Is retirement something that is important to you right now? Maybe not. Especially if you are under 30, you may think that saving for retirement is totally irrelevant. If you are in your 40's or 50's, however, you probably know all too well its importance. The goal of this article is to convince you that retirement savings is central to the whole concept of "financial security" and "accumulating wealth", and that retirement savings under a 401(k) (or similar) plan can have amazing short- and long-term advantages.
A 401(k) plan is a "defined contribution employee benefits plan" that allows tax-deferred retirement savings. 401(k) plans are made possible by a paragraph in the IRS tax code numbered 401(k), hence the name. The words "defined contribution" imply that employees contribute their own money to the plan, normally through a payroll deduction. The money in a 401(k) plan is "tax deferred", which means that you do not pay taxes on the money when you contribute it but instead when you withdraw and actually use the money during retirement. There are limits to the amount of money you can channel into a 401(k) account, currently 15% of income or a maximum of $9,500 per year per person. If you are married, both you and your spouse can each open separate accounts with your respective employers and these individual limits remain in effect individually.
As a savings vehicle, 401(k) plans have a number of distinct advantages:
It is the loan provision that makes 401(k) plans particularly interesting, because it means that you can actually use your money before you retire with no tax penalties. Therefore, you can use the funds you accumulate in your 401(k) plan as a safety net, or you can accumulate funds in your 401(k) plan and then use them to make a down payment on a house, etc. The IRS and your employer will impose certain restrictions (for example, you cannot borrow more than 50% of the account value). Because it is your money, however, 401(k) loan policies are generally lenient.
There are no significant disadvantages to 401(k) plans. However, be aware of the fact that money contributed to a 401(k) plan cannot be withdrawn until age 59.5 without a penalty (the penalty is that you must pay taxes on the money withdrawn, plus you pay a 10% fine to the IRS). The loan provision makes the age limit on withdrawls a moot point for most people.
With all of these advantages, and no disadvantages, you should be contributing some amount of money into your 401(k) plan no matter what your financial situation is. In truth you should be contributing as much as possible: 15%. But let's say that Bob (or you) were to contribute just $50 per month (less than $2 a day) to his 401(k) plan until he retired in 40 years, and that money earned 10% interest in the account. When he retired, Bob's 401(k) account balance would be about $265,000 - over a quarter of a million dollars. That is a lot of money, even if you take inflation into account, especially when you consider that Bob currently tosses about that much money at sodas and cookies and gets nothing in return.
What if Bob were to contribute the maximum 15% of his $3,000 per month salary? That is $450 per month. Assume also the money grows at 10%. Here is what his account balance would look like over the next 40 years:
Note that at the end of just one year, Bob would have enough money for his beloved pilot's licence and could easily take a loan and get his lessons after just two years. At the end of five years he would have $34,000, half of which would make a very nice down payment on a house. At around the 11 year point he would have accumulated $100,000. Where, exactly, can a normal guy get hold of $100,000? That amount of money is unbelievable to most people, but there it is: $100,000 in cash, in your name, that you earned yourself. At the end of 40 years, there is over $2,000,000 in the account. This is not small potatoes - this is real wealth. And two things this chart does not include are a) any employer matching funds and b) the fact that most peoples' salaries rise with inflation (so their monthly contribution can rise with inflation as well). The final balance will therefore be even bigger - in Bob's case the final balance would be over $3,000,000 if you assume a 3% raise per year and no matching. If you assume a $20 match per $100 contributed, then Bob's balance is almost $4 million after 40 years. This kind of money is absolutely staggering to most people. And yet, it is easily within reach.
Here is a funny "keep up with the Jones's" kind of mental image to try out. Imagine the people around you at work. Imagine those "fuddy duddies" who bring in their lunch in a little nylon lunch box or a brown bag every day. Those are exactly the kind of people who have been contributing 15% per year to their 401(k)s for the last 10 years. They have hundreds of thousands of dollars in the bank right now, and they know it. Some of them are millionaires, and they know that too. They don't have to flaunt it or shout about it. They don't drive huge, fancy cars. They simply live quiet, healthy lives secure in the knowledge that they are totally set when it comes time to retire. Something to think about, and something to keep in mind when you and your friends are chuckling at them. They may know a lot more than you think, and they are probably a lot richer than you are.
The question is, can Bob afford to drop $450 per month into his 401(k) account? Really the question is, given all of these advantages and the huge amount of money he can accumulate, can he afford not to? But let's focus on the first question. Bob currently makes $3,000 per month and pays $1,150 in federal, state and FICA taxes. He takes home $1,850 per month. If he were to contribute $450 to his 401(k) plan per month, one would expect that he would take home:
$1,850 - $450 = $1,400However, that is not the case. The $450 is taken off pre-tax, so while you still pay FICA (social security) on it you do not pay federal or state taxes on it. That makes Bob's take home pay more like $1,530 or so. Therefore, if Bob can adjust his lifestyle enough to fit within $1,530 per month he is set. This adjustment would allow him to make progress on the retirement front and on the pilot license front simultaneously. Recall Bob's expenses:
Rent 700.00 Car payment 300.00 Gas, oil change, etc. 70.47 Power bill 76.47 Phone bill 37.16 Groceries 134.19 Cell phone 42.76 Cable TV 49.17 Computer 122.81 Music 25.66 Entertainment, lunches, etc. 421.94 ------- 1980.63 Hidden Expenses 100.00 ------- Total 2080.30
It will require a little perseverence, but it is definitely possible to fit his life into $1530 per month. Certainly not easy, but possible. Perhaps he could contribute 10% to his 401(k) immediately and then move up to the full 15% at his next raise.
If your company offers a 401(k), and especially if your company matches employee contributions, you will want to seriously consider enrolling. There are significant advantages to doing so.