Committing to an investment plan early in life will lead to a much more prosperous future. But the question is, how much of your current income should you be investing if you want to retire and become financially free at an earlier age?
There are rules of thumb for this sort of thing, but the real answer is that the amount will depend entirely on your personal preferences. If you’re willing to make sacrifices in the present to benefit your future, you’re going to invest a higher percentage of your salary. On the other hand, there’s nothing wrong with living in the moment and enjoying the time you have right now. In this case, you still want to prepare for the future, but maybe you aren’t willing to sacrifice as much of your current salary.
Investing Rule of Thumb
If you want the quick answer, most financial advisors will suggest investing 10 to 15 percent of your salary. If you earn a gross income of $50,000, you’re bringing home around $40,000 after taxes, depending on which state you live in. With 10 to 15 percent as a baseline, you’re looking at investing anywhere from $4,000 to $6,000 each year. That means you should be saving around $300 to $500 per month to fund your portfolio.
Contribute to an IRA
The simplest way to invest $4,000 to $6,000 per year is by contributing to an IRA plan. The maximum amount you can contribute to an IRA in 2020 is $6,000 or $7,000 if you’re over 50-years-old. You always want to contribute the maximum amount that you can to your IRA because this becomes tax-free income if you wait long enough on a Roth IRA, or it becomes tax deductible each year on a traditional IRA.
A Roth IRA makes more sense if you believe you’ll be in a higher tax bracket during retirement. If you’re currently in a 25 percent tax bracket and contribute $6,000 to a conventional IRA, you can save $1,500 on your federal taxes that year. But if you’re in a 33 percent tax bracket when you retire, you’ll have to pay $1,980 in taxes for every $6,000 you withdraw.
If you think you’ll be in a higher tax bracket when you retire, there is no reason to select a conventional IRA over a Roth. The Roth IRA also helps by deferring your savings. With a traditional IRA, you may not end up setting aside the money you saved on your taxes in a savings account. But when you withdraw from your Roth IRA, the income is entirely tax-free, and you’ve deferred that money until when you need it the most.
Don’t Forget your 401(k)
If you have a 401(k) through work, don’t forget to tally up whatever percentage of your paycheck is being deducted. If you’re contributing five percent of your paycheck, you may only want to invest an additional five to ten percent of your salary. Or, if you’d rather simplify your investing altogether, you can go ahead and contribute a more significant percentage of your salary to your 401(k). If your employer has a 401(k)-match policy, at the very least, you should be contributing as much as your employer is willing to match.
Why are you Investing?
When coming up with the proper amount of money to invest, you have to think about why you’re investing in the first place. Are you investing for the long run, or are you looking to make a profit and cash out? Are you single and looking for a nest egg to live off in retirement? In this case, you’re saving for the long haul and only need to worry about having enough money to have a happy retirement.
But if you’re trying to save enough to pay for your kid’s college tuition, that’s another story. In this case, you’ll likely need the money sooner than if you’re saving primarily for retirement. You will need to figure out how many years you have until your kids are college-aged, and then calculate what your likely return will be from your portfolio of investments.
A strong portfolio may return ten percent a year, but you can’t count on that every year. A reasonable rate most people use to project investment returns is 6.5 percent a year. Luckily, many online calculators can take care of the compound interest to help you determine how much your portfolio will return by the time you need the money.
Invest the Maximum Amount You Can Afford
As you approach retirement, or your kids become teenagers with aspirations of going to college, you’ll be a lot happier if you squeezed every last dime you could afford to invest when you were younger. So many suggest investing as much as you can. I’m not saying you should live off ramen noodles and tap water in order to invest the maximum amount, just that prioritizing your investments isn’t the worst idea.
Life is full of unexpected expenses, and before you start investing a high percentage of your paycheck, you should make sure that you have an emergency fund in place. A common suggestion for how much money to have in an emergency fund is three to six months’ worth of living expenses. For example, if you spend $3,000 a month on everyday expenses such as food, traveling, utilities, and housing costs, you should try to save between $9,000 and $18,000 for your emergency fund.
In addition to your emergency fund, you may also want to have a sinking fund in place for other unexpected costs. You can read more about sinking funds here.
Invest What You Can
If you can only afford to invest five percent of your salary, you’re still going to be ahead of the game. All that matters is that you are actively planning for your future. That five percent will likely turn to ten percent five years from now, and if it doesn’t, don’t get discouraged. The fact that you’re investing now will make you much happier in the long run. Even if the amount you invest every year stays at five percent of your salary, your salary will likely be increasing. So as long as you continue to invest that five percent each year, the amount you’re investing will continue to grow.