Retirement Planning in Your 20s (& Beyond), Part 4: Riding Compound Interest to the Finish Line

So you've estimated the big number you need for retirement and it's freaking you out. Well, if you're in your 20s, you're in luck. We can take advantage of the wonders of compounding interest, so our goals aren't as insurmountable as they seem. (Well, obviously, everyone gets to take advantage of compound interest, but the younger you are, the more it pays off.)

Just think about it. In Part 3, I mentioned the Rule of 72-- take 72, divide it by your interest rate/predicted returns/etc, and you get the number of years it takes your money to double. So, if we assume 8% returns, your money will double every 9 years (72 / 8 = 9). If you have $1,000 today, you'll have $2,000 in 9 years, $4,000 in 18 years, $8,000 in 27 years, $16,000 in 36 years, and $32,000 in 45 years. See the benefits of starting early? Your savings can be half as much as the person 9 years older than you or one-quarter as much as the person 18 years older than you, and if returns are consistent you'll have the same amount at the same retirement age. This is why it pays off so much more to save when you're young than when you're older-- think about that when you're making your savings decisions in your 20s!

I'm basing my calculations on a retirement age of 68, in the year 2050, which is 44 years away. For curiosity's sake, how much would I need in savings today to end up with the $1.6 million I've projected I need? Well, my money ought to double nearly 5 times, so by my math, I'd need a little more than $50,000.

$50,000. Doesn't that sound a lot more manageable than $1.6 million?

Of course, I don't have $50,000 now, and I won't have it anytime soon. I have about $14,000. So how about another easy number-- 36 years out from retirement, enough time for my savings to double four times with 8% returns. For me, that's 2014, eight years from now, at age 32. If I end up with $100,000 by then, and my other assumptions hold up, I could theoretically leave my money to compound, never save another dollar for retirement, and still reach my goals. I'd have $100,000 in 2014, $200,000 in 2023, $400,000 in 2032, $800,000 in 2041, and $1,600,000 in 2050. (Isn't that exciting to watch?!)

(Important disclaimer: don't forget about taxes! The $100K I need by age 32 is the after-tax equivalent. The amount in Roth IRAs is fair game, but anything tax deferred is going to shrink when it's withdrawn. So if you have a certain amount in a tax-deferred account like a 401(k) or a traditional IRA, you'll need to account for taxes. For example, I'll reduce my tax-deferred savings by, say, 33%. The state of taxes decades in the future is yet another of those hard-to-predict things, but I think 33% is a pretty fair estimate. So, for example, I should think of the $4,500 in my 401(k) as equivalent to $3,000; if you add the $9,500 in my Roth IRA, that makes $12,500. The $14,000 number that I use in my net worth calculations-- the sum of the account balances-- isn't the right one to use for this discussion.)

I think I am going to try hard to reach that $100,000 goal by age 32. It's ambitious, like all good goals are, but also realistically acheivable. Then everything I save for retirement after that time would be pure gravy (well, also insurance against all of the ways my assumptions could be wrong, but that's a given). I like that thought a lot.

You can come up with a similar goal. Just fiddle around with the Rule of 72 until you come up with a goal you think works for you. You could assume 8% returns like me, but set a goal of 1/8 of your retirement "number" to be reached 27 years ahead of retirement (instead of my 1/16, to be reached 36 years ahead of time). You could assume 9% returns, and set your short-term goal at 1/16 of your retirement goal, 32 years before your retirement date (doubling four times, once every 8 years). You could assume 7% returns (so your money doubles every 10.29 years) and look to reach 1/8 of your retirement goal 31 years before retirement. See how flexible it is?

So, there we are. I've estimated my annual retirement expenses in Part 1, thought through Social Security in Part 2, calculated my needed savings in Part 3, and now I've come up with a plan to reach that total with time to spare. I have a goal-- to save $100,000 for retirement by 2014-- and the confidence that if I do so I have a reasonable chance of reaching my retirement goals without significant additional savings after that point. I'm sure I will continue to save past 2014, but this goal also opens things up for me to imagine more flexible ways of working and living in my 30s, 40s, and 50s which focus on the present without worrying so much about the future. I've enjoyed this process, and I hope you have too.

How about you? Do you have a short-term goal for your retirement savings? Do your calculations assume you'll contribute a set dollar amount (or percent of income) up until the day you retire, or do you hope to reach what you need early so the rest is just gravy? Or do you just plan to retire as soon as you've hit the number that'll carry you through?