Young Investors: 401(k) Savings and Compound Interest

November 17, 2022
Some pros say your early investing years are among the most critical, including whether you set up a 401(k). Learn how to work toward your financial goals.

When you're a young investor, retirement may seem far away. But there are good reasons to start preparing now through sensible budgeting, contributing to a 401(k) or similar workplace retirement savings plan, and taking other practical steps. The years go by quickly, but in your case, time is an ally. It will take a while to reach your financial goals but getting there is much easier if you start now.

Putting yourself on the right path requires a long-term focus and consistent investing over many years to help ensure your savings are there when you need them.  

Establish a financial plan and stick to it

Everyone knows the rent is due at the beginning of the month—so there's no reason you shouldn't be prepared. Paying your bills on time and regularly tracking income and expenses are foundational principles of retirement planning. Another good idea: Build an "emergency" fund that covers about six months' worth of living expenses. When you receive a bonus, tax refund, or other windfall, consider only spending half and saving the other half in your emergency fund or an individual retirement account (IRA).

Also, credit card debt at potentially high interest rates may derail your budget, so aim to pay off your card balances every month. Additionally, there are many choices when it comes to credit cards, with a wide range of interest rates, fees, perks, rewards, and credit limits, so it's important to do your research and understand what you're signing up for.  

Max out your 401(k)

Contributing as much of your monthly income as you can to a 401(k), 403(b), or similar workplace retirement savings plan is a worthy goal. For 2022, workers younger than 50 can contribute a maximum of $20,500, unless your employer's plan has a lower maximum. Workers 50 or older can contribute another $6,500 per year in "catch-up" contributions. 

If your company offers to match a percentage of your contribution, take advantage of it—it's literally free money. Contribute whatever you can to get at least all that matching contribution. Every time you get a raise, consider increasing the amount you're saving by the same percentage.   

Leverage the power of compound returns

Compound returns, or compounding, happens when you earn returns, or profits, on your previous investment gains—meaning you earn profits on top of your earlier profits. The sooner you put compounding to work for you, the better.

For example, suppose one investor, starting at age 25, puts $2,000 into the market every year for eight years; another waits until age 33. At an average annual return of 8%, the first investor would only need the initial $16,000 to build a nest egg of $125,000 by age 55. The second investor would have to invest nearly three times as much and still would be several thousand dollars behind the first investor once their 55th birthday rolls around.

Even a small amount of money put away each month makes a huge difference, thanks to compounding. For someone who's got 40 years to save, compounding could make the difference between not having enough in retirement and building a nest egg of $1 million.  

Get to know Roth IRAs

Once you've built a financial foundation, consider adding a Roth IRA, which can provide tax-free income once you retire. A Roth IRA can be a good alternative if your company doesn't offer a 401(k). 

Another advantage of tax-free withdrawals from a Roth IRA is that Medicare premiums are based on your taxable retirement income. Reducing your health care costs in retirement means you'll keep more of the money you have coming in and make your retirement savings last longer.   

What about risk and diversification?

One of the first things to do is to gauge the level of risk you're comfortable with in your retirement investments. An overly conservative approach can sacrifice needed growth to beat inflation, while investments that are too aggressive can create too much exposure to market volatility. Exactly how much risk you take depends on your individual situation. Consider discussing your risk tolerance level with a financial planner or investment advisor. 

Overemphasizing any particular investment—whether it's an index fund, your company's stock, or something else—can be risky. This is where diversification comes in, based on the rationale that many investors potentially might benefit from having their portfolio spread across different types of assets.  

Start small and keep building

As a young investor, time is one of your most valuable assets, but it goes by quickly (as you may have heard). That's all the more reason to establish healthy savings habits and get going on a nest egg—not next week or month but as soon as possible.

The important thing is to get started and be consistent. Even small contributions made each month can grow, and you can increase your contributions as your financial situation changes throughout your life. Saving early and making regular contributions can give you a head start on planning for retirement, which may allow you to reach your financial goals sooner.   

How much will you need to retire?

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The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. 

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness, or reliability cannot be guaranteed. 

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

Diversification, automatic investing and rebalancing strategies do not ensure a profit and do not protect against losses in declining markets.

Schwab does not provide tax advice. Clients should consult a professional tax advisor for their tax advice needs.

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