Saving Your Way to the Good Life
Young investors stashing away a little cash can become rich through compounding.
Jan. 20, 2009 — -- When it comes to saving and investing, the greatest advantage one can have is time. The power of compounding works almost magically over decades. That's why a recent college graduate is thinking right even if she's not sure how to save.
Question: I'm 23 years old, graduated college this past May and have just started a new job. Even though my expenses are low (my car is paid for, my rent is cheap, I don't drink and I have minimal student loans) and I make good money ($40,000), I don't seem to have much breathing room when it comes to my finances, and I have no idea how to manage them. I know I need to save money, and I always did in college, but I don't seem to have hardly anything left over after paying bills. What are some money managing tips for those of us who are entering "the real world" for the first time and beginning to build credit?
- Marisa, Dover, Del.
Answer: Marisa, congratulations on completing your education and beginning your career. Despite your apparent difficulty saving money at this point in life, it sounds like you have exactly the right attitude. The fact you recognize the wisdom of setting aside money at a young age puts you ahead of many of your peers.
As to your question about how to save, the answer in some ways is quite simple: Put your savings on auto pilot.
By that I mean find a way to save automatically each time you get paid, whether it's weekly, biweekly or monthly. Arrange to have a set amount deducted from each paycheck and directed electronically into some type of savings or investment account. That way you don't need to think about it and the money is removed from your checking account before you find a reason to spend it.
I find that the strongest force in personal finance is inertia. Get started on the right path, and you will probably continue to head in that direction no matter what else happens in life.
In my view, the best place to start this savings routine would be through a retirement plan sponsored by your employer. Depending on the type of employer, you could be eligible to participate in one of several different kinds of plans: 401(k), 403(b), 457 or SIMPLE IRA.
They all work the same basic way: You're allowed to contribute up to a certain amount each pay period, and that amount is sheltered from taxation. The resulting tax savings is an instant return on investment. At your salary level, for every dollar you contribute, you would likely save 15 cents in federal taxes and possibly more in state or local taxes.
Your instant return on investment is even higher if your employer provides a matching contribution. This is "free money" nobody should turn down. A typical matching formula provides for a 50-cent employer contribution for every $1 the employee saves on the employee's first 6 percent of compensation.
At a $40,000 salary, that would mean the employer would contribute up to $1,200 if the employee set aside $2,400. The 15 percent savings in federal income taxes on your $2,400 contribution would amount to $360. That means a $2,400 contribution would generate a gain of $1,560 -- or 65 percent -- right away.
Tell me, where else these days do you think you will find a guaranteed 65 percent rate of return?
The employer match plus the tax savings means you'll get the most "bang for your buck" by saving in an employer-sponsored retirement plan. That's why if you find it tough to save, that's where I'd start saving, setting aside enough to capture the full employer match. Then, plan on increasing your contribution by 1 percentage point once a year, maybe at the time you would receive an annual raise.
Even if your employer does not provide a matching contribution, the tax savings and automated nature of retirement-plan savings make a 401(k) or other similar account a good place to start saving.
At the same time, I would also set up a bank savings account that is funded through direct deposit from your paycheck. Even if it's just $10 or $20 a week, you want to begin establishing a cash reserve that you can tap for major expenditures or emergencies. You need this type of fund to help avoid tapping retirement accounts and other long-term savings in times of need.
For this account, shop around for the most competitive interest rates. I like the idea of setting up this account with an online bank, which typically pays higher rates than a local bank. Also, there might be less temptation to tap an online account than a bank located just around the corner that you can walk into or tap with an ATM card.
Over time, increase how much goes into this cash account, just as you would with retirement savings. Better to start small, build some momentum and then add more.
Eventually, as you earn more money and feel more comfortable about your finances, I would look to establish a Roth IRA -- or if available through work -- contribute to a Roth 401(k) or Roth 403(b). You will pay taxes on money contributed to these types of account, but over the long haul, you'll likely come out ahead because no taxes will be due on withdrawals taken during retirement.
At 23, time is on your side. Take advantage of it.
This work is the opinion of the columnist and in no way reflects the opinion of ABC News.
David McPherson is founder and principal of Four Ponds Financial Planning in Falmouth, Mass. He previously worked as a financial writer and editor for The Providence Journal in Rhode Island. He is a member of the Garrett Planning Network, whose members provide financial advice to clients on an hourly, as-needed basis. Contact McPherson at david@fourpondsfinancial.com.