Monday, February 21, 2005

Why Teenagers Should Read This Blog

When I was a child, I was really interested in time travel. My boyhood journal contains entries like:

Erik, if you're reading this in the future, if you have a time machine and some money, you can send it to me.

I was very interested in getting hooked up by my future self.

Well, now that I'm older, I know that traveling back in time is probably impossible. However, I also know something that never occurred to little Erik.

It was possible for him to hook me up.

How is that possible? What did little Erik have that big Erik doesn't?

Time. Time, as the song goes, was on his side.

If you're a teenager, it's on your side, too.

When you invest money, it earns interest. Once that money earns interest, the interest and the money start to earn interest. Then the money and the interest and the interest all earn interest together. This can snowball into bigger and bigger savings.

Let's say little five-year-old Erik had got his hands on $100. It would have been tough, but if he scraped together allowance, birthday money, Christmas money, maybe everything he got that year, he could have done it. And let's say instead of spending it, he put it away somewhere where it would earn 12% interest, compounded annually.

If that money was destined for me, 30 year old Erik, his $100 would have given me just shy of $2,000. Pretty generous of that little boy.

Of course, if the money didn't go to me, if it went to 65-year-old Erik, getting ready to retire, it wouldn't be $2,000. It would be worth over $100,000. All it cost him to do that was that $100. I don't even know what he really spent it on.

So what does this mean to you, the sixteen-year-old who's just starting his part time job? It means you have a huge advantage over me to give your future self that gift.

Guess how much it would cost you to become a millionaire? What could you do, right now, that would place a million dollars in a little box with a bow on it, labeled To: Me From: Me?

The answer is: $2,000 a year, for two years.

For $4,000, you can retire a millionaire.

Now I know what you're thinking. You're thinking, "That's a lot of money. I want a stereo. I want CDs. And I really want a car. When I'm older, I'll have more money for stuff like savings. I'll have lots of time to save for retirement later."

What you don't understand, though, is that time is what you're giving up if you wait. If you wait just a little, if you wait until you're twenty, you won't be able to do it in two years any more. You'll have to put in $2,000 a month for four years if you want to retire with a million dollars. Instead of costing you $4,000, it will cost you $8,000. Those four years cost you $4,000.

But hey, that's still not so bad. $8,000 to retire a millionaire? Maybe I can do it when I'm twenty, you say.

But you know what'll happen when you're twenty? You'll be going to college, and then starting a family, and then wanting a house. Pretty soon you're going to be thirty, like me, and you're going to finally get around to starting your investing.

Guess how many years I would have to save $2,000 a year if I wanted to have a million dollars when I retired? Ten? Fifteen?

Well, technically I could stop in twenty years, when I turned 50. But I would still have about a hundred thousand less than you'd end up with from your $4,000. In fact, I could put away $2,000 a year every year, from now until I retired, and I still wouldn't have as much money as if you invested as a teenager. I wouldn't even have as much as if I'd invested at 20, and stopped at 24. I would never catch up.

So who's the wisest?

The guy who does all three. The one who leaves himself a million dollar present as a teenager, leaves himself a million dollar present as a twenty-something, and then leaves himself another million dollar present from thirty on.

Now, if you're a particularly sharp teenager, you noticed a little something on that paycheck you got. You didn't get it all. The government gets a good share in taxes. So you're probably worried that when you save that million, the government's going to take a huge chunk of it away. Up until just a few years ago, you'd have been right.

But a few years ago, a guy named Roth came up with a tiny little change in the way Individual Retirement Accounts work. Instead of paying with pre-tax dollars, and then taxing retirees when they withdraw money, what if they pay with after-tax dollars, and the money grows tax-free?

In other words, there is a place you can put your money where the Government cannot tax it, where it will grow free, and every penny of it is yours when you're done.

It's called a Roth IRA, after that Roth guy, but you may call it your little patch of heaven. Because it's sheltered, the government limits the amount you can put in it, but don't worry. The limit is exactly $2,000 a year. And there's no age limit on when you can start contributing.

Even if you can't do the full $2,000 this year, do $1,000. If you do $1,000 a year in a Roth IRA, you'd only have to pay until you were 20--an extra $1,000--to hit the million. A $5,000 total cost.

The real point--beyond the security you'll be giving yourself--is that you'll learn something about your money. As you put it in that account and watch it grow, you'll be slower to give your money away for "stuff." I'm not saying you can't get some "stuff." Stuff's fun, and having fun is part of what teenagerhood is for. But there's this powerful ability you have right now to turn that one dollar into many, many more.

Because if you did it consistently, do you know how much you would have, if you invested $2,000 a year from age 16 until retirement in an IRA, earning around 12% interest in some good growth stock mutual funds?

Over 5.3 million dollars.

Wait two years. Go ahead. Start when you're 18. The number drops to 4.2 million.

Still sound okay? Sounds like you can wait?

Well if you wait any longer, say until after college, and start saving for retirement at 25, the number drops to 1.9 million.

Wait until you're thirty, like me, and you'll barely clear a million.

But please, don't put it off any longer than that. Do you know what the number drops to if you wait until you're 40? Take a guess.


Wait until you're fifty, and it's not even $100,000.

Time is money. That's not just an expression; that's the mathematical truth.

The little boy me eventually grew up to understand the laws of physics that prevented future me from shooting those dollars back to him, so he forgave me, I think. After all, it just wasn't possible.

But I wonder about future me, waiting there at the end of my career, knowing full well that I had it in my power to leave him a wonderful gift of security and peace of mind. I wonder about my wife's future self, who may have to be without me for a time, who also understands the power our younger selves had to launch this gift forward to them.

Will they forgive us, because they remember how pressing the purchases of today seemed to us? Or will the purchases she and I are making, the stuff we put on credit cards, the money we spent paying interest instead of earning it all be as inconsequential to them as the purchases little Erik made are to me?


theFrog said...

Actually, the Roth IRA contributions were raised to $3000 per year provided you fit the Roth income criteria and you don't contribute to a non-Roth IRA.

Also, if you file jointly on your tax return, non-income-generating spouses can contribute to a Roth as well.

Rebecca said...

Can you provide suggestions for where to go to yield 12% interest? I currently have a roth that I put very little in, but it only yields 4-6% or something. I'd like to get a better one, but I don't really feel like doing the research.

Erik said...

Frog--thanks! I actually knew that. That's what I get for always posting in the middle of the night. D'oh!

Becky-- Just about any "Growth stock" or "index" type mutual fund will average around 12% for 10-15 year periods. I was suprised to see that despite the market slump of the last few years, the 15 year average STILL comes out to almost exactly 12%.

If your current IRA is in bonds or notes, you'll want to change it over to a growth stock mutual fund (or a few different growth stock mutual funds, or some combination of growth stock and index funds) with a good 10-15 year track record.

If you're already in a mutual fund like that, consider this period the same way you would a sale at the store. Right now, your dollars are buying more stock than they would if the market was stronger.

Jarrod said...

The Roth IRA maximum contribution for 2005 is $4,000. ($4,500 for age 50 and over.)

Erik said...

This, I did not know.

Nor that Jarrod read this blog.

Both are pleasant bits of news.

Rebecca said...

I'm going through Modern Woodman of America. It's an insurance company, rather than a mutual fund. Any suggestions on a company?

Erik said...

I reccommend whatever group decides to be the first to accept my affiliate application.

But I also like the no-load Vanguard index funds.
Vanguard's a good company all around and you can get lots of free info from them on mutual funds and investing.

Rebecca said...

I think someone gave my some information on Vanguard a while back. I'll have to look into that when I unpack it! Thanks for the suggestion!