Of all the steps a young person should take towards financial
health, the most important is to take advantage of retirement
accounts.
Why? The difference in starting to save for retirement at
age 19 and 28 is astonishing.
How big is the difference?
Retirement accounts such as 401(k)s and Roth IRAs are among
the smartest ways to invest your money because they combine
two of the most powerful principals of investing:
- Compounding interest
- Tax-deferred growth
Compounding Interest
Compounding is a cumulative "snowball" effect of
interest accumulating over time, both on your original investment
as well as the interest earned. Money compounding at a steady
rate of return grows not at a constant, but at an accelerated
rate. So the longer your money can compound, the more you
will enjoy the benefits.
Without compounding, $1,000 invested at 10% for 20 years
would grow to $3,000. This may sound fine, but if the same
investment compounds at 10% interest over 20 years, it would
grow to $6,730--almost 7 times the original investment.
Tax-Deferred Growth
With non-retirement investments, you have to pay capital
gains tax when you sell investments for more than their purchase
price. You also pay tax on any dividends recieved. In tax-deferred
retirement accounts, your money is allowed to grow tax-free,
so you only have to pay taxes when you withdraw funds from
your account (depending upon your level of income). Since
taxes don't take a bite while your money grows, the acceleration
of compounding is maximized.
Employer-sponsored 401(k) plans (if you work for a governmental
or non-profit organization, you have a 403(b) plan) are even
better retirement accounts because employers usually match
the contribution you make to your account (up to a certain
amount).
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