The earlier you start investing for retirement, the bigger your gains can be. The key to success is compound interest, which can play a big part in your retirement account to make saving early for a short period more financially beneficial than saving for a longer period later on.
There are plenty of ways to save for your retirement, some offered by employers, some offered by insurance companies and others you can set up on your own. It is important to research all your options to decide which plans will best suit your budget and your needs.
What is compound interest?
Compound interest refers to the interest your money makes based on the original amount, or principle, along with the interest you’ve already earned. For example, let’s say you put $100 in a savings account and earned 10% interest on the money over time, taking the total to $110.
With compound interest, you earn 10% interest on $110, rather than only on the original $100, taking your grand total to $121. Although that example only earned you an extra dollar, earning money for simply letting your money lie around is nothing to scoff at. Larger amounts would earn you larger amounts of interest, with the interest rate depending on the type of account and the financial climate.
What’s an example of compound interest at work?
The Department of Labor outlines a prime example of compound interest by comparing an employee who saves for 10 years early in her career versus another employee who saves for 34 years but starts later in his career. The first employee, who saved $1,000 per year from age 20 to age 30 amasses a total of $11,000 and then leaves it in a retirement account.
The second employee also saves $1,000 per year, starting at age 30 and up to age 64. Although he ends up saving a total of $34,000, his retirement fund ends up lower than the first employee’s because his money did not have the same lengthy opportunity to amass compound interest that can really make it grow.
The DOL used a 7% interest rate to calculate the amount of savings each employee would amass over the period and with the amounts they saved. The one who started early and saved for only 10 years ended up with $20,000 more for her retirement, thanks to her forethought and compound interest.
What are retirement savings options?
You have many retirement plan options however some of these will depend on your employment. Many employers offer a 401(k) plan and some even encourage participation in the plan by matching your contribution with a dollar amount. This means the company contributes $1 for every $1 you put in. It can also opt for a lesser amount, such as contributing 50 cents for every dollar you put in, which means the company deposits $0.50 for every $1 you contribute. In either case, the 401(k) ends up earning you free money with your company’s contributions.
The drawbacks of 401(k) plans include the requirement that you wait until a certain age until you can withdraw the money without penalty. Since the plan is meant to save for retirement, this should not be an issue, although it can be if you find yourself in a pinch and need emergency cash and withdraw the money early.
Individual Retirement Accounts (IRA)
An IRA is another way to save for your retirement. This is simply a personal savings account you set up on your own at your bank or financial institution of choice with the goal of saving for your retirement. You can regularly deposit funds from your checking account, savings account or from your paychecks. Penalties typically apply for withdrawing your money before the age requirement.
Annuities
Annuities are an option that takes away the danger of you spending all your retirement in one fell swoop the minute you receive it by scheduling regular payments for you to use. Deferred annuities are those that start paying out when you hit age 65, although you can start depositing money as early as possible.
Once you hit age 65, the annuity regularly pays out a set amount until you die. If you die before you’ve used up all your funds, the insurance company gets the excess funds. If you live longer than your money lasts, the insurance company is responsible for keeping up the regular payments out if its own pocket. The big drawback for annuities is that you usually cannot remove your money early, period. Not all can be rolled over to new jobs like 401(k) plans, and you may be locked in for life.
What else do I need to know about retirement savings accounts?
Money in retirement savings accounts doesn’t just sit around gathering dust. You will generally have a list of options of places you can invest your money while you’re waiting to retire. Mutual funds are a common investment option and they come in the form of index funds and life cycle funds.
An index fund earns interest based on a specific portion of the bond or stock market, such as Standard & Poor’s 500 Index fund. A life cycle fund is one that bases your investments on your age. A life cycle fund automatically adjusts your stock and bond investments to match your age as well as the number of years left before you retire.
Regardless of the type of retirement account you choose or where the money from that account is invested, the greatest retirement rewards come from to who start investing early.
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