Retirement Planning: A Top Priority
It used to be that most people who worked had pensions that were provided by their employers. Between their pension checks and Social Security payments, retirees had enough money to live comfortably. Times have changed, though, and pensions are, for the most part, a thing of the past. In addition, the Social Security system is targeted for restructuring, and there have long been questions about the certainty of its future. To compound the problem, people are retiring earlier today than they used to, meaning they'll need to have more money saved to keep them going.
Studies show that most people will require about three fourths as much money to maintain their standard of living during retirement as they required before retiring. Of course, all kinds of factors go into that estimate (with the increase in prescription drug costs and Medicare supplement insurance premiums increasing at a rate much greater than inflation, this number may increase in the years ahead), and remember that it's an average. At this point, there is no way to know what your retirement years will bring. You can't know what your health will be like in 40 years or what other circumstances will be affecting your life.
Remember these two important facts about saving for retirement:
- The earlier you start, the easier it is to accumulate all the money you'll need.
- Little savings can add up over the years to make big savings.
If you find it hard to believe that a couple of years makes a big difference in what you'll be able to save, take a look at this example: If you invest $5,000 when you're 25 at an annual rate of return of 6 percent and let it sit until you're 60, you'll have $38,430. But if you wait until you're 35 to invest $5,000 at the same rate of return, you'll have only $21,459 when you turn 60. If you wait until you're 45 to invest the money, you'll have only $11,983.
The following sections discuss examples of how starting early is advantageous to your retirement's good health.
It Pays to Start Early
The following chart compares the profiles of two people who invest in diversified portfolios. The original investment made by Employee A was at age 21. Employee B didn't make his first contribution until he was 30. The results assume a 10 percent compound rate of return with a new $2,000 investment being made on January 2 of each year. Results are as of December 31 of each year.
|EMPLOYEE A||EMPLOYEE B|
|Begins at age 21.||Begins at age 30|
|Invests $2,000 each year until he or she is 29, and does not put any more money in after that.||Invests $2,000 each year, and continues to do so until he or she is 65 years old.|
|Total contributions made over 9 years: $18,000||Total contributions made over 35 years: $70,000|
|Age||EMPLOYEE A||EMPLOYEE B|
As you can see, it makes more sense, and is, in the long run, much easier on your pocketbook, to start saving money as early as possible. Retirement seems eons away when you first start working, but the years pass by quickly and you'll have other financial commitments along the way.
Little Savings Can Mean a Lot
If you can't imagine that saving a couple of dollars here and there will make a difference, consider these fun facts from Fidelity Investments. The amounts are based on saving for 30 years at 9 percent interest:
- If you save $300 a year by exercising at home instead of joining a gym, you'll have $44,572.
- If you save $35 a month by collecting all your change, you'll have $64,557.
While many people aren't saving at all, or aren't saving enough for retirement, the increasing popularity of 401(k)s is improving the situation somewhat. Still, studies show that many people who have the opportunity to contribute to an employer-sponsored retirement plan such as a 401(k) do not take advantage of it.
Some experts say that questions concerning the future of the Social Security program and the proliferation of 401(k) plans are causing more and more Gener-ation Xers to start saving. We say, “Whatever it takes!”
Unfortunately, the IRS limits how much you can contribute annually to your 401(k) plan, although these limits are increasing and will continue to increase in the next several years. The 2004 limit is $13,000, increasing to $14,000 in 2005, and then increasing to $15,000 for years 2006 and after. Some employers also limit the amount of money you can contribute to the plan. Be sure you know if yours does.
The question is, then, if you have money to invest somewhere else, either instead of a 401(k) or in addition to your 401(k), where should you put it? The answer is that you should look at other retirement funds in which to invest your earnings. Why? Because of the tax advantages.
More on: Family Finances
Excerpted from The Complete Idiot's Guide to Personal Finance in your 20s and 30s © 2005 by Susan Shelly and Sarah Young Fisher. All rights reserved including the right of reproduction in whole or in part in any form. Used by arrangement with Alpha Books, a member of Penguin Group (USA) Inc.
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