Image Courtesy 401kCalculator.org
Can a 20 year old invest for the future, even without a regular paycheck, a 401(k), and with only a tiny amount to begin? Yes, Absolutely!
Recently, a young member of my family gave me the following set of goals and asked for some advice:
Start saving now so I have funds in the future.
I know Social security might not be around when I need it so I thought saving now would be the best idea. Save money now and that money will grow in the future.
Wow. Honestly, the first reaction I have is intense jealousy that I didn’t have my act together like this when I was 20. I’d be retired already… twice!
So, obviously, she has her head on straight. I dug a little further and got the following information. She has earned around $3,100 so far this year, and is looking to invest $1,000 to start. She is a college student, and may earn more money this year, but it’s probably safe to say that it won’t be more than double the amount earned to date.
Our investor thinks she can be relatively tolerant to risk, but has never seen her investment values fluctuate wildly before, so she doesn’t really know for sure. She did ask me when she could access the money, which indicates some anxiety about having access to the funds.
Let’s use what we learned in the post about writing a investment policy statement to jot down a few goals. I’m taking a little license with the goals since our investor hasn’t got the experience to be completely sure about them.
Her goal is to invest for growth and achieve financial security. She wants to invest in an account type that gives her access to her investment in case of emergency.
Account Types Available to a 20 Year Old Investor
Since our investor doesn’t have regular employment, and thus doesn’t have benefits or a 401(k), that option is out. Various savings accounts are bonds are out, too, since our goal is growth or the money and those have terrible returns. This leaves two really good options.
The first is a Traditional IRA. This retirement account, which stands for Individual Retirement Account, allows you to save up to $5,500 a year without paying taxes on your contributions. As an example, let’s say our investor made $10,000 this year, and contributed $1,000 to a Traditional IRA. When it’s time to file her taxes, her bottom line income would be based on $9,000. The government pretends that she never even made the money she contributed, and only taxes her on $9,000. She might get a few hundred bucks extra back on her tax return. Now let’s flash forward to age 59.5, and assume the $1,000 investment is now worth $10,000. Our investor taxes the money out, and is taxed on that amount. The government is basically saying “We’re happy to not tax you on this small amount now, because we’ll get to tax you on a larger amount later.” Sneaky, huh?
In theory, the investor can’t access this money until she turns 59 and a half. I want to point out that it is possible to access your money in a Traditional IRA before 59.5 by using a few tax loopholes. Because I’m trying to keep the content simple, I’m not going to explain them here. I’ll cover them in a future post, but you can also Google “72(t) rule” and “Roth Conversion” to learn more.
The other good option available is the Roth IRA. A Roth IRA works a little bit like a Traditional IRA. You can still contribute up to $5,500 per year, but that’s where the similarities end. With a Roth IRA, you put money out of your own pocket in (which you’ve already paid the taxes on), and your growth is untaxed! Let’s use our same $10,000 income example. The investor puts $1,000 in a Roth IRA, and her income shows as $10,000 on her tax return. On this amount of income, the only risk is that the tax return might be lower by a few hundred dollars. Flash forward to age 59.5, and the investment is worth $10,000 again. Our investor takes it out and… and nothing. It’s all hers, without tax or penalty. In this case, the government is saying “We want you to invest, but we want you to pay taxes now, too, so we’ll let you keep the gains tax-free.”
Also relevant to our saver: You can withdraw contributions to a Roth IRA at any time. I’m hesitant to call this a positive, since my advice is to not treat your Roth IRA like a savings account that you can raid when you have an emergency. Better by far to act as though you can’t get at it so that this money grows and grows. There is one great reason to access your Roth IRA before 59.5: Early retirement. If my family member saves super aggressively and retires at 30, the Roth IRA is excellent because she can fund the first years of her retirement (until she hits 59.5) by using only the amounts she contributed, and never pay another cent in taxes!
Which to Choose?
Let’s recall that one of our investor’s goals is to have the flexibility to access the money at some point in the future. Though I’m hoping she won’t do so any time soon, this really leaves us with only one good solution for the stated goals: A Roth IRA. If she invests her $1,000 today and has a emergency tomorrow, she can take her $1,000 back out without any fees or penalties, other than the shame of seeing my judge-y, glowering face at Thanksgiving. Just kidding. Sort of.
In all seriousness, a Roth IRA is a great option for a young person. Someday she might be very successful and make “too much” money, at which point she couldn’t add any more money to her Roth IRA. In that case– early retirement or no– it’s great to cram as much money into a Roth while you’re able. If you add enough to them while young, they can grow huge, and all that money is free of taxation!
What to Invest In?
Conventional wisdom goes that the younger you are, the more aggressively you should invest, because time will smooth out market volatility. Basically, what this means is: In the short term, your investments may go down a little, up a little, but in general over the long run, they go up. Thanks to the power of compounding, starting young and aggressively means much bigger account balances over time.
It’s important to understand that when I say “invest aggressively,” I don’t mean “pick stocks.” What I mean is use an index fund with a large proportion of its holding in stocks. An index fund is a big bouquet of stocks, and sometimes bonds. It means that in each share of an index fund, you hold a teensy, tiny piece of the companies in that index. If you buy a US Total Market Index Fund, you own a little bit of Apple, and Tesla, and Exxon, and everyone else.
In this way, we’re impervious to the failure of a single company, or even many companies, because they’re just a small portion of our bouquet. Our investment will never disappear. No matter what, we will always hold as many shares of our index fund as we bought, and the value won’t become zero. One company goes out of business and is plucked out of our bouquet, and a new company goes public and is added. Mmm, fresh.
As I discussed in another post, if you bundle up all the years the stock market has existed, going back almost 130 years and including events like the Great Depression, and you look at their average returns, you get about 8% growth per year. This is what you can expect to gain on an stock index fund investment if you can just ignore it and let it grow!
Seriously! Leave it alone! Step away from the computer!
Where Should I Open an Account?
Vanguard. Next question.
Okay, okay, I’ll elaborate. Investment banks, by and large, operate funds run by evil Wall Street types designed to put your money in their wallet. One day, a man named Jack Bogle came along and started a company called Vanguard. Vanguard was special because it is investor owned. It doesn’t exist to make horns-and-tails broker-types rich, it exists to make you rich. Their management fees are many times lower than most competitors because they are only seeking to cover costs, not achieve profits.
So, Vanguard.
What Will $1,000 Buy?
Another small issue is the small starting amount. Many good, low-cost index funds have minimums of $3,000 or even $10,000. There’s one shining, perfect exception to this at Vanguard, though: Target Retirement Funds. These funds basically own a couple other funds, and you can open an account with $1,000. Basically, the further away the date of the retirement fund, the more aggressive the funds it holds. This means a Target 2060 fund will be made up mostly of stocks, and will grow much faster than the 2020 fund, which will hold many fewer stocks. The tradeoff is that the 2060 fund may swerve up and down on a daily basis more too. Over time, Vanguard slowly changes the holdings of these funds as the date gets closer, and they become more conservative. They make less money, but are less “scary,” too.
For a 20 year old investor, we should pick the furthest Target Retirement Fund possible for the best growth over the longest time: the Vanguard Target Retirement 2060 Fund (VTTSX).
How Much Will This Thing Grow, Anyway?
Let’s look at a couple scenarios: In the first, my relative puts $1,000 into her Roth IRA and ignores it, leaving it alone for 20 years. In the second, she adds $100 a month for 20 years.
In the first case, based on 8% expected returns, she could expect her investment to be worth about $4,950. In the second, she will have contributed $25,000 over the life of the investment. Her investment will be worth about $64,250. Not too shabby!
A great and easy investing book for young people is The Richest Man in Babylon (link is to a paper copy, but the book is public domain and can be downloaded here). It’s actually a very old book that is disguised as a book of fables “discovered” by a fictional archaeologist. It’s a fun, short read that makes the gradual action of a few dollars over time clear. A hundred years of rain will move a mountain– 20 years of $3.33 a day will make you a lot of money.
The Extreme Example
I’d be remiss if I didn’t mention what a 20 years can do if my relative can save 50% of what she makes from day one. Let’s assume she gets out of college and gets a job making $70,000 after tax, a distinct possibility in California. She contributes $2,916.66 per month for 20 years, with an 8% rate of return. How much does she have?
Answer: $1,735,197
TL;DR
Open a Roth IRA, pour the whole $1,000 into VTTSX, and make yourself a promise not to check the value for at least a year. Then make yourself a promise not to check the value for another year. Repeat as necessary. Decide every year what you can afford to put into the account each month, then do it before paying any other bill. Pay yourself first.
As always, it’s critically important to track portfolio growth and expenses. A great tool to do this is Personal Capital, which is completely free. You can create an account here, and I may (or may not) receive a referral payment to help support the site.