by Maurie Backman / Motley Fool
Many of us push ourselves to sock away as much money for retirement as we can, but there comes a point where we cut ourselves a little slack. After all, just because it’s possible to eke out a little extra savings here and there doesn’t mean we’re ready to sacrifice all of life’s luxuries in hopes of saving enough money for the perfect retirement down the line.
That said, if we all allocated just 1% more of our income to retirement savings now, we’d all be in a much better position down the line.
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It’s all about compounding
Compounding is basically a way of earning interest on interest. When you invest money, be it in stocks, bonds, or a savings account, if all goes well, you make some money on whatever amount you initially put in. When that happens, you can then invest your profits again, kicking off a virtuous (and lucrative) cycle of accelerating gains.
What does compounding have to do with retirement? It’s simple: The earlier you start putting money into a 401(k) or IRA, the more time you get to take advantage of compounding. Similarly, the more money you contribute up front, the more you stand to earn on that money.
Up your contribution early on
Putting any amount of money into a 401(k) or IRA is a good start, but the more you can contribute early on, the better. Say you’re 30 years old, earn $60,000 a year, and currently contribute 5% of your salary, or $3,000, to a 401(k). Let’s also assume that you intend to continue contributing 5% of your salary for the remainder of your career, and your salary increases 3% each year. If your 401(k) generates a 6% return (which is actually well below the stock market’s average) then you’ll have about $502,000 saved up by age 65 — certainly a respectable balance. But let’s say you find a way to contribute 6% of your salary each year instead of just 5%. Using our same assumptions, by age 65, you’ll have a balance of $602,000 — $100,000 more than what a 5% contribution would’ve made you.
Let’s look at what that extra 1% means for you today. Based on a $60,000 salary, that’s $600 less per year to spend on living expenses. While that may seem like a lot at first glance, we’re really only talking about $50 a month, which you can easily compensate for by packing your own lunch a few days a week instead of dining out, or by clipping supermarket coupons to lower your grocery bills.
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Now let’s say you’re at a point in life where you’re making more money, but retirement is looming. If you’re 55, earn $150,000 a year, get an annual salary increase of 3%, save 6% of your salary, and earn a 6% return, then you’ll have $138,000 by age 65. On the other hand, if you save 7% of your earnings instead of just 6%, you’ll accumulate $161,000, or an extra $23,000, over the course of 10 years — a nice boost to your retirement savings, but not nearly as significant as the $100,000 difference we saw earlier.
The bottom line is this: Maxing out your savings early on in your career can make a huge difference by the time you reach retirement, and trust me: Squeezing an extra 1% of your income won’t be a major lifestyle-buster. But the longer you wait to start saving that extra bit, the less of an opportunity you’ll get to capitalize on the beauty of compounding. So the next time you reach for the phone to order delivery, think about what that money could be doing for you instead. Then go into your freezer, bust out some leftovers, and imagine your retirement fund growing by the minute.