If you are in your 20’s then you have the full advantage of time – use it and you will reap the benefits of an early investment
Time Is of The Essence
There are many sensational stories of investors who made it out big with short-term stock market gains, but this is more akin to gambling with your money and should not form the basis of your investment strategy.
Instead, the focus should be on time. Time is the essential factor in safe, long-term investments, and you need to make sure to keep it on your side and make it work for you.
Let’s say you invested $2000 at the age of 25 at an annual rate of return of 8% and then forget about it until you’re 65 years old – you will be surprised to learn that you have a little less than $44,000 in your account.
In an alternative scenario, you decided to wait to make the same investment until the age of 35. Now when you go to make that withdrawal at the age of 65, you’ll only have around $20,000.
You invested the same amount, and you showed great patience, but in the former instance you took action faster and were awarded for that action by an additional $24,000.
This is an example of the compounding interest formula at work and why taking action sooner than later can be a fantastic leverage point in generating extra dollars in the long run. Now let’s look at three investment options you can start with right away.
Investment Strategy #1: 401(K)
If you are working for a company that offers a 401(k) package, you should take advantage. The 401(k) allows employees to contribute a part of their earnings in a tax-deferred account from which they can withdraw income without a 10% penalty after the age of 59 1/2. Most employers match the employee’s dollar contributions up to a certain percentage or dollar value.
For example, a company may have a 401(k) plan to match the employee’s dollar contributions up to $500. So if the associate contributes $500 to her 401(k), the company will supplement the account with an additional $500, thus making the total contribution $1000.
There is an annual set limit of the contributions that can be made to this account by the federal government – as of 2018; the total yearly deposit as of 2018 is $18,500.
Here are three benefits of a 401(K) plan aside from the company match policy
- The portion of the income contributed to the account is on a pretax basis and so is not subject to federal and state income tax, therefore lowering the income tax liability
- All interest earnings over the length of the investment period are tax-deferred until a withdrawal after the age of 59 1/2. Because most individuals fall into a lower tax bracket
- Can also deposit a portion of your earnings into an IRA account to reduce income tax liability even further and enjoy a higher tax advantage in the long run
Investment Strategy #2: IRA
An Individual Retirement Account (IRA) allows individuals who may not have the option to participate in a 401(k) package to also be able to contribute a portion of their earnings for retirement. The tax advantages of an IRA come into play in the two different types of IRA that we are going to discuss:
The traditional IRA allows individuals to deposit their earnings without having to pay taxes at the potentially higher tax bracket during the peak of their earning years. After retirement, most individuals move to a lower income tax bracket thereby paying a lower tax rate on their withdrawals after the age of 59 ½ years.
Here are the three advantages of a Traditional IRA account
- Lower tax liability – withdrawals after retirement places most individuals in a lower income tax bracket thereby allowing them to pay a lesser tax amount over time
- Contributions made to the account can be deducted from the annual federal and state income tax return
- No yearly income limits – single earners can contribute to a traditional IRA account even if they make more than $120,000-$135,000 annually
The Roth IRA differs from the traditional IRA in that deposits are made with post-tax dollars. In the short term, your income tax would be higher, but the advantage is that all interest earnings cannot be taxed thereby shielding your money from future tax hikes as would be the case with the 401(k) and the traditional IRA.
Here are the three advantages of a Roth IRA
- Principal deposits can be withdrawn anytime without a penalty
- All interest earnings in the account are tax-free and can be withdrawn without penalty after the age of 59 ½ years.
- The money from this account can be withdrawn for qualified first-time home purchase without any tax penalty on the earned interest income
Learn more about the Roth IRA Here