I recently made a presentation to a group of parents, grandparents and young people from ages 16 to 25. The topic was essentially how to get a financial head start in life.
I was mostly talking to the parents and grandparents in the audience, but the young people certainly paid close attention, as they should have, because the whole idea was how their parents and grandparents might help those young people, and how they can help themselves.
I proposed what I called a radical idea, one that certainly can be very effective. Some people get ahead in life because of what they do when they’re young. And that absolutely applies to getting ahead financially.
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I laid out some numbers, which I will share with you shortly, showing the implications of saving money early. As it turns out, the first five years can make an overwhelming difference in the long run. We all know that saving money for the future is difficult for people in their early 20s. Yet those do save money in that time and set it aside for their retirement will be miles ahead in the long run. As we will see, it’s no exaggeration to say that what you do in the first five years of your 20s is a million-dollar decision. So here’s my radical idea: Find a way save $5,000 a year for five years, from age 21 through 25, and invest that money in something as simple as the S&P 500 index SPX, -0.11% then let it grow until you retire — presumably when you’re 65.
Based on more than 90 years of stock market history, I think it’s reasonable to expect that $25,000 you put in at the outset could be worth nearly $1.4 million by the time you are 65.
Sure, you could wait for five years and start making those annual investments when you’re 26 and it’s presumably more comfortable. But if you did that, you’d LOSE FOREVER the precious early years that can do so much for your retirement.
That’s the basic math, and the question remains: How can a young person do this?
After all, $5,000 is a great deal of money for somebody who’s still in school or just out of school, paying student loans, setting up a household, and just getting by.
Here’s where my radical idea comes in to the picture. When I presented this idea I was speaking directly to the parents and grandparents, who may be able to contribute to such an amazing long-term result. I told them to consider making a loan to their child or grandchild of $5,000 a year for five years. Here are the terms I would propose: Make this a real loan with an actual rate of interest, maybe 5%. Establish a payback agreement that starts five years after the first $5,000 advance was made.
Then let the young person pay this back over 20 years. That might seem like very long time, but remember the ultimate payoff is about $1.4 million. (And of course it could be considerably more than that with better investments or a good investment climate.) By my calculations, the 20-year annual repayment would be $2,217, which is a small burden for most adults in their 30s and 40s. I came up with the figure of $5,000 a year partly because it’s approximately what’s someone could put into an IRA every year, and partly because that number is easy to grasp.
And if this investment is made in a Roth IRA, the retirement payouts will be completely tax-free, at least under today’s tax laws.
Now think about what that payoff could be. Speaking about only this first $25,000 that was invested, assuming nothing more was added to this young person’s retirement at all, at age 65, the first year’s annual payout, assuming a 5% draw on $1.4 million, would be about $70,000.
I know that’s not enough to live on, particularly after inflation is taken into consideration.
But remember this $70,000 resulted from only $5,000 a year, and for only five years. Under this proposal, the young person doesn’t start making payments until age 26, and those payments — less than $200 a month — are extremely reasonable, considering the expected result.
I’m a parent, and also a grandparent, and I know that most of us may struggle to loan our kids or grandkids $25,000. And many young people don’t have anyone they can call on for such help. So what should they do? Well, here’s the deal:
Some people get ahead in life because of what they do when they are young. They know what their long-term goals are, and they are willing to give up immediate gratification to achieve those goals. So if you’re a young person and you don’t have someone who could easily loan you $25,000, don’t despair. If you want to get in on this $1.4 million gravy train, there are ways you can do it. You can take an extra part-time job for five years and put your earnings aside to do exactly what I am proposing.
If you do that, you won’t even have to make payments to your parents for 20 years. Once you have your $25,000 invested early, you can relax a little bit, knowing that time is on your side. Undoubtedly, in order to do this, you will have to give up some things your friends will be doing.
You might not be able to go on a cruise.
You might have to drive a used car instead of a new one.
You might have to skip your friend’s destination wedding in Italy.
But I promise you that life will not stop if you forgo some of those things. In fact, it’s very likely that when you’re 65, or even earlier, your friends will be struggling to just make it to retirement, when you have that extra $1.4 million in your account. It’s quite possible some of your friends will be thinking they will have to work another five or even 10 years just to catch up with you!
In the top of this article, I mentioned a $2 million bonanza. Here’s what could make that happen. If instead of putting the money into an IRA, you contributed $5,000 a year into a 401(k), you might be eligible for matching funds from your employer. If you got a 50% match on those five years of $5,000, that would boost your eventual nest egg from those five years to $2.1 million.
This is a pretty simple message, and it’s easy to understand. It’s an example of how people get ahead in life. Some young people will do this, but most people won’t. Now I have a question for you if you’re a young person: Which group will you be in?
Richard Buck contributed to this article.