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Saving for retirement starting at a young age is crucial because it allows your money to grow over a longer period of time. If you believe that saving $10 here and $20 there is pointless, we’re here to show you that this isn’t the case. Every dollar saved matters, thanks to the compound interest that can be earned on your funds. This article will explain strategies to start saving for retirement, even with small amounts of money.
Strategies to Save for Retirement, Even On a Low Income
There are several low-cost retirement plans and ways that you can prepare for retirement, even if you are on a low income. These are the key things you can do to help your retirement planning today.
Start saving as early as possible
It is essential to start saving for retirement as early as possible, even in your teenage years. The sooner you start saving, the sooner you can earn compound interest on your savings and maximize your retirement savings. Therefore, the earlier you start, the more money your money can make.
Consider the example of saving just $20 per month in a high-yield savings account, earing 4% interest compounded daily. Saving this small amount each month starting at the age of 25 would give you $62,628.73 by the full retirement age of 67.
Budget wisely
The 50/30/20 rule is a budgeting tool to help allocate where your funds should be used. The rule states that 50% of your income should be utilized for essential needs like housing, energy, and groceries. You should use 30% of your income for other expenses and save 20% of your income.
To consider this budgeting strategy in action, take a post-tax income of $1,000 per month. If you cap your essential expenses (rent, utilities, groceries and transportation) at $600 per month, discretionary expenses such as dining out and shopping at $200, you can still put 20% of your monthly post-tax income, that is $200, directly into a savings account.
Saving $200 per month for just 10 years in a savings account yielding 4% interest compounded daily would yield over $28,600. Although that certainly won't cover all of your retirement expenses, it's a nice cushion to start with. Check out our free 50/30/20 calculator to start budgeting now.
Use your tax refunds to your advantage
Although it's tempting to cash in your tax refund for a pricey gadget or nice vacation, think again. Utilizing your tax refund to pay off high-interest debt, like credit card debt, can significantly reduce your interest payments in the long run. Instead of potentially getting into more debt using those funds for an impulse purchase, you can chip away at your debt and make way to save for retirement.
Say you have $2,000 in credit card debt with an APR of 24%. If you used your $2,000 tax refund to immediately pay that debt off, you wouldn't incur any additional interest charges, freeing up more funds for retirement saving. In contrast, if you let that same $2,000 keep piling up for five more years without making additional payments, the total debt amount would reach over $6,793.
See our Guide on Smart Ways to Use Your Tax Refund.
Automate your savings
This is an extremely important saving technique that many people often overlook. It is far easier to save money for retirement if you set up an automatic transfer over fixed periods. You don’t have to think about it, and seeing the weekly or monthly deduction becomes normal when reviewing your bank account. Even if you can only save a small amount, it’s incredible what saving that $20-$25 a month can do with interest compounded for several years. Automating that $20-25 monthly transfer is the best way to ensure that you keep saving this regular amount.
Start a 401(k)
A 401(k) is a retirement plan employers offer that allows you to contribute pre-tax income. Not only does this reduce your taxable income, but many employers also provide a matching contribution of between 4 and 6%. If this is the case, you should contribute as much to your 401(k) as possible, or you are leaving money on the table.
Say you contribute $500 per month to your 401K starting at the age of 24, with your employer matching your contribution at 5%. With an average annual investment return rate of 7% per year and an average salary growth rate at 3% per year, by the age of 67, you would have a 401K balance of $270,000 plus total investment growth, at minimum.
Open an IRA
If you’re wondering how to save for retirement without a 401(k), opening an Individual Retirement Account (IRA) is a tax-efficient strategy to save funds for retirement. Two types of IRA are available, both of which have advantages and disadvantages. Traditional IRAs have tax-deductible contributions, but any withdrawals you make during retirement are taxed. On the other hand, Roth IRAs have tax-free withdrawals but contributions after your income has been tasked. If you are on a lower income, a traditional IRA will likely be a better option.
Assess risky investments closely
Looking at other ways to save for retirement, many look to investment. Yet, if funds are scarce, you are better offer making small, sure contributions than risky investments. For example, some mutual funds may offer the promise of high returns, but such funds often come with high management fees. These fees will reduce your returns over time.
For example, you decide to place $10,000 in a series of mutual funds. The funds have a management fee of 2%. While that percentage may not seem high, after 10 years, you'd be sacrificing about $2,000 worth of your investment return in fees.
Ultimately, if you are able to implement any of these strategies, it will help in your quest to save for retirement while on a low income. Try to achieve more than one of the strategies to really get a head start. Remember that consistent, small contributions are hugely valuable, and the impact of compound interest really makes a huge difference.
The Power of Compound Interest for Retirement Savings
Understanding compound interest is perhaps the most crucial step in understanding why saving for retirement from an early age is so important. Compound interest allows you to earn interest on both the initial amount saved and the interest earned to date on the savings. The earlier you start saving, the more compound interest you will generate.
To illustrate just how much of an effect compound interest can have on your savings, we’ve highlighted some different scenarios. In both examples, we will start saving at the age of 18 and stop at the age of 67. What is most striking is the difference between if your interest compounds on a daily basis or a monthly basis.
Scenario 1: Saving $50 per month, starting at the age of 18
Imagine you invest $50 a month in a high-yield savings account offering a 4% interest rate, which compounds monthly.
To calculate the total amount you will have when you are 67, we use the following formula:
- $50 x ((1+0.04/12)^(49*12)-1)/(0.04/12)
This formula tells us that if you invest $50 a month, or $600 a year, for 49 years from the age of 18 at a 4% monthly compound interest rate, you will have just over $106,000 at the age of 67.
So what happens if you invest the same amount of money over the same time period, but interest is compounded daily, not monthly? Incredibly, your savings would then reach a whopping $156,250. This is why you should look for an interest-bearing account that compounds your interest on a daily basis.
So, what happens if you start saving $50 at 4% daily compound interest from the age of 23 instead of from the age of 18?
The impact of those lost five years of saving is enormous. If you start saving at 23, your total saved at 67 would be $105,500 –more than $50k less than if you’d have started saving at the age of 18. Ultimately, this highlights the power of saving early and the importance of compound interest.
Scenario 2: Investing in index funds, starting at the age of 18
Invest $50 a month in S&P index funds, averaging at a rate of 7%
The principal is the same as shown in scenario two, but this time we’ve invested in S&P funds which tend to have a higher rate of return. In scenario one, with annual interest compounded monthly at 4%, we return an amount of $106,000 at retirement. In the exact same scenario with a 7% return instead of 4%, the amount saved by retirement is over $350,000! Daily compounding further makes a difference, returning just under half a million dollars.
These scenarios really do show how saving just $50 a month from the age of 18 can hugely impact your life at retirement.
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Conclusion
The key takeaway from this article is that retirement planning is essential, and the earlier you can start, the more money you will save. The impact that compound interest has on your savings makes a huge difference, so try to find a saving mechanism that compounds interest on a daily basis and save little and regularly, starting today.
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Personal Finance
As an experienced content writer, Lauren's passion for the finance sector is only exceeded by her love of writing. With years of experience writing for financial websites, she has honed her expertise and developed a deep understanding of the industry. Lauren specializes in delivering top-quality, specialized content with an expert tone of voice and a unique flair, leveraging her extensive knowledge and expertise. In addition, she holds a First Class Bachelor's degree from Staffordshire University.
