Saving for Retirement – It’s Never Too Early (or Too Late!)
As we’ve said in this space before, time is the most important ingredient in the financial plan Clients use to guide them to retirement. The power of compound interest is the reason this is true – each additional compounding period available to a Client’s savings increases the growth prospects of those funds exponentially (literally). This piece will explore some of the policies Yeske Buie uses to support Clients in this pursuit, and will also review two examples to illustrate how this concept works in practice.
The first place to which our cash flow policies direct Clients’ savings (after establishing an Emergency Fund) is to their Employer Retirement Plan, as oftentimes an employer matching contribution allows the Client to take advantage of “free money” added to their account. We recommend contributing the larger of 10% of one’s salary or the annual limit (ex. for 401(k)s, the limit is $18,000 with a catch-up provision allowing an additional contribution of $6,000 for individuals who have reached age 50); doing so will help to ensure retirement savings replace income once a Client stops working.
We also recommend diversifying the types of accounts a Client funds while preparing for retirement. Because many employer retirement plans are funded on a tax-deferred basis, limiting retirement assets to these types of accounts ensures that all distributions made to fund retirement spending will be taxed as ordinary income. To add flexibility to a Client’s retirement plan, we recommend directing savings that exceed the amounts listed above to ROTH accounts (which grow tax-free indefinitely) and/or brokerage accounts (preferred investment income tax rates are applied only to growth above a Client’s basis).
Let’s look at two examples to illustrate the virtues of beginning to save earlier in one’s career:
- Lump Sum
Assume you have a lump sum of $100,000 that is growing at a rate of 8% per year. Given 40 years, with no additional savings, this sum will grow to almost $2.2M. If the growth period is reduced to 30 years, the sum grows to just over $1M. This clearly illustrates what Warren Buffett meant when he said “wealth grows exponentially – a little at first, then slightly more, and then in a hurry for those who stick around the longest” – the last 10 years in the example provide the opportunity for a million dollars to double (and then some!).
- Ongoing Savings
Now assume that you are just beginning your retirement savings. In your first year (and every year thereafter), you save $10,000. Assuming the rest of the facts from the first example are the same (regarding growth rates and time horizons), saving at this rate for 40 years yields a retirement nest egg of almost $2.6M. If the investment horizon is trimmed to 30 years, the sum shrinks to just over $1.1M.
As you can see, it doesn’t matter if you save in chunks or receive a windfall – the longer the funds are invested, the greater their earning power. Although the two examples above are oversimplified, they prove just how valuable each year leading up to retirement can be if utilized to add to a Client’s savings. And although we often say that young people have an implicit superpower (their age) with respect to planning for retirement, it’s never too late to start saving for tomorrow!