Even if $1 million isn't quite enough to fund your dream retirement, saving that amount of money is still a significant achievement. For many investors, successfully building a million-dollar portfolio is a huge psychological milestone and a great sign they're doing everything right.
However, your first million may be more attainable than you think. Even if you don't have a six-figure salary and aren't the savviest investor, there are a few strategies you can use to get your portfolio into the seven-figure range.
Avoid taxes (legally, of course)
One advantage savers have is the ability to defer taxes on their savings, allowing any investment returns to compound tax-free until the time comes to withdraw the money.
The most well-known example of a tax-deferred savings plan is the 401(k) plan, which is offered by many employers. Basically, no taxes are taken out of your contributions, and you don't pay annual taxes on your investment gains. And a lot of employers match a certain amount of their employees' contributions -- a benefit you should take full advantage of.
In addition to a 401(k) or similar employer-sponsored retirement plan, motivated savers can contribute to an IRA, which is a tax-advantaged investment account designed to save for retirement.
IRAs come in two main varieties: traditional and Roth. Both accounts allow you to contribute up to $5,500 for the 2014 tax year ($6,500 if you're over 50), and both require you to wait until at least 59-1/2 years of age before you begin withdrawing your investment returns without paying a penalty. And both accounts allow your money to compound tax-free year after year.
The main difference between the two account types is when the tax benefit occurs. Traditional IRA contributions are tax-deductible (depending on your income), but withdrawals are taxed as income once you begin taking distributions. With Roth IRAs, on the other hand, your contributions are not tax-deductible, but your eventual withdrawals will be completely tax-free. While you should consult a financial professional to find out which might be better for you, both offer incredibly valuable tax benefits.
If you're unsure of what to buy, you can just invest in everything
OK, so you've maxed out your 401(k) match and set aside some money in an IRA. But what should you invest in to take advantage of the full effects of compounding? If you're unfamiliar with investing, or you don't want to choose your own stocks, this can be the hardest part.
One good option is to simply buy shares of some ETFs (exchange-traded funds), especially that track the major indexes like the S&P 500 or the Russell 2000. So, if the market goes up, your investments make money. You'll also get some income from these, as the dividends paid by the individual companies in the index are passed through to you.
For example, the biggest S&P 500 ETF, the SPDR S&P 500 (SPY -0.21%), invests in all 500 of the companies in the index, on a weighted basis. The fund currently pays a dividend yield of 1.85%, and you'll also benefit from any price appreciation of the index.
Other funds invest in particular sectors of the market, such as tech or healthcare. My article about investing in these funds should help you get started.
Compound interest: the saver's best friend
The No. 1 weapon you have as an investor is time, because time allows you to harness the awesome power of compound interest. Do you know any elderly people who have amassed millions, even though they never had high-paying jobs? This is likely how they got there.
Let's say you open an IRA at the age of 25 and save the maximum allowed each year -- i.e., $5,500 per year until we reach age 50 and then $6,500 every year thereafter. That's a total contribution of $236,000 by the time you reach age 65. And those contribution limits are in fact likely to increase over time to keep up with inflation.
If you put that money into stocks or funds, your money could grow tremendously over time. As you can see from the graphic below, the returns may not be huge at first, but over time they can be staggering. Over the past two decades, the S&P 500 has averaged total returns of about 9.3%, so if you were to achieve similar results, you'd have a portfolio worth more than $2 million by the time you reached age 65. And you'd cross the million-dollar mark while you were still in your fifties. That's why it's so important to start as early as possible and let your gains compound.
The Effect of Compounding Your Investment Returns | Create Infographics.
If your goal is to be a millionaire in 30 years, you would need to begin setting aside about $670 per month in your IRA or 401(k). If you want to accelerate the process, monthly contributions of about $1,085 should get you to a million in 25 years.
And if you have a long time frame to work with, it can be much easier. By setting aside just $270 per month (about $9 per day), you could end up with $1 million in 40 years.
It could be easier than you think to get to a million
So long as you develop good saving and investing habits, getting your portfolio into the seven-figure range could happen quicker and easier than you may think. If you were to average 9% total returns on your investments every year -- which is actually below the S&P 500's 20-year average of about 9.3% -- you might be surprised by how little you need to set aside.
When it comes to investing, consistent, modest gains are the most certain way to wealth there is, so stay the course and you'll thank yourself in the end.
