One of the most popular pieces of financial advice that we hear today is that we need to start saving for retirement. The IRS even gives us the benefit of tax-deferred retirement savings accounts, in order to provide us with an extra incentive to save for retirement.
However, according to a recent article by Market Watch, most Americans are far behind on their retirement savings:
The gap between what Americans need for retirement and the amount they have saved is a staggering $6.6 trillion, Retirement USA, a coalition of workers’ groups, said in a study published Wednesday.
“The retirement income deficit is the gap between the pensions and retirement savings that American households have today and what they should have today to be on track to maintain their living standard in retirement,” said Karen Friedman, executive vice president and policy director of the Pension Rights Center, in a conference call with reporters.
This means that as a nation, we are so far behind when it comes to saving for our golden years, that it almost seems hopeless. These abysmal numbers are due to a number of common mistakes, and the most common one is starting too late.
When to Start Saving For Retirement?
The answer to this question is quite simple…today! With all of the other financial priorities in our lives, why should we put them aside and begin saving for retirement today?
The Power of Compound Interest:
Albert Einstein is known for saying this regarding compound interest:
Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.
Allow me to quote another “genius” (me ;-)) to further explain what compound interest actually is:
Simply stated, compounding interest describes what happens when interest is calculated on a principal amount of money, and then that interest is added to the principal and now interest will be calculated on this new higher amount.
For instance, if you save $10,000 and it earns 10% interest over the course of a year, you have earned $1,000, meaning you now have $11,000 in your account. If we are dealing with compound interest, the next year will begin with a new principal amount of $11,000 and your 10% interest will now earn $1,100 in the second year!
So every year both the principal amount that you invested as well as your earnings from those investments will continue to grow (unless your account loses money). That means that every year you decide to put off saving for retirement, you lose all of the potential growth on your investment as well as the earnings on that growth for the next 20 to 40 years!!
Let’s say that you wish to retire at age 65, but you decide to wait until you are 40 before you begin saving for retirement. Save the current IRA contribution limit of $5,000 each year for the next 25 years and you’ll end up with $365,529.70!!! That is assuming an annual rate of return of 8% (of course your actual return will fluctuate each year, but assuming a steady rate makes it much easier to present an example), and that you deposit the $5,000 as a lump sum at the end of the year.
Now, let’s see what your result would be if you started saving at age 25 – and all other inputs remained the same. If 25 years got us about $365k, then it would be safe to assume that adding another 20 years would get us around $292k. However, starting at age 25 would leave us with $1,295,282.59!!! That’s why it is the 8th wonder of the world!
Take a look at one more example in order to see how important it is to start saving for retirement today:
If you choose to invest $5,000 into your IRA for 10 consecutive years, you would have $72,432.81 (assuming the conditions above). If you choose to not invest another penny, and just allow that amount to grow over the next 30 years, you will end up with $728,867 in your retirement account! That is almost double what you would have if you only give yourself 25 years to invest. Because, in this example, you started early and took advantage of compound interest, you only had to contribute to the account for a total of 10 years to see this result!
If you look at the 401k contribution limits, you’ll see that you can save up to $16,500 for your retirement. Do that for 25 years and you’ll be up to $1.2 million. However if you start early and give yourself 40 years, you will bring your account up to almost $4.3 million!!!
Giving Away Free Money
Most companies that offer 401 (k) plans will also offer a 401k employer match. What this means is that your employer will match the amount that you put into your plan up to a certain percentage of your salary.
The current limit for an employer match is 6% of the employee’s pre-tax salary. That means that if you make $100,000 per year, then by not saving for retirement through your 401k, you are missing out on $6,000 of free money each year!
Of course you also have to consider what your real loss would be once you factor in compound interest. Just that $6,000 each year would bring you over $1.55 million in 40 years!
So not only are you passing up free money, but you are also forfeiting the affect of compounding on that free money!
Even if you do not have another 40 years left until your desired retirement age, it’s not too late to get back on track with your retirement planning! Maybe consider using the 2011 payroll tax holiday as a chance to save for retirement!
photo by Hygiene Matters
Reader Questions:
- Do you think you are currently on track with your retirement savings?
- If you are currently not saving for retirement, what is stopping you?
- Have you seen the power of compound interest work in your behalf?
