Why Investing at the Last Moment Can Hurt Your Returns

If you haven’t put money into an individual retirement account for 2022, do it before the April deadline. That’s a standard tax tip for investors this time of year.

And it does make sense to stash as much money as you can manage in tax-sheltered accounts of one variety or another.

The Internal Revenue Service allows to you wait until April 18 this year to contribute money to an I.R.A. for 2022. These extensions are a boon if you are short on cash — as I was for many years, when it was hard to pay the bills and also to save a little money for the future.

So pay the bills first and just do the best you can with investing. “Every little bit helps,” said Roger Young, a certified financial planner at T. Rowe Price.

But be aware that making a habit of waiting until the last minute is likely to hurt your investment returns over the long haul.

That’s true if you invest in an I.R.A. at the last possible moment every year, and it’s also the case if you delay even starting your retirement savings for a decade or more.

It’s never too late to put money aside. But if you have access to tax-sheltered accounts — and that includes workplace retirement accounts like 401(k)s and 403(b)s, as well as I.R.A.s and health savings accounts — you will be better off over the long run if you can manage to start investing early and keep doing it regularly.

Thanks to the shield against taxes these accounts provide, and because of what has been called “the miracle of compounding,” the benefits of early and regular investing in tax-sheltered accounts are startlingly large.

By the same token, if you wait, you will pay what Maria Bruno, the head of U.S. wealth planning research at Vanguard, calls a “procrastination penalty.”

You may be startled by how much money you could be leaving on the table.

A Few Assumptions

I asked Ms. Bruno to run two sets of fresh numbers, which illustrate the costs of delaying your investments.

I made a few critical assumptions: first, that the stock market, over periods of a decade or more, is likely to rise. That assumption is based on history, and while I believe that it’s quite likely to be correct, it’s not guaranteed.

If you absolutely can’t handle the risk of losses, and especially if you will need your money soon, don’t view these calculations as a recommendation to put your precious resources into stocks. Go for safer short-term vehicles, like Treasury bills, high-yield savings accounts and money market funds.

I invest in stocks through broad low-cost index funds that mirror the entire market, and I have held onto these funds for decades. That reduces the risk of picking individual stocks and of trying to time the market.

For the Vanguard calculations, I made an arbitrary choice for likely stock market returns — an average of 6 percent a year annually, over the long haul. That’s not a prediction of future returns, but I think it is reasonable.

It is an intentionally modest figure: much less than the 10.4 percent annualized returns of the past 20 years (although more than the 18.2 percent loss of the S&P 500 last year, including dividends).

With a little bit of luck, you might do better than this, but you might do considerably worse. Consider this, then, as rough illustrations of the differences, based on these assumptions, between investments made early and late, both for a single tax year and over a lifetime of work.

The Annual I.R.A. Penalty

For simplicity’s sake, Ms. Bruno compared $6,500 in contributions made at the beginning of January with those made on April 15 the next year, about 16 months later, but credited to an I.R.A. account for the preceding year.

Waiting until the last minute like this may be the best you can do, but there is a cost, and because of compounding, it is magnified the longer it goes on.

Here are the results, and the penalty over the following periods:

• In 10 years, if you invest in early January every year, your earnings will amount to $27,597; if you wait until April the next year, your earnings will be $21,092 — $6,505 less.

• In 20 years, the early investor’s earnings will total $128,424; the procrastinator’s will be $110,270 — $18,153 less.

• In 30 years, the early investor’s earnings will amount to a whopping $357,704; the procrastinator’s will be $318,878 — $38,826 less.

Looking closely at that 30-year period, both people will have contributed the same amount of money: $6,500 a year, or a total of $195,000. And both will end up with handsome portfolios. But the early investor’s will be worth $552,704. The procrastinator’s will be worth $513,878.

It’s clear that investing at the beginning of the year, rather than 16 months later, is much better: Your earnings would be almost 11 percent higher than if you waited until April 15.

Different Decades

I also asked Vanguard to calculate the retirement investments of two people who started putting money away at different times of life.

The core assumptions remained the same: annual tax-sheltered investments of $6,500, and 6 percent annual returns.

But in this race, one person started at age 25 and made contributions for just 10 years. For the next 30 years, she let the stock investment grow in her tax-sheltered account (which could be an I.R.A., a 401(k) or even a health savings account). This early investor contributed a total of $65,000. At 65, thanks to tax-sheltered, compounded returns at 6 percent a year, her account was worth $558,931.73.

The second person didn’t start until she reached age 35. Then, realizing that she needed to catch up, she kept investing $6,500 a year for the next 30 years. That amounted to a total of $195,000 in contributions. At age 65, her account was worth $544,710.90.

Again, that’s a nice nest egg. But consider this: She invested much more money than the early bird, made regular contributions for a much longer period, yet still lagged her counterpart by more than $14,000.

When Money Is Scarce

Clearly, starting early is better, but sometimes, and especially in your 20s, you may just not have the money.

In that case, Ms. Bruno suggested considering a Roth I.R.A. as a kind of double-duty vehicle — one that can be used for long-term investing but also as a repository for an emergency fund.

Unlike with a traditional I.R.A., you won’t get an immediate tax break with a Roth. But you can withdraw the principal (not the earnings) from a Roth at any time without a penalty, so it may be a reasonable option for money you may need to draw on. If you use it that way, though, I would avoid investing the emergency fund in the stock market because it may not be there when you need it.

Similarly, if you are drawing down money in retirement, or are about to do so, in any kind of account, I would shift some of the money to bonds and shorter term fixed-income funds, for greater security.

For truly long-term investing, using automatic deductions in a workplace tax-sheltered account is a wise strategy, especially if you can get matching contributions from your employer. Putting aside at least 15 percent of your paycheck is what T. Rowe Price recommends, but if that’s too much to start, don’t worry. Begin with whatever you can, Mr. Young said, and then increase the percentage in future years.

Ultimately, getting ahead of the deadlines and investing early and often in tax-sheltered accounts will be in your own best interest.

Start small if you must. With a little luck, you are likely to find that compound returns are a beautiful thing when they accumulate over decades.