When it comes to saving for retirement, it's easy to put it off for another day -- a day when you'll have more money, fewer bills, and a greater willingness to save.
The problem is that those days are few, which is why it's so hard for most people to even begin saving. In fact, 46% of baby boomers nearing retirement age have nothing at all saved for retirement, according to a study from the Insured Retirement Institute.
One reason it's so difficult to start saving may be the fact that investing for retirement seems like a daunting task. The average retiree will need over $738,000 during retirement, and the idea of saving nearly three-quarters of a million dollars can be overwhelming.
Fortunately, it's easier than it seems thanks to the power of compound interest -- as long as you start early. The earlier you start saving, the more compound interest can work its magic, exponentially growing your savings. And as you'll see below, waiting even one year to start investing can set you back more than you might imagine.
Compound interest in action
Compound interest is essentially earning interest on your interest. As your savings grow, so do your returns. For example, if you invest $1,000 in a portfolio that gains 5% per year, then in the first year you'll gain $50, bringing the balance to $1,050. The next year, you'll gain 5% of $1,050, or $52.50. In year 10, you'll gain $78, which means your annual returns will have increased by 56% without any additional investment or work on your part.
Let's say you start saving at age 25 and contribute $200 per month, earning a 7% annual rate of return on your investments. If you continue saving at this rate, you'll have around $497,000 by the time you turn 65.
But if you were to start saving at age 26 and all other factors remained the same, your total savings by age 65 would drop to $462,000. In other words, the $2,400 you saved between age 25 and 26 could have turned into about $35,000 by the time you retired, thanks to compound interest.
The results are even more dramatic if you wait longer than a year to start saving. In this scenario, waiting until age 35 would have reduced your savings to $235,000 at age 65. Wait until 45, and you'd end up with just $102,000.
It's also increasingly challenging to catch up on your savings if you wait too long. When you're younger, time is on your side, which means compound interest is, too. But as time goes by, you can't simply contribute a little extra cash each month and expect to catch up.
For instance, say you want to retire at age 65 and have determined that you'll need around $750,000 saved to retire comfortably. Assuming your investments are earning an annual return of 7%, here's how much you'd have to save each month if you started saving at age 25, 35, and 45:
|Age||Monthly Contributions||Total Amount Saved|
By postponing saving for retirement until your mid-40s, you'd need to save nearly five times as much per month than you would if you'd started in your 20s.
How to take advantage of compound interest
To get compound interest working for you, start saving now. Even if you don't have much to contribute, small amounts can grow into big savings over time. And if you're already behind on your savings, you'll need to work harder to maximize your retirement contributions.
If your employer matches 401(k) contributions, contribute at least enough to get the full match. If you can, try to cut back in other areas of your budget to put more money toward your retirement. It's worth repeating that small contributions can add up quickly, so don't discount the power of a few extra dollars here and there.
For instance, say you're currently 45, you're earning $50,000 per year, you have $50,000 saved, and you're contributing $100 per month to your 401(k). Let's also assume your employer matches 100% on contributions of up to 3% of your salary, or $1,500 per year ($125 per month).
Right now, you're just $25 per month short of earning your full employer match. Here's what your savings would look like after 20 years if you continued saving $100 per month (plus $100 per month from your employer) or if you boosted your savings to $125 per month (plus $125 from your employer):
|Age||Contributing $200/Month||Contributing $250/Month|
In other words, saving an extra $25 per month to reach your full employer match could net you an additional $25,520 over 20 years.
There's no denying that saving for retirement is hard, no matter when you start investing. But starting earlier can make it much easier, because compound interest will do most of the work for you.