April was Financial Literacy month, which brought back to the forefront of my mind one of the best things I ever did with my own money. Thanks to the advice I received in a college course that I took on personal finances, when I started my first job, I immediately signed up for my company’s 401k plan and contributed 15% of my income. I was “paying myself first” and taking advantage of the power of tax deferral and compound interest.
You may be thinking “15%, that sounds like a lot”, but in reality, you should be striving to set aside around 20% of your income between your various savings goals. When saving for retirement, I recommend you strive to contribute between 10-12% of your gross income and take advantage of any employer match available to you. If you can’t contribute that much right away, then start with an amount you are comfortable with and be sure to set a reminder to increase it by 1-2% each year (ideally timed with any pay increase).
Why Compound Interest is Important
Why is it so critical to start saving for retirement when you are young (and retirement is likely the farthest thing from your mind)? There is this powerful thing called compound interest that can boost your savings by an incredible amount, the longer it has to work in your favor. Compound interest arises when interest is added to the principal of a deposit so that, from that moment on, the interest that has been added also earns interest. This addition of interest to the principal is called compounding.
Let’s look at an example. We will assume a 22 year old is starting their first job and is earning $50,000. If they contribute 10% of their income ($5,000) and continue to do a flat $5,000 contribution every year until age 67, and earn an average rate of return of 6%, they will have accumulated $1,132,540 by age 67. Now let’s assume this person decided to wait until age 30 to contribute to their retirement plan, is still earning $50,000 and signs up to contribute $5,000 for every year until age 67, also earning 6% on average every year. By 67, they would have accumulated $679,521. So, by starting at age 22 and contributing an additional $40,000 over those first 8 years, the 22 year old would have accumulated an additional $453,020! And THAT is the power of compound interest. (See the chart below for a depiction of the differences in starting to save $5,000/year at different ages.)
Timing is Important in Your Journey to Retirement
So, if you haven’t yet started saving for your future, I encourage you to start today, even if you have to start small and build up to a greater contribution over time. Time is your greatest ally in this journey to retirement. And if you happen to know someone who is graduating from college soon, please share this article with them….they may thank you in the future!
This is a hypothetical example and it does not represent the performance of any specific investment.
About the Author
Kelly Stanley, CFP®, MBA is a Certified Financial Planner and a Certified Wealth Advisor Representative offering securities and financial advisory services. You can reach her at Kelly@TheCogentAdvisor.com or 312-382-8388.