When discussing investments, the focus often lands on maximizing returns. Whether aiming for a 7 percent yield and striving for 8 percent, or reaching for higher figures like 9 percent, the pursuit of greater returns is commendable. However, amidst this pursuit, the fundamental key to wealth accumulation often gets overshadowed: saving diligently from the start.
It’s crucial to recognize that while individuals cannot fully control market fluctuations or associated costs like commissions and taxes, they do have agency over their saving habits. Evidence suggests that initial savings, rather than investment gains, play a pivotal role in long-term wealth accumulation.
Consider the following perspective:
Prioritizing increased savings can mitigate the impact of modest returns. By maximizing savings, one can alleviate the pressure to achieve the highest investment returns. In fact, a significant boost in savings can often outweigh the importance of a higher rate of return.
To illustrate this, let’s explore two scenarios:
In the first scenario, saving $5,000 annually over 30 years with a solid 10 percent annual return results in approximately $900,000.
In the second scenario, increasing annual savings to $8,000, despite averaging a slightly lower 8 percent annual return, leads to a total of around $978,000. This demonstrates how a relatively modest increase in annual savings, such as an additional $3,000 per year or $250 per month, can more than compensate for a 2 percent difference in return. Further elevating savings to $10,000 per year yields an end sum surpassing $1.2 million.
Increased savings can translate into more matching funds, especially if you participate in a 401(k) plan offered by your employer. Typically, such plans offer matching contributions from the company, often up to a certain percentage of your salary. For instance, your employer might match all contributions up to 5 percent of your salary, with some companies offering even more generous matches. Essentially, this constitutes free money, but you’ll only receive these matching funds if you contribute yourself.
According to Fidelity, approximately one in five 401(k) plan holders fail to contribute enough to maximize their potential matching funds. If you’re uncertain about how much to contribute to your 401(k), the optimal strategy is to contribute as much as you can, aiming to at least meet the maximum company match.
Increasing your savings can result in a larger tax benefit, particularly with traditional IRAs and 401(k) plans, where contributions are subtracted from your taxable income. For instance, if you earn $50,000 annually and contribute $5,000 to your 401(k), only $45,000 of your income is subject to taxation. Following current tax regulations, this translates to a $1,100 reduction in taxes compared to being taxed on the full $50,000.
Contribution limits for 401(k) plans stand at $18,500 per year, while traditional IRAs allow contributions of up to $5,500 annually. These contributions represent significant sums that can accumulate into substantial amounts over time, leading to substantial tax savings.
Regarding Roth IRAs, while it’s generally advisable to refrain from withdrawing funds before retirement, there are exceptions. In the event of a financial emergency, you’re permitted to withdraw your contributions without incurring penalties or taxes. Some financial advisers even suggest considering a Roth IRA as an emergency fund under dire circumstances.
However, withdrawing capital gains incurs taxation along with a 10 percent early withdrawal penalty. Consequently, if you haven’t contributed substantial amounts to your Roth IRA initially, your available funds for withdrawal may be limited.
