Intro to Retirement Savings
Your 401(k) could make you the millionaire you have always dreamed of being. Allowing you to go sit on the beach whenever you desire, or travel to the tops of the mountains (in money or in person).
The sooner you begin saving, the more time your money has to grow. This year’s gains can generate gains in the next year, even if you do nothing. This is the powerful wealth-building phenomenon that we all know as compounding. Ultimately, compounding is what we all need to understand. Once you understand compounding, I believe that you will understand the importance of starting young to save for retirement. The definition of compound interest is: interest added to the principal of a deposit or loan so that the added interest also earns interest from then on. The addition of interest to the principal is called compounding. The principal is the money initially, separate from the interest.
$1 Today or $1 Tomorrow
Mary puts in $500 every year for 10 years at the age of 20 and stops putting any money in. With a 7% interest rate, at the age of 60 how much money will she have? Taking that $500 and adding the 7% interest rate, at the end of year 1 she will have $535 (500* (1+7%)). So in year 2, Mary will continue adding to that $500 to total her contributions of $1,000. However, to find out the total amount in her retirement fund, you need to add year 1 ($535) + year 2 contributions ($500) and compound with interest (($535+$500)*(1+7%)) giving a total at end of year 2, $1,107. If you continue this cycle until age 60, Mary will have contributed $20,500; however, her retirement account will have compounded year after year to total $114,816.
Let’s look at a different example with Joe. Joe decides he wants enjoy his 20’s a little more and so he does not begin contributing until age 30. Now, we will use the same contribution of $500 per year at the same 7% interest rate until age 60. How much money will he have? The answer is $54,609; however, he only contributed $15,500. Although Joe contributed $5,000 less he also has $60,207 less than Mary when he wants to begin retirement.
Our third example is Tom. Tom decides he is going to contribute the same $500 each year during his 20’s at the 7% interest rate; however, at the end of age 29 he will stop contributing. Tom’s total contribution to his retirement is only $5,000. However, after compounding year after year until age 60, Tom’s retirement account has a total of $60,207. Tom contributed $10,500 less than Joe, yet Tom is ready to begin retirement with $5,598 more than Joe.
“But I am only 22 years old, I don’t know….”
• When I am going to retire
• How much I’ll need in retirement
• How long I am going to live for on retirement income
• What kind of job I am going to have in the future to invest money with
• What I will do during retirement
The list goes on, but it is fact: It PAYS to Invest early! Our example of Mary, Joe & Tom is on a small scale. I do not know anyone who is going to survive in retirement with only $114,816 in Mary’s case or even less in Joe or Tom’s scenarios without having to still work a ton of hours every month. So you can only imagine what the drastic change would be given a larger dollar amount contributed each year. You might not know the answers now, but if you begin contributing at a younger age, you also learn to budget your expenses based on your income AFTER beginning to contribute money to your retirement fund.
Advantages of Contributing to Retirement Funds
Most retirement accounts (ex. IRA or 401(k)) allow you to defer taxes on the money you save and the returns you earn within the account. Deferring your taxes means that the amount you contribute, escapes the income taxes until you begin withdrawing money years later. Therefore, you are able to invest more money and earn more returns over time. Also, by the time you go to retire, more times than not, your tax bracket will have decreased, meaning you will pay less taxes on your “income” from your 401k than what you would have paid in taxes at age 25, 35 or 45.
Another advantage is employee matching. Many employers will match part of their workers’ contributions to employer-sponsored retirement plans. The plans can always differ but it is definitely something to be aware of when comparing job positions. It can also make a difference of whether you would choose to contribute money into the employer sponsored 401(k) plan or an IRA. An important thing to remember about employee matching is in reference to vesting.
What is vesting? Vesting refers to the practice of delaying an employee’s ownership of the company match for a specified number of years. Vesting encourages the employee to perform well and remain with the company. Some companies might not have vesting, other companies could have a various number of procedures setup within their benefit plan. The most basic example and way to understand vesting is the $1/$1 principle of employer contribution matching. Say I put $5,000 in per year and my company matches that $5,000 towards my 401(k) for a total of $10,000. However, my company’s benefit vesting plan is a 5% of salary match, vested after 5 years. This means that if I were to leave before the 5-year period has ended, I would not be able to rollover any of the company match contributions.
Many people are misled when it comes to employer retirement accounts. Too many people think that if you get a new job,
you lose all the money you’ve contributed to your retirement account. WRONG! This is so far from the truth. Whatever you contribute, will always be yours. If you begin contributing at your job at Starbucks or Cabela’s for your first 5 years (ex. Aged 20-25) and forget to move it, it will continue to grow and it will still be yours. However, it is easy to forget about the few thousand dollars you contributed at such a young age when you turn 60 and want to evaluate your retirement account; because of this, most financial advisors would not suggest you leave it, but rather move it to your new retirement account. More on moving funds at a later time.
Whether it starts out as a small amount (even better if a large amount), begin contributing to your 401(k) today. Start as soon as possible. The sooner you start, the bigger the habit becomes and the better off you will be at an older age. After all, who wants to be 70 and still working 40 hours per week?