For millennials, retirement can seem like a very distant goal. But there’s one big incentive to start saving early: If you start contributing to a retirement account when you’re young, your money can grow exponentially by the time you need it.
“It’s magical stuff,” said certified financial planner Harriet Brackey, director of investments at GSK Wealth Advisors in Hollywood, Florida. “Retirement is such a distant concept for younger people. A lot of people miss the opportunity to make themselves millionaires simply by saving.”
That milestone is not out of reach if you save early and consistently. Let’s say you’re 25 and making $60,000 a year, for example, and have an employer that matches your 401(k) contributions up to 5 percent of your salary. If you contribute just $250 a month (or 5 percent of your current pretax income) and your employer matches it, you could stick with the same contribution amount until you retire at 65 and end up with nearly $1 million in your account. (That’s assuming a 6 percent average annual return.) Increase your contribution a little more, and your retirement nest egg could be even larger.
Want to make sure you’re maxing out your savings? Here are four common mistakes and how to avoid them.
Don’t assume the default rate is enough.
A whopping 64 percent more workers between the ages of 18 and 34 started contributing to 401(k) plans last year compared to 2013, according to data on the 2.5 million people participating in retirement plans administered by Bank of America Merrill Lynch. A big reason for the increase: widespread adoption of auto-enrollment programs.
By the end of 2013, about 65 percent of companies reported having auto-enrollment programs, in which employees are automatically defaulted into a plan with an option to opt out, a feature that became increasingly widespread after passage of the Pension Protection Act in 2006, which provided safeguards for employers that adopted it. (Before the law passed, an estimated 20 percent of employers had retirement plans with auto enrollment; the number has nearly quadrupled since.)
But the default contribution rate for most of those plans remains at 3 percent, the amount many companies adopted when they first added the feature.
“A lot of folks accept the default, and it’s not until later they realize they are invested way too conservatively for someone their age,” said certified financial planner Howard Pressman of Egan, Berger & Weiner in Vienna, Virginia. Most advisors suggest a 10 to 15 percent contribution, including the match.
Don’t leave match money on the table.
Each employer is different, but one 2013 analysis found that companies match up to 4.5 percent on average. That means that if you contribute 4.5 percent of your pre-tax salary to your 401(k), your employer will match that 4.5 percent—typically at 50 cents or a dollar per every dollar you put in. It’s essentially free money.
By 2013, the “vast majority [of employers] offered some type of employer-matching contribution” to encourage workers to save more, according to a recent Aon Hewitt analysis of nearly 150 plans with 3.5 million eligible employees.
Don’t assume you need a 401(k) to save.
No 401(k)? No problem. Just open an IRA, or individual retirement account.
If your company doesn’t offer a 401(k) program, you have a couple options: an IRA or a Roth IRA. With each of these, you can contribute up to $5,500 this year.
Read More Millennials flock to 401(k) plans
With a traditional IRA, you’ll be taxed when you start taking money out, but you won’t pay taxes in the meantime on annual gains. A Roth IRA lets you grow your money and withdraw it after retirement tax-free, but you do pay taxes on contributions.
Since younger people typically aren’t in a very high tax bracket,Brackey said it usually makes more sense to opt for a Roth IRA, which can provide “tax-free income in retirement.”
Don’t be too conservative.
As millennial investors, time is on your side. You have decades to take advantage of compounding and grow your money. “One of the biggest factors when you’re just starting out is the long timeframe of your career. It’s a long time to reap the benefits of compounding interest,” said Pressman.
He suggests putting most of your money into stocks, and some into bonds, when you’re a young investor. Those with a high risk tolerance can put as much as 80 to 90 percent of their portfolio in stocks, he said, and the rest in bonds.
“The younger you are, the more years you have to ride out the market ups and downs, so putting most of your money in equities is a reasonable option to do at a young age,” agreed Brackey.
If you want to maximize your savings work toward saving 15 percent of your salary each year. But you don’t need to do it all at once. The most important thing is to start putting money toward your retirement as early as you can so it can start growing. “Time is the magic elixir,” said Brackey. “All of us older people are jealous.”