be offered through a brokerage and the money can only be used for college expenses. If your kid doesn’t go to college there are lots of alternatives but the best might just be to take the money out, pay the 10% + Taxes and you will have a solid chunk of money that grew tax-free afterward.
Extra Investing
Another downside of many of these tax-sheltered accounts is the limit on contributions. For a 401k is $19,500 a year, for a Roth IRA it’s only $6,000 a year, and for 529s it varies from state to state and depends on gift tax laws but it’s in the ballpark of $15,000. One thing that does not have a limit is a regular, non-tax-sheltered brokerage. Any old account will do and you can contribute as much as you like. This also comes with the benefit of having more control over where your money is invested (usually another limit of the 401k).
I could go on. But I hope this demonstrates the importance of getting started as soon as possible. The world of personal finance is vast and there are programs, often hidden away, that can bring tremendous value to you if you just go looking.
I hope this short dive into some of the aspects of planning for the future financially helped you in some way. As always we at Personal Finance Radar seek to put the best ideas in the world of personal finance on your radar.