Table of Contents
If you're new to the world of stocks and bonds, just getting started can seem like a daunting task. Fortunately, that can be solved with the proper information and insights. Here are some important considerations to bear in mind as you learn how to invest in your 20s.
One of the crucial factors in achieving your investment goals is starting as soon as possible. While positive market returns are never guaranteed from year to year, investing early can help you grow your wealth over longer stretches of time. One reason why a head start is so important is the concept of compounding.
To illustrate this, imagine that a 25-year-old makes an initial investment of $10,000 in a mix of different securities. If the portfolio gains 5% during the first year, that investment will be worth $500 more than it was at the start, leaving a balance of $10,500. If the portfolio again returns 5% the next year, it will grow by a slightly larger amount, $525, even if the account holder makes no additional investments. That's because the market returns apply not only to the initial balance but to any earnings thereafter, too.
Consequently, compounding can potentially create a snowball effect where your assets have the opportunity to increase over time. Assuming a continual 5% growth, the account would increase in value by $2,058 in Year 30 alone, resulting in a balance of $43,219 from that initial investment. In reality, of course, the market doesn't perform consistently from one year to the next — some years can have negative returns — although the effects of compounding still apply over the long term. Investments cannot guarantee growth or sustainment of principal value; they may lose value over time. Past performance is not an indication of future results.
So, does investing early in your career matter? Well, picture this: Two workers each contribute $500 of after-tax money every month to their investment account, but one starts at age 25 and the other at age 35. Assuming there's a consistent 7% annual rate of return, the investor with the earlier start will end up with $1.2 million by the time they reach 65. However, the worker who starts at 35 will only have $570,571 by age 65. In reality, returns can fluctuate from year to year, and some years may have negative returns.
One of the big advantages of prioritizing investments in your 20s is that it becomes easier to reach your financial goals while contributing a manageable percentage of your salary. Investors who earn a similar wage but start in their 30s or later have to contribute more money in order to achieve the same balance at the same age. Our Retirement Calculator can help you determine what portion of your earnings you may need to invest now for your needs later in life.
While building your investment portfolio is important to your long-term financial health, you don't want to sacrifice your short-term needs in the process. You may need to reconsider how much you contribute to a retirement account if it comes at the expense of building an emergency fund that can cover three to six months' worth of expenses. Once you've established a source of funds that you can tap in a worst-case scenario, it can be easier to start focusing on your longer-range investment goals.
Build an Age-Appropriate Portfolio
Choosing individual securities or mutual funds typically involves a trade-off between risk and reward. High-grade bonds, including government bonds, can lose value in a bear market, although they have historically been more stable than stocks and stock-oriented mutual funds. However, though historical results are never guaranteed to repeat, past occurrences suggest that stocks may have a greater potential for long-term growth.
For those with a long-term investment horizon, experts generally recommend portfolios that are skewed toward stocks or equity funds, even for young workers saving for their retirement. Ultimately, your asset allocation depends on your specific risk tolerance and financial goals, so you may choose to consult with a financial professional about what makes the most sense for you.
Regardless of which asset classes you choose, diversification is a vital way to minimize downside risk if you're investing in your 20s. While a basket of securities can always decrease in value, investing across multiple asset classes tends to help reduce downside risk. Selecting mutual funds inherently provides some diversification, although a mix of different funds — including those consisting of large-cap and small-cap stocks and international stocks — can be a way to further lower your risk.
On the fixed-income side, you may also think about developing a blend of short-term and long-term bond and bond fund holdings in order to mitigate the potential effects of interest rate changes. Keep in mind, however, that diversification cannot guarantee profit or protection against loss in a declining market.
Investing Options to Consider
These are just a few considerations for those who want to understand how to invest in your 20s. If you're looking to build a strategy that meets your unique needs, you may want to speak with a financial professional who can take a closer look at your finances and help you create a plan tailored to your specific needs.
When figuring out how to invest in your 20s, one way to maximize your long-term returns is by using tax-advantaged accounts. Investors who have a 401(k) plan through their employer may want to start here — for several reasons.
One of the perks of a 401(k) is the opportunity to reduce the long-term tax impact on your investments. A traditional 401(k) allows you to deduct contributions, up to the annual IRS limit, from your taxable income for that year. The funds grow on a tax-deferred basis as long as they're held in the account, meaning you ordinarily don't pay any taxes until you withdraw funds after age 59½.
If your employer offers a "Roth" version of the 401(k), things essentially work in reverse. You invest after-tax dollars — that is, you can't deduct them in the year you make the contribution — but you typically incur no income taxes when you withdraw the funds after age 59½, provided that you held the account for at least five years.
Another advantage of 401(k) plans is that many employers offer matching funds up to a certain percent, which can help to boost your account balance. For example, a company might offer a 50% match on every dollar you contribute to the account, up to 6% of your salary. Because of compounding, every dollar you kick in during your 20s — whether from your own wages or from your employer's match — could have a greater impact than it would later in your career.
Individual Retirement Accounts (IRAs)
A 401(k) plan isn't the only tax-advantaged account to consider. Individuals with earned income are also eligible to invest in individual retirement accounts, or IRAs, which are available through many mutual fund companies, brokerage firms, insurance providers and banks.
One reason why young adults open an IRA is because they're not offered a 401(k) or similar employer-sponsored plan at work. A 2019 study by the American Retirement Association found that this scenario isn't uncommon, with more than 28 million full-time workers lacking access to a retirement plan through their employer. For those individuals, an IRA can be a way to achieve similar tax treatment outside the workplace.
Like 401(k)s and other workplace plans, contributions to a traditional IRA are tax-deductible up to allowable limits, and assets are tax-deferred until you reach age 59½. For 2021, tax filers under age 50 can contribute up to $6,000 in traditional and Roth IRAs. This amount is typically updated each year by the IRS.
IRAs may also be appealing to workers who have maxed out their 401(k) contributions for the year. To boost tax-deferred investments, employees under age 50 are allowed to put $19,500 into workplace plans in 2021. These accounts also offer greater investment flexibility compared with workplace plans, where you're typically limited to a menu of pre-selected mutual funds, exchange-traded funds and target-date funds.
Perhaps you've exceeded the contribution limits for tax-advantaged accounts or you need the ability to withdraw your money before you hit retirement age. For these and several other reasons, you may want to open an investment account through a brokerage house or other investment services firm.
You'll have to invest after-tax dollars and pay applicable taxes on any earnings you generate in the account, but you'll also have a lot more flexibility. You can access the funds almost any time you want, and you can purchase a wide range of different investments. Now, opening a brokerage account is possibly easier than it's ever been.
Even when investing through brokerage accounts, there are still ways to help minimize the amount you'll have to pay the IRS. For example, passive investments — such as index funds and ETFs — tend to buy and sell stocks less frequently. This typically results in fewer short-term capital gains, which are taxed at a higher rate than securities held for at least a year. Selecting funds with low management fees is another way to help keep more of what your investments earn over time.
Traditional vs. Roth Accounts
Both traditional and Roth 401(k)s, as well as IRAs, offer important tax advantages over other retirement vehicles. However, there are key differences between the two that are especially important for young investors.
With traditional retirement accounts, you enjoy the tax benefit on the front-end. Contributions are tax-deductible up to allowable limits, although the amount you withdraw after age 59½ is taxed as regular income. The opposite is true of Roth 401(k)s and IRAs; investments are made with after-tax dollars, and eligible withdrawals after age 59½ are not subject to federal tax. You won't owe any taxes on your gains in retirement as long as you meet certain requirements for a qualified withdrawal, including being at least 59½ and having held the account for five years. Distributions taken before you've held a Roth account for five years or longer will incur a 10% penalty fee and possibly additional taxes.
Determining which version will provide you the bigger tax benefit requires some consideration. If your tax rate is lower today than you anticipate it being in retirement, you may be better off taking the tax hit now by putting money into a Roth account. If you expect to be in a lower tax bracket in retirement — a scenario that depends on your career trajectory and future changes to tax law — a traditional retirement account will likely offer a bigger benefit.
Because workers in their 20s are typically not in their peak-earning years yet, many choose Roth IRAs or even Roth 401(k)s if they're offered by the employer. Often, plan sponsors may allow you to stake out a middle ground, allocating some of your contributions to a traditional account and some to a Roth.
Automate Your Savings
When it comes to making investment contributions, practicing consistency may help you reach your financial objectives faster. One of the easiest ways to do that may be by automating your contributions.
With 401(k)s and other employer-based retirement plans, automating your savings is fairly simple — most employers simply deduct a specific dollar amount or percentage of income from your paycheck. Even if you're investing outside of the workplace, you can set up automatic drafts from your bank account to ensure that funds are regularly being diverted toward your investment account.
If you're slightly behind in terms of your investment goals, you may want to consider making gradual increases in your contribution amount to help catch up. When deferrals are made automatically, it can be easier to avoid the temptation to use that money for short-term wants instead of long-term needs.