According to a recent Federal Reserve report, only 11% of adults between the ages of 18 and 29 invest in an IRA for their retirement. Sadly, more millennials (over 15%) keep retirement savings in a taxable brokerage account or (even worse) a bank savings account. And they aren't relying on their employers for help: Only 37% of this age group has a 401(k), 403(b), pension, or other employer-sponsored retirement plan.
If you're young, the greatest weapon in your investment arsenal is time. At this point in your life, delaying your financial planning for even a few years can put a huge dent in your retirement savings. Here's why it's so important to start investing now and to capitalize on the decades you have left before retirement.
The awesome power of compound returns
Let's say you start an account this year with $2,500 and you contribute an additional $2,500 every year until you retire. After 30 years, you will have contributed $75,000 to the account.
If your investments match the 9.5% annual return that the S&P 500 has averaged over the past two decades, how much do you think that account will be worth at the end of 30 years? $100,000? $200,000, maybe?
Actually, you would end up with more than $400,000. And if you let the account build for 40 years, you'd have more than $1 million -- by saving just $2,500 per year. That's why it's so important to start saving and investing your money while you have decades to work with.
"Compound returns" are the exponential gains your portfolio experiences as it grows; the more money you have in the account, the faster it grows. Look at how this hypothetical account would grow over time:
Now, imagine if you were able to save even more -- say, $5,000 per year. It's pretty easy to see how beginning early could lead to financial freedom down the road.
How to get started
One thing that I didn't mention in the above example is taxes, which can eat into your investment returns. Fortunately, there are accounts specifically designed for retirement savings, called Individual Retirement Arrangements, or IRAs, that let your money compound tax-free (or tax-deferred).
IRAs come in two main varieties: traditional and Roth. The basic difference is when your contributions are taxed. With a traditional IRA, your contribution might be tax-deductible (depending on your income), but your withdrawals will be considered as income and will be subject to taxation.
Roth IRAs, on the other hand, don't allow you to deduct your contributions, but all of your withdrawals in retirement will be tax-free. With a Roth account, you can also withdraw your original contributions at any time, which makes them a great choice for people who don't want all of their money tied up until retirement. However, you will need to meet certain income requirements to open a Roth IRA.
With both accounts, your investments are allowed to grow and compound without being taxed, so you won't have to pay taxes on dividends and profits from the sale of your investments each year. You can contribute a maximum of $5,500 per year ($6,500 after you turn 50), which, as we have seen, can grow nicely over time.
Open your IRA today
Most major brokerages will let you open an IRA with no minimum deposit required. In other words, if you can only spare $50 right now, you can start saving and investing for your retirement. Then, the next time you get paid, put in a little more, and keep upping your contribution as much as possible.
When it comes to investments, keep it simple, especially when you're just starting. Index funds are a great way to invest without the guesswork involved in picking stocks. Basically, these allow you to spread your money across a broad group of stocks, instantly granting you diversification and thereby lowering your risk of major losses.
For example, the SPDR S&P 500 ETF (NYSEMKT:SPY) invests in the 500 companies that make up the S&P 500 index and mirrors the index's returns. A financial-sector index fund such as the Financial Select Sector SPDR Fund (NYSEMKT:XLF) invests in banks, insurance companies, and other related stocks. For a more thorough discussion of index funds, read this article.
You don't need a lot of money -- just time and patience
As you can see by the chart above, with a smart investment strategy, a relatively small amount of money can become a large amount of money over time.
So stop making excuses like "I don't have enough money to invest," or "I'll start saving for retirement in a few years." Start now -- you'll be glad you did.
Matthew Frankel has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.