Please ensure Javascript is enabled for purposes of website accessibility

4 Crucial Retirement Savings Rules for Twentysomethings

By Matthew Frankel, CFP® – Updated Aug 1, 2018 at 2:52PM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

Want to build a big retirement nest egg? Here's how to do it.

I have few regrets in my life so far, but one of my biggest is failing to start saving and investing for retirement when I got my first job. In fact, I didn't get serious about saving for retirement until my 30s.

Your early working years are the most crucial time to develop strong retirement saving habits and to take advantage of the long-term compounding power you have. With that in mind, here are four retirement savings rules for twentysomethings that could help you get started on the path to a financially free retirement.

A group of young people smiling as they stand together outdoors.

Image Source: Getty Images.

Don't be afraid of the stock market

One common mistake that far too many younger investors make is avoiding the stock market. In fact, in a recent Bankrate survey, fewer than one-fourth of millennials said stocks are the best place to invest money that they won't need for a decade or more. The top choice? Thirty percent said cash is the best place to put savings.

To be fair, this view is understandable. Many of today's twentysomethings saw their parents lose tons of money during the financial crisis and view the stock market as more of a casino than a reliable investment vehicle.

It's true that stocks can be extremely volatile over short periods. Over the past 50 years, the S&P 500 index has risen by as much as 38% or fallen by as much as 37% in a single year. In fact, in 10 of the past 50 years, the S&P has moved more than 30% in either direction.

However, stocks are surprisingly predictable over longer periods. The market has historically returned an average of about 10% per year. There is simply no better passive long-term wealth creator. To put this return rate in perspective, let's say you're 25 and begin investing $5,000 per year in stocks. Assuming a long-term 10% annualized return, you could have $2.2 million by the time you're ready to retire at 65.

The takeaway: When you're young, nearly all of your investment assets should be in stocks. Slowly transition to bonds and cash investments over time as your time horizon gets shorter, but stocks are the best place to be in your 20s.

Know the best tax strategy for you

Without getting too deep into a discussion of IRAs, here's a primer on their tax treatment. There are two different types of individual retirement accounts, or IRAs, available to most people -- traditional and Roth. And the key difference is the tax benefits of each.

A traditional IRA is a tax-deferred account. That means qualified individuals get a current-year tax deduction for their contributions and don't pay any dividend or capital-gains taxes while their money is in the account, but eventual withdrawals will be treated as taxable income.

On the other hand, a Roth IRA is a tax-exempt account. You won't get a deduction for your contributions, but your eventual qualifying withdrawals from the account will be 100% tax-free.

Here's the point. Contributing to a traditional IRA makes the most sense if you're in a relatively high tax bracket now. Contributing to a Roth IRA makes the most sense if you're in a lower tax bracket now, as most people who are just getting started in their careers are.

It's also worth noting that many 401(k) plans offer a Roth contribution option, so you may be able to use some tax strategy with your employer-based retirement plan as well.

If you have a 401(k), take full advantage of your employer's match

To be fair, most Americans get this one right. However, about 20% of workers whose employers are willing to match some of their 401(k) contributions don't take full advantage.

Younger workers are especially susceptible, and here's why. While employer matching programs vary significantly, many match employer contributions of up to 4%-6% of total salary. However, more and more employers are auto-enrolling their workers in their plans. The problem is that the automatic contribution rate is often low -- just 2% or so.

Here's the rule. At a bare minimum, you should be contributing enough to your 401(k) to take full advantage of your employer's matching program. Not doing so is literally refusing free money. In other words, if you earn $50,000 and your employer will match contributions up to 5% of your salary ($2,500), but you contribute only 2% ($1,000), you're missing out on $1,500 each year.

Never, ever cash out a 401(k) early

Workers these days change jobs more frequently than in previous generations. So the issue of "what do I do with my old 401(k)?" comes up quite often.

There are several answers to this question, all of which can be smart ideas. You may be able to leave the money alone to grow in your old employer's plan. You might have the option to move the money into your new employer's retirement plan and keep everything in one place. Or you could roll the money into an IRA.

The only option you want to avoid at all costs is cashing out your old 401(k) when you leave a job. Doing so can hit your financial well-being now and later.

Let's say you just quit a job you've been working at for a few years and that you have $20,000 in your 401(k). If you're in the 22% tax bracket, you'll pay $4,400 in federal income taxes on top of the $2,000 you'll pay the IRS for withdrawing your retirement savings early. Just like that, your $20,000 becomes $15,600 -- and that's not including any state or local taxes.

On the other hand, if you leave that $20,000 in the 401(k) and it earns a historically conservative 7% annualized return, it could grow to more than $152,000 in 30 years. Would you rather have $152,000 when you're getting ready to retire, or about one-tenth of that amount today? Seems like a no-brainer to me.

Unless you're in desperate need of money, it's almost never a good idea to cash out any retirement savings early. Not only are you setting yourself up for a big tax hit, but you're also robbing from your future retirement security.

Follow these rules, and you'll be on the path to a secure retirement

To recap, the important retirement savings rules younger workers should follow are as follows:

  • Stocks are your friend -- they should be the largest asset class in your retirement portfolio.
  • Know the tax advantages available to you, and choose the best for your situation.
  • Take full advantage of your employer's matching contributions.
  • Never, ever cash out a 401(k).

If you stick to these four basic rules and save somewhat aggressively (at least 10% of your earnings), you'll be well on the way to the retirement of your dreams.

The Motley Fool has a disclosure policy.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.