How to Save For Retirement as a 20-Something

A Layman’s Philosophy

Thanks to Lily Pytel for input!

I’ve grouped several topics into three phases; I consider the earlier ones to be a higher priority, but your mileage may vary.

BIG CAVEAT: I am NOT a professional financial planner, nor have I ever worked with one personally. Take this advice at your own risk. I wrote this article to lay out a basic framework to get my friends started on their financial journeys, and since we like to talk about this subject at my office :)

Phase 1

Check Expenses

Track and categorize your expenses. Figure out which categories seem higher than you expected. Think about whether you can trim down certain categories without sacrificing quality of life too much. In particular, cut out monthly payments for stuff you don’t need. Think about whether you spend too much on food or entertainment. Get rid of any savings, checking, or credit card accounts with annual fees or poor terms. I like the free website Mint for this but feeling leery about giving them your banking passwords is understandable.

Create Emergency Fund

An emergency fund is like an insurance policy against random financial setbacks. It’s basically just a pile of money that you can use if you lose your job or have a large, unexpected expense such as a medical bill. Your emergency fund should cover 3–6 months of expenses, depending on your risk tolerance, your other available funds, and the amount of time you think finding a new job would take. Not having one could mean taking on a large pile of debt if something unfortunate happens, which could become an even larger financial setback than it already is.

Pay off debts

You should usually pay off your student loans, credit card debt, car payments, and other types of loans before you start saving for other stuff. This is basically because the debt will cost you more in the long run than you’ll be able to make up with profits on investments. There are sometimes exceptions to this, such as low-interest loans. Regardless, the first thing to do is check your debts and see what the interest rates are. If they are higher than 4 or 5%, paying them off sooner is a usually the savvy financial move. If you have a lot of credit card debt, do some research on debt consolidation options (though watch out for scams). You may be able to replace expensive debt with cheaper debt; you’ll still owe the same amount, but you’ll have a lower interest rate.

Phase 2

Invest in a 401K or IRA

Stocks, despite the risks, are the best way to grow money over a long period of time. However, because of capital gains taxes, you can do much better in a 401K or IRA than in, say, a normal ETRADE account. These types of accounts have huge tax benefits, but you can’t use the money in them until you retire (they exist because the government wants you to save for retirement).

Once you set up your 401K or IRA, you’ll need to decide how much money should be withdrawn from your paycheck automatically. How much is withdrawn is up to you, but you should put in as much as you can afford while still saving money for non-retirement purposes. You should also make sure your emergency fund is topped off and your expensive loans are paid off before you start shrinking your paychecks too much.

Once the money is actually in your account, you’ll need to decide what to invest in. Picking individual stocks is hard, and you should probably not do so at all. There are studies that suggest that most pros can’t even beat the market on average. You should set up your 401K or IRA to purchase broad-market, non-actively managed funds with low expense ratios. An expense ratio is the amount a fund charges you to invest with it. Despite the fact that this number is often hidden away on the brokerage’s website, it is probably the most important number to look at for a given fund. An actively managed mutual fund’s fees can be so high that you basically can’t make any money unless the market does well. A hands off exchange traded fund (ETF), on the other hand, will probably do just as well (if not better), and cost you a fraction of the amount. Look for cheap ETF’s such as SCHX with expense ratios less than 0.05% (SCHX has 0.03% as of this writing, compared to 1% or more for an actively managed mutual fund). It may not sound like a big difference, but it’s actually massive over longer periods of time.

A quick note on stocks: The stock market is volatile. It is not a place for short-term gambling, unless you are playing with a “fun” account and understand bankroll management (a poker gambling concept). When you buy stock, you should not expect it to go up in value right away. Assuming historic behavior continues, the market will eventually recover any time it goes through a downturn. However, you need to have the patience and financial flexibility to ride out, or preferably ignore, these inevitable storms.

Note that not all companies offer a 401K, but if yours does, you should take advantage of it. Some even match a certain contribution amount, e.g. the first 3% of your paycheck that you allocate. This is basically a free 3% raise, so if you do literally nothing else, please max this out! If your company does not offer a 401K, you can open an IRA account, which is a similar concept but has a lower annual max you can invest (about $5500 as of this writing). Many banks and brokerage firms offer these for free, though check the fine print. You’ll have to pay a commission when you buy stocks.

Plan for big purchases

Before you throw all of your savings into retirement, you need to at least be aware of your other financial goals. The reason for this is that 401K’s and (Roth) IRA’s make more money because of capital gains taxes, but you can’t use that money for other stuff, such as buying a house (note: it’s slightly more complicated than that, but this is the basic rule of thumb). If you’re the planning type, you can set a date for your other financial goals and then do a little math to figure out how much you need to save per month in order to get there. If not, just remember that you should probably split the amount you’re saving per month into two buckets: retirement and non-retirement savings, and only put the retirement savings into your retirement account(s).

Phase 3

Start a Personal Investment Account

As discussed before, you’ll probably want to save money for other things besides your retirement. In addition, if you’re saving a lot, you might even max out your 401K and/or IRA. Either way, you won’t want to let that money languish in a savings or checking account where it will lose value to inflation. Once you’ve topped off your emergency fund, you can start investing the rest. The same rules apply here as for 401K’s; you’re not doing this to get lucky and pick the right stocks. Again, you should buy low risk, low-fee, broad-market securities such as ETF’s. Just know that these accounts can still lose value due to stock market volatility, so don’t invest for the short term. And take into account that these accounts take a capital gains tax hit when you make money on them (though it’s only assessed when you withdraw that money).

Invest in a Roth IRA

If you don’t have a regular IRA because you have a 401K or have an IRA but will not max it out by end of year, there’s another good spot to invest extra income that you’re sure you want to use for retirement. The Roth IRA is like an IRA in that it has tax benefits and you can’t use the money until you retire. However, it has the benefit of allowing you to put in money whenever you want, rather than having it deducted it from a paycheck automatically. Unlike an IRA or 401K, since you already paid income tax on that money, there’s no tax removed when you withdraw it later in life (it’s worth noting that laws sometimes change over half a century, but hopefully not to our disadvantage). Roths are not necessarily better than a 401k or a regular IRA, but it’s useful if you realize that you didn’t put as much into your other retirement accounts as you could have. If you’re not positive you want to put this extra money away for retirement though, you may want to use a regular investment account so you can use it for other things like a house.

A final note: there is also a Roth 401K out there; I basically don’t know anything about these; I think your employer has to offer one. They’re not as common, but it may be worth investigating.