Compound interest is a type of interest in which you add the original amount invested, a.k.a. the principal, to the interest accrued.
If you add $1,000 to a checking account, you’d still have $1,000 a decade later. (Most checking accounts have little to no interest rate.)
But what if you add $1,000 to an account with a 10% interest rate, compounded annually? After a year, you’d have $1,100 ($1,000 in principal + $100 in interest); and after two years, you’d have $1,210 ($1,100 in principal + $110 in interest). After 10 years, you’d end up with $2,593.74.
In this example, two people invest $100/month at a 5% annual compound interest rate. The person who started saving earlier has almost 2x as much at age 65 as the one who started later. The later saver will need to invest more in order to earn as much as the early saver by 65.
For a rough estimate, Paulino suggests multiplying your annual expenses by 25, derived from a general rule used to figure out how much a retiree should withdraw from a retirement account every year (a.k.a, the Four Percent Rule). That means if you currently spend $30,000 a year, you’ll need to have about $750,000 invested for retirement.
Use a retirement calculator — Paulino recommends this one from Personal Finance Club — and work backwards.
Let’s say you’re 25 with $0 invested so far. You spend $48,000 each year, and you invest $500/month into retirement with a very conservative 7% return on investment. If you retire at 65, you’ll have nearly $1.3 million. At 80, you’ll have $2.5 million. “But you don’t need $3 million at 80,” Paulino says. If you can afford to invest $500 a month, maybe aim to retire sooner.
If you’re investing in an individual retirement account, choose a brokerage firm (e.g., Vanguard, Fidelity, or Charles Schwab). If you’re investing through your employer’s retirement account, your company has already chosen the firm for you.
Take note of the percentage of the amount you’ve invested that you’ll have to pay the firm, a.k.a. the expense ratio. A 1% expense ratio might not seem like much now, but it can add up as your investment grows and could cut into the rate of return. Paulino’s accounts have a maximum expense ratio of 0.15%.
You have two main options: tax-deferred accounts and tax-exempt accounts.
Tax-deferred accounts, like employer 401(k) plans and traditional IRAs, defer taxes on your income. They allow you to pay less taxes now, but you’ll have to pay taxes on future withdrawals based on your income at that time.
Tax-exempt accounts, like employer Roth 401(k) plans and Roth IRAs, don’t lower your taxable income when you contribute, but you don’t have to pay taxes on any withdrawals you make from them at retirement.
Single and making less than $140,000? Paulino suggests contributing to a tax-deferred 401(k) or 403(b) up to whatever an employer will match and then contributing to a tax-exempt Roth IRA.
Single and making more than $140,000? Max out your 401(k)/403(b) and then contribute to a traditional IRA that you can later convert to a Roth IRA, Paulino says — or to a taxable brokerage account, which, unlike a 401(k) or IRA, you can withdraw from anytime without penalty. (If you’re single and your adjusted gross income exceeds $140,000, you’re not allowed to contribute directly to a Roth IRA.)
Self-employed? Invest in a traditional IRA, Paulino recommends. It’s tax-deferred, allowing you to pay less taxes right now.
This will depend on your priorities and what you can afford, as well as the limits on tax-advantaged accounts, Paulino says. For example, in 2022, employees will be able to make annual contributions of up to $20,500 to 401(k), 403(b), and most 457 plans, up from $19,500 in the previous two years.
Want to set it and forget it? Paulino suggests a target-date fund, which many 401(k) plans offer. It’s basically a type of mutual fund that the brokerage firm manages, adjusting the balance of assets as you near retirement.
Want to be more hands-on? Consult J.L. Collins’s The Simple Path to Wealth, which explains how to build a three index fund portfolio, which each fund tracking the U.S. stock market, the international stock market, and bonds, Paulino says.
Paulino recommends starting a study group with friends or family members so you can stay motivated and hold each other accountable. If you can swing it, sign up for a retirement planning class or hire a financial coach.
“When you’re investing, you’re earning money while you sleep, while you’re hanging out with your friends,” Paulino says. Whatever road you take, planning for retirement is worth the effort.
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