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What Is the Advantage of Investing Early for Retirement? 4 Reasons

What Is the Advantage of Investing Early for Retirement? 4 Reasons

Posted on March 21, 2024
Writer: James Miller

The benefits of saving early for retirement go beyond just having a larger nest egg; they include peace of mind and financial freedom in your later years. The importance of investing early lies in giving your money the greatest gift of all: time. Time to grow, time to compound, and time to secure a future you can look forward to.

For instance, starting your retirement savings in your 20s rather than your 30s could mean the difference between a nest egg worth over $1 million and one worth half that much, all due to the power of compound interest.

Ready to learn why it is important to plan early for your retirement? Keep reading to find out the four reasons why you should start saving for your future today.


Understanding Early Retirement Investment

The ideal starting point for retirement savings is at the onset of one’s career, preferably in the 20s.

Man opening retirement savings account online

The amount you’ll need to save can vary widely depending on your current age, intended retirement age, lifestyle expectations, and the cost of living in your desired retirement location. To estimate a good monthly retirement income, consider the following:

  • Aim for 70% to 80% of your pre-retirement income to maintain your lifestyle
  • Generate 25 times your annual retirement expenses
  • Save at least 15% of your income annually, including employer contributions
  • Factor in Social Security, but don’t rely on it entirely

But even before you invest your first dollar, you may be wondering, “What are the best retirement plans for young adults?” There are several retirement savings account options, each catering to different needs and financial strategies:

401(k)

A 401(k) is a retirement savings plan offered by employers that allows employees to save and invest a portion of their paycheck before taxes are taken out. Contributions are deducted from your salary before taxes, which can lower your taxable income. The funds grow tax-deferred until withdrawn in retirement.

Pros:

  • Often includes employer matching contributions, which can double your savings.
  • High contribution limits allow for significant retirement savings.
  • Automatic deductions make saving easy and consistent.

Cons:

  • Limited investment options, depending on the employer’s chosen plan.
  • Potential penalties and taxes for early withdrawal.

Traditional Individual Retirement Account (IRA)

An IRA is similar to a 401(k), but it is individually sponsored, meaning it is not provided through your employer. You contribute pre-tax dollars, which can reduce your taxable income, and the investment grows tax-deferred until retirement.

Pros:

  • Contributions may be tax-deductible, lowering taxable income.
  • A wide range of investment options you can choose from.
  • Can contribute regardless of participation in a 401(k).

Cons:

  • Contribution limits are lower than 401(k) plans.
  • Mandatory withdrawals, known as Required Minimum Distributions (RMDs), start at age 72.

Roth IRA

A Roth IRA is similar to a traditional IRA but with post-tax contributions, meaning withdrawals in retirement are tax-free. You contribute with after-tax dollars –  there’s no immediate tax deduction, the account grows tax-free, and withdrawals during retirement are not taxed.

Pros:

  • Tax-free growth and withdrawals in retirement.
  • No RMDs, allowing for greater flexibility.
  • Can withdraw contributions (but not earnings) at any time without penalty.

Cons:

  • Contributions are not tax-deductible.
  • Income limits may restrict high earners from contributing.

Precious Metals IRA

A precious metals IRA allows you to invest in physical precious metals, such as gold and silver, within a retirement account. It functions like a traditional IRA but is focused on investing in precious metals instead of stocks or bonds. Your taxes will also be similar to a traditional IRA, with taxes applied upon withdrawal.

Pros:

  • Offers diversification and a hedge against inflation.
  • Physical assets may appeal to those wary of financial systems.

Cons:

  • Storage and custodian fees.
  • Less liquidity compared to stocks and bonds.
  • Market volatility can affect value.

What Is the Advantage of Investing Early for Retirement?

If you’re just starting your career, you may ask yourself, “Why is it important to start making retirement plans early in life?”

Retirement jar full of coins next to clock

Investing early for retirement lays a foundation for financial stability and independence, offering several key benefits. It harnesses the growth potential of compound interest, protects against inflation, and builds a strong investment portfolio.

1.   Compound Interest: The Power of Time

Often referred to as the “eighth wonder of the world,” compound interest means that the money you earn from an investment starts earning more money on its own. This way, both your original amount of money and the interest it earns grow over time, making your total amount increase faster. This principle highlights one of the advantages of investing early for retirement because it allows your investments more time to compound, resulting in a larger sum by the time you retire.

For instance, let’s compare two individuals who invest $10,000 at an average annual interest rate of 7%, compounded annually. One starts at age 20, with 45 years until retirement, and the other starts at age 40, with 25 years.

For the 20-year-old:

  • Principal amount (P): $10,000
  • Annual interest rate (r): 7% or 0.07
  • Times compounded per year (n): 1 (compounded annually)
  • Time in years (t): 45

Future value calculation: A = 10000 * (1 + 0.07/1)1*45

Future value result: Approximately $210,024.52

For the 40-year-old:

  • Principal amount (P): $10,000
  • Annual interest rate (r): 7% or 0.07
  • Times compounded per year (n): 1 (compounded annually)
  • Time in years (t): 25

Future value calculation: A = 10000 * (1 + 0.07/1)1*25

Future value result: Approximately $54,274.33

As our hypothetical scenario demonstrates, investing in your 20s sets aside money for the future but also significantly increases the potential value of those funds.

2.   Reduced Financial Burden in Later Years

Starting your retirement savings early significantly eases your financial load as you approach your later years because it spreads savings over a longer period of time. Here’s how early retirement savings can help you reduce your financing burdens later:

  • Impact of Early, Small Contributions: Starting early enables small, regular savings to grow significantly through compound interest. This strategy eases the financial burden, eliminating the need for large, budget-straining contributions as retirement approaches.
  • Financial Planning Flexibility: Early investing offers the ability to adjust your savings strategy over time. As your income evolves, you can modify contribution levels, ensuring steady progress toward retirement without financial strain during lean periods.
  • Smooth Retirement Transition: Beginning your savings journey early reduces the stress of needing to aggressively save later in life.
  • Avoiding Last-Minute Pressures: Delaying retirement savings can lead to drastic lifestyle changes or falling short of retirement objectives. Starting early places you in a stronger position to enjoy a balanced approach to retirement preparation, free from urgent financial constraints.

3.   Benefits of a Diversified Investment Portfolio

By spreading investments across various asset classes, such as stocks, bonds, and tangible assets, investors can tap into the benefits of different market conditions.

Diversified investment portfolio analysis

Here’s how diversifying your retirement portfolio early benefits you:

  • Risk Management: Diversification aims to enhance returns by mixing investments that respond differently to the same economic events. This means that if one investment falters, another may thrive and stabilize the portfolio’s performance.
  • Exploring Diverse Opportunities: Early investors gain access to a wide range of investment options, enhancing their ability to make well-informed choices and seize growth across different sectors over time.
  • Stabilizing Returns: While individual investments may experience volatility, a diversified portfolio often yields more consistent overall returns, offering a smoother journey toward meeting retirement objectives.

4.   Tax Advantages and Retirement Accounts

Saving early for retirement isn’t just about putting money aside for the future; it’s also about making smart choices that can save you money on taxes. The tax advantages that come with using retirement accounts, like 401(k)s and IRAs are another one of the early investment benefits.

Many retirement accounts offer “tax-deferred growth.” This means you don’t have to pay taxes on the money you earn within these accounts until you withdraw it during retirement. Here’s why that’s great: since you’re not paying taxes on your investment gains each year, your money has more time to earn compound interest.

When you contribute to certain retirement accounts, like a traditional IRA or a 401(k), you can often deduct the amount you put in from your income when you do your taxes. In simpler terms, if you earn $50,000 a year and contribute $5,000 to your 401(k), you only have to pay taxes as if you earned $45,000. This can lead to paying less in taxes now while also building up your savings for later.

Roth IRAs work a bit differently. Instead of getting a tax deduction when you contribute, you pay taxes on your money as usual. But here’s the bonus: when you retire and start withdrawing from your Roth account, you don’t have to pay any taxes on the money you take out, including the earnings. This can be a huge advantage if you expect to be in a higher tax bracket when you retire or if tax rates go up in the future.

Thanks to compound interest, small amounts saved today can grow into significant sums over the years. The tax advantages of retirement accounts add to this growth, helping you save more efficiently.


When Should You Start Saving for Retirement?

While it may seem that young professionals never stop to think about retirement, the truth is that most people want to plan for it — they just aren’t sure when to start saving for it. The answer is simple. As explained previously, due to compound interest, the earlier you start saving for retirement, the more you will earn.


Final Thoughts on Early Investment Benefits

Beginning your retirement savings early offers a wealth of benefits, from leveraging compound interest to easing future financial burdens. It provides a head start in building a diversified portfolio, ensuring a smoother and more secure transition into retirement.

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