“Someone’s sitting in the shade today because someone planted a tree a long time ago” is one of the most famous pieces of financial advice from Warren Buffett. Out of fear for current conditions of the stock market or a misguided belief that small amounts do not make a difference, few people take Buffett’s advice as seriously as they should. Review why it is better to start saving right now, even at a small rate, rather than just trying to catch up later on in life.
Power of Interest Compounding
The present time is always the best time to start investing and saving. Saving $100 now is better than saving $1,000 in 10 years because you are able to earn interest on every one of those 10 years. Consider the following scenarios:
If you were to deposit $100 every year for 10 years in a high-yield savings account with a 1.05% annual interest rate, you would have $1,054.55 at the end of the 10-year period. Some high-yield savings accounts require no minimum deposit, have no monthly maintenance or annual fees, and provide a boost to your interest rate if you make no withdrawals and you make deposits each month for a number of consecutive months. Such features increase your total investment at the end of the 10-year period.
If you were to make the same series of deposits for 10 years in an investment account paying an annual return of 4.5%, you would have $1,258.57 at the end of the 10-year period. The higher the interest rate, the better the payoff of investing $100 every year.
However, it is still possible to do even better. The historical average annual return for the S&P 500, adjusted for inflation, is around 7%. If you were to invest $100 every year in an index fund that mirrors the S&P 500 through your retirement account, you would have $1,433.48 at the end of the 10-year period.
Effect of Inflation
Inflation is another reason why you need to start investing now. Measured in terms of the Consumer Price Index (CPI), inflation chips away at the actual value of your money. Every year, retailers, business owners and just about everybody else raises prices of goods and services to account for higher costs. For example, assuming 2% inflation, if you were to leave $1,000 in a checking account that gains no interest, your deposit would be worth $903.92 in five years and $817.07 in 10 years. To maximize your purchasing power in the future, you need to start investing now.
List of Benefits From Retirement Accounts
Investing in retirement accounts, including 401(k)s and traditional IRAs, allows you to boost your investment by deferring applicable income taxes until retirement, when you are more likely to be in a lower tax bracket.
By contributing to your retirement account on a pretax basis every year, you effectively reduce your taxable income. For example, if you were to contribute $100 out of your $2,000 bi-weekly paycheck to an employer-sponsored 401(k), you would only pay federal income taxes on $1,900. When you are close to the upper limit of your tax bracket, contributing to a retirement account prevents you from paying more taxes.
Another benefit of contributing to a retirement account now instead of in 10 years is you are taking advantage of your annual contribution limit. In 2015 and 2016, you could contribute up to $18,000, or $24,000 if age 50 and over, to your 401(k) plan each year. If you do not contribute at least $100 each year, that chance is gone forever. And so are the potential returns that could have accumulated until you retire.
The Bottom Line
It is better to start saving now, even at a small rate, than just trying to catch up later. Even an annual contribution of $100 to your savings account, investment account or retirement account improves your odds of reaching your investment goals.