Key concepts and guidelines to retirement savings

Retirement Planning 101

by Gary Foreman

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Dear Dollar Stretcher,
I've seen a lot of advice for older people to plan for retirement, but not much for 20-somethings. I'm 23 years old, and I know that I have time on my side, but I'm at a loss as to how to start. I want to begin to put money away for retirement to take advantage of compound interest, but I also have more than $30,000 in student loan debt! I haven't graduated yet, and need to know how to start!
Tracie H.

Tracie is wise to begin taking control of her finances early. Let's see if we can't help her with a couple of key concepts and guidelines that she can use to begin saving for her retirement.

Probably the first question that Tracie needs to answer is should she begin investing before she's paid off all her student loan debts. And, whether it's credit card debt, a home mortgage or student loan debt, it's an important question to answer. Unfortunately, there's no one right answer for all situations. But, there is a way to find the best answer for your specific situation.

If you think about it, what Tracie is really asking is, "Where will I earn more on my money?" And that's a question that can be answered. Just compare the cost to borrow money with the expected growth of the investment. Paying off debt is really just like making an investment that pays the interest rate of the debt.

Let's look at an example. Suppose Tracie was being charged 7% for the money she borrowed on her student loans. And she was considering putting some savings into her money fund at 4%. Which would give her the better return? Paying off the loans.

In most cases you'll want to pay off debts first. But, there are some exceptions. For instance, suppose she gets a job that offers a 401k program. And her employer generously matches dollar for dollar the first 2% of her salary that she contributes. Well, in that case she has made 100% on that money before any investment return! So, unless Tracie's dealing with a loan shark, she'll get a better return on the 401k.

Related: Should I Stop Contributing to My 401k So I Can Pay Off Debt?

Each case will be different, but the rules are the same. To do a thorough job, you should consider the effect that taxes will have on both the debt and the investment. What you're really after is how many after-tax dollars you'll have in your pocket to spend.

Now let's take a look at where Tracie should start investing. The choices seem endless. But, for basic investing it's not necessary to have an MBA in finance. The first thing any new investor needs to do is to put away some emergency money. Typically that's an amount equal to about 3 months of your expenses. The money should be invested in something that's safe so that the money will be there if you need it. Savings or credit union accounts, money market funds and CD's are good choices. Remember that the return OF your investment is more important than the return ON your investment!

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Once an emergency fund has been accumulated, it's time to start looking at things that have more risk and reward. The easiest and safest way to participate in the stock and bond markets is to use no-load mutual funds. The funds offer a number of advantages for the small investor. First, you don't need to make a lot of decisions. You won't need to decide whether to buy this stock or sell that one. Professionals will do that for you. You don't need a lot of money to start. Most funds will let you begin with $500 or $1,000. And you can add in small increments. They're set up to work with people who want to put away $50 or $100 every month or so. And they pretty much do all the record keeping for you.

And, it's really not that hard to pick a fund. You'll find comparisons of the funds in a number of consumer and news magazines. Just look for a general fund that has done well for the last five or ten years. While it's hard to predict the future, a fund that has done well for many years is likely to continue to do well.

Finally, let's take a quick look at compounding. Tracie is right. Compounding makes a huge difference in your finances.

There's an easy way to quickly calculate the effects of compounding. It's called "The Rule of 72." One quick calculation will tell you how quick your money will double at a rate of interest. It's so easy that in many cases you can figure it in your head.

For instance, let's suppose the Tracie is able to save about $5 per week, or $250 in the next year. We'll also assume that she earns 6% interest on the money.

The rule of 72 will help Tracie quickly calculate how fast the money will double. Just divide 72 by the interest rate (in this case 6). The money will double in roughly 12 years. So if Tracie is 23 years old today, that $250 will be worth $500 when she's 35; $1,000 when she's 47; $2,000 when she's 59; etc. And that's if she never adds another penny to the account.

But, the opposite holds true, too. If that $30,000 school debt carries an 8% interest rate it will cause the debt to double every nine years (72 divided by 8). If for some reason she didn't make payments on the debt (admittedly an unusual situation), it would grow to $60,000 at age 32; $120,000 at age 41; $240,000 at age 50, etc.

It's better to begin saving for your retirement as soon as you can. In Tracie's example a dollar saved today is the same as saving $4 when she's 47. Usually it's easier to save one dollar now than to hope to be able to save $4 later. For most people, later never comes.

Another lesson is that compounding works with both big and small dollar amounts. Let's face it, some money-making opportunities are only available to the rich. But compound interest works fine with even the smallest accounts.

And that's the power of compounding. Whether you're a saver or a debtor, compounding will cause a balance to grow without you doing anything. A savings or investment account will continue to grow without you having to work up a sweat. But so, too, will a credit card balance.

So Tracie needs three tools to get started on a retirement savings plan. First, the ability to decide whether to pay off debt or begin investing. Next, knowing where to put her initial investments. And finally, an understanding of compound interest. Understanding and using those three tools will put Tracie on the right path and take her a long way to a successful financial future.

Gary Foreman

Gary Foreman is a former financial planner and purchasing manager who founded The Dollar website and newsletters in 1996. He's the author of How to Conquer Debt No Matter How Much You Have and he's been featured in MSN Money, Yahoo Finance, Fox Business, The Nightly Business Report, US News Money, and Gary shares his philosophy of money here. Gary is available for audio, video or print interviews. For more info see his media page.

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