A 401(k) is a type of retirement plan that is eligible for special tax benefits from the IRS. You can contribute a portion of your pre-tax salary (up to $19,500 in 2020) and pay no taxes on the contributions and any earnings on those contributions until you make withdrawals from your account. You typically have the option to customize the investment portfolio yourself or stick with the default investment option that typically is provided by your employer. Many employers also offer matching programs where they will match your contributions up to a certain threshold. In other words, not only is your employer paying your base salary, they're also giving you free money as a reward for planning for retirement.
There are a number of reasons your 401(k) is such an important tool for retirement. The first reason is the tax benefits mentioned earlier. Because you invest pre-tax dollars, you get an up-front tax deduction which lowers your taxable income. Then, unlike a taxable investment account, you pay no taxes on any dividends, interest and capital gains in your 401(k) account, which allows your nest egg to grow much faster.
The second reason is a financial concept called compounded interest, which Albert Einstein called “the eighth wonder of the world.” Compounded interest is essentially "interest on interest." By reinvesting each year the interest and dividends earned on your investments, you increase your overall principal balance. This means that your next round of earned interest will be even greater than the last since you're now earning interest on the original principal + previous interest and dividends. Let's walk through an example.
Imagine you contribute $1,625 a month your first year and max out your 401(k). Assume you earn 10% a year with interest compounded monthly.
Balance in 1 Year: $20,419
Balance in 5 Years: $125,835
Balance in 10 Years: $332,873
Balance in 20 Years: $1,233,974
Balance in 30 Years: $3,673,292
This means that after 30 years of contributing $1,625 a month, your total contributions come out to $3,673,292. Therefore, you've earned $3,088,292 of interest. All you had to do was make the same payment each month. That's a powerful tool.
This example also highlights another important concept called time value of money (TMV). In simple terms, the longer you allow your investment to grow (and earn compound interest) the more impactful it will be to your final retirement balance. This is why it's so important to start saving for retirement early. If you wait until your early 30s to start saving, you miss out on almost 10 years of compounded interest. And if you're using the example above, that equates to more than $100k.
Now, if you are someone who has waited to save, don't fret. There's nothing you can do to change the past so focus on moving forward! It's never too late to start saving and no sum of money is too small to start with. Even if you can't contribute the IRS maximum (because maybe you, like the majority of college graduates have student loans to pay off) make it a goal to contribute something. And if you're fortunate enough to have an employer with a matching program, make sure you always at least contribute an amount equal to your employer’s match, as doing so means that you earn a 100% return on these contributions. It’s free money, and who doesn’t like free money?
Comments