You just got a 2% pay increase! Use it wisely.

Some things age more gracefully than others. This was first posted 8 years ago, so caveat lector. Links may be broken, things may be wrong (this is the internet, after all), and you may be better off finding more recent and relevant content. Blogs are rarely graceful on a good day, let alone after a few years.

…well, kind of, sort of. On Dec. 17, Congress agreed to extend many of the Bush-era tax cuts, which is generally pretty awesome in the more-money-in-my-pocket way but not so much in the holy-staggering-national-debt-increase-Batman! way. In addition to the extensions is what I’ll call Making Work Pay 2.0 (officially the Tax Relief Act)—a employee payroll tax decrease.

The payroll tax, more commonly known as the Social Security tax, is normally 6.2% of your gross income. Everyone who earns money by legal, non-tax-avoiding ways pays this, no ifs-ands-or-buts, although if you make more than $106,800, your maximum tax is $6,621. For 2011, the tax for employees is reduced to 4.2% (a max savings of $2,136). If you’re self-employed, you’ll still have to pay the full employer-side 6.2% for a total of 10.4% instead of 12.4%. And if you’re an employer, you still have to pay 6.2% for each of your employees.

So, that begs the question: what are you going to do with it?

I’ve already made my decision—it’s going straight into my retirement account. I figure I might as well save for my own retirement while I’m getting a reprieve from paying for someone else’s. The proper paperwork has been signed, sealed and delivered. I waffled about this or paying off debt faster, but I’ll have my over-5%-interest consumer debt all taken care of by the end of January, and I expect that my retirement returns will be higher than that in the long run. It just makes financial sense. After all, thanks to compounding interest, your early 20s is a great time to start saving for retirement.

What’s your plan, Stan?

One note of import: since it’s all very last minute, your employer has until Jan. 31 to fix their payroll system so that the money goes in your check instead of to the government. This means you may not see an increase until February. Then, your employer has until Mar. 31 to give you whatever they owe you from not having the system set up correctly in January.

Great Time to Start an IRA

“You’re in your early 20s. That’s too early to start thinking about retirement.” Wrong. So completely wrong. Now is the best time to think about retirement. Sure, it’s a long way off, but even a small percent of your salary can mean a nice bit of savings in the long run thanks to the power of compounding interest.

Start an IRA

I was inspired to write this post because ING/Sharebuilder is offering FREE automatic investments for the year when you start a new IRA with them before 15 Apr 2010. I already have a Roth IRA with them, but I decided to start another one. Those normal $4 commissions really add up and put a dent in returns, especially when saving as little as I am, and if I can get all of those transfers for free for a year, well, I’m gosh darn gonna try! The promotion applies to both Roth and Traditional IRAs as well as Rollover Roths.

If you’re not interested but are considering opening up a non-IRA account with them, leave a comment to that affect and I’ll pass along a referral that nets me five free investment trades and you $25 to invest.

Why?

As I said, compounding interest is amazing for growing money. I started my Roth IRA just a few months before my 23rd birthday. There’s not a lot of money in there, because I only put in $50/month right now while I pay off debt. At $4/trade, that’s a lot of fees in relation to the investment, so I started doing the investment every other month at $100 for now, until I can bump up my monthly contribution. But let’s run some numbers about what I’m gaining by even my paltry investment.

In my calculations I’m considering a really low return: 5%. Historically, smartly invested funds will net about 10% in the market over the time we’re talking about before retirement. At 5%, we should barely beat inflation. But, this requires investing in the market or things like bonds, not letting it sit in your local bank savings account or CD.

Effect of Compound Interest
Starting age Monthly investment Money invested Interest earned Total value at age 65 Monthly to match age 23 Increased investment Interest earned
I’m rounding. Numbers aren’t precise, but close.
23 $50.00 $25,200 $60,724 $85,500
33 $50.00 $19,200 $28,236 $47,436 $ 90.00 $34,560 $50,940
43 $50.00 $13,200 $10,867 $24,067 $178.00 $46,992 $38,508
53 $50.00 $ 7,200 $ 2,679 $ 9,879 $433.00 $62,352 $23,148

I’m using simple math here. Compounding annually, ignoring inflation, conservative return, ignoring commissions.

What does this show us? By saving $50 a month in an investment vehicle that is only returning 5%, starting at age 23, you get over $60,000 interest on top of your principal. If you wait 10 years, starting at age 33, that free money shrinks to only a little over $28k. Meanwhile, if you plan to have $85,500 in the bank at 65 like you would had you started at 23, you’ll have to bump up your monthly contribution to $90, and you’re still losing out on $10k in interest. And that return shrinks exponentially the longer you wait.

If you don’t believe me, play around with this calculator. It’s simple, but simplicity at it’s best: it’s very clear about the differences between starting now and starting later, with nothing fancy to confuse the fact.

N.B. The savings I’m talking about here is on top of any employer-based retirement plan if one with matching is available. If you’re not already contributing enough to get the employer match if you have one, you’re doing things wrong. Obviously, saving $50/month for retirement isn’t going to secure you a nest egg. Even my full retirement savings, currently around 7.6% of my income including a 3% employer match won’t set me up for retirement. I know I have to step it up once I pay down debt. But based on these numbers, the money I’m saving now is miles beyond better than saving nothing, don’t you think? So, why not start now?

But, I’m in debt!

I argue that even being in debt is no excuse not to start saving. With a caveat: If you’re so in debt that you’re paying minimum balances, pause retirement savings. You need to set up a budget, forgo some luxuries and pay off debt so that you can start saving. But I’m not a financial adviser. If you really are struggling that much, you need to go see one.

My Craziest Investment: Lending Club

I finished my BA a couple of years ago better off than some, in terms of student loan debt, but worse off than those lucky people whose parents paid their way. Between those loans and dumb credit card debt I accrued while in school, I pay a fair amount toward debt every month, but I also make sure to save and invest. I take advantage of my company’s matching in a SIMPLE IRA, have my own ROTH IRA, and occasionally throw some spare money at a non-retirement investment account or two. The most interesting? My Lending Club Account.

The referral promo has ended. As of 12 Aug 2010, friends get $25 dollars to invest. That’s the cost of a single loan note.

What is Lending Club?

Jumping on the social trend, Lending Club is a Web-based (but completely legit) social lending/borrowing platform. On the investment side (the lenders), it offers pretty nice returns, and on the borrowing side, it offers relatively low-interest personal loans. They tout their stringent loan approval processes to protect the lenders, but do offer loans to a variety of risk-level borrowers. Their spiel:

Why should banks make all the money? We started by asking this one simple question. Now Lending Club offers investors higher returns and borrowers lower-cost loans through an online financial community that eliminates the high cost and complexity of traditional banks.

How does the investing work?

Investors/Lenders buy notes, $25 chunks of loans being requested by the approved borrowers. From what I understand, all of the notes in a loan must be purchased by investors for it to be considered “fully funded”, otherwise the loan is rejected. The lenders have a few tools to help make intelligent choices about which notes to purchase. To start with, each loan is ranked by a very convoluted point structure that ultimately results in a letter grade and numerical secondary-grade. The higher the grade (A1 at the top, G5 at the bottom), the lower-risk the loan is. Lower-risk loans have lower interest rates for the borrowers, and lower returns for investors, but are, of course, the safest.

Investors can browse through the notes, and view quite a bit of information about the purpose of the loan, amount, monthly payments, etc. They also have the option of asking the borrowers questions to clarify any confusion, or gather more information that might help them make their decision to help fund a specific loan. There’s also the option to set up automatic investments based on certain criteria (such as risk, purpose), if you aren’t willing to micromanage to the point of choosing specific notes.

Like with many other types of investments, there’s a risk of loss, especially if you suck at choosing notes to invest in, but one important thing to note is that uninvested money in your account is FDIC insured (up to the current limit). For investors who are constantly reinvesting their returns, that’s probably not a good deal, but the payments I’ve received from borrowers are currently sitting uninvested until I have enough to buy another note, so it is a good thing for me.

What made me start investing?

To put it bluntly: a $50 sign-up bonus that was being offered a while ago. $50 is enough to purchase two notes, and get a feel for how it works. So far (after 4 months), my two notes are both current, although both are pretty low-risk; I have A- and B-grade notes. My low-funded investments won’t return much, although it is a 9.72% return at the moment. The real goal is to have enough invested so that you are constantly purchasing new notes after receiving monthly payments on the current notes you hold. I’m planning on investing enough of my own money in the future to do just that.

Right or wrong, I love the ability to pick and choose the notes you buy, because it gives me the feeling of helping someone be responsible with debt repayment (I stick mostly to debt consolidation loans). For instance, a recent one I saw was a guy trying to consolidate credit card debt and help pay for his daughter’s wedding. I can quickly see that I have no desire to fund that loan. Why on earth would you go into more debt when you’re already needing to consolidate? I’m sorry, but you definitely shouldn’t go into debt to fund a wedding! But, that’s just my opinion.

Are you intrigued?

Lending Club is offering another sign-up bonus right now to the tune of $64.62. Like I mentioned earlier, that will get you 2 notes without any investment of your own money. And, you’ll be in a better position to reinvest sooner with that extra $14 and change.

Learn more about Lending Club, and get $64.62 for signing up to invest.

The $64.62 deal is a limited time thing, but even if it has passed, they seem to offer $25-$50 on a fairly regular basis. It’s great seed money if you’re a little hesitant to jump right in. As with any investment avenue, make sure to read all the fine print, including the state and net worth limitations. Sadly, they don’t have approval to lend/allow investments from all states right now. It’s also US-only, FYI.

Want to hear what others think? Plenty of Personal Finance bloggers have blogged about their experiences. Head over to a search engine and see what you can find. I know Five Cent Nickel has an ongoing series of posts detailing their experience.

Or, if you’re already using Lending Club, please comment and let us know what you think!