“What?!?!” I exclaimed. My long-time friend called me one day asking if she should sign up for her company’s 401(k) plan. With an awesome 6% match, her company offered quite an incentive to save for retirement. But for the last 18 months working there, my friend left an extra 6% raise on the table. No more, it was time to start saving for retirement.
She Didn’t Know What to Do
When I asked why she was leaving that money, she said she didn’t really understand how the account worked, which investments to choose, and just gave up. That is a common story, particularly for people in their 20s and 30s.
If you’ve put off enrolling in an employer 401(k), or 403(b) for some education and non-profit workers, because you found the options confusing, you are not alone. You, and my friend, are part of a large number of people who choose to skip enrolling in a 401(k) because they just don’t understand how it works.
What is a 401(k)?
A 401(k) is a retirement savings account that lets you contribute today tax free, you pay the taxes when you withdraw in retirement instead of today.
Most private employers offer employees a 401(k) that automatically takes the money from your paycheck and invests it how you choose with some sort of match. Typically, employers will match a certain percent of your paycheck if you contribute, but you can always contribute more without a match up to a certain limit.
If you make $50,000 per year and your employer offers a 100% 401(k) match on 3% of your pay
In the example above, you can choose to put 3% of your pay into a 401(k) divided evenly among each paycheck. If you are paid every other week, that is $1,500 per year or about $57 per paycheck. When you put $57 per paycheck into your account, your employer will add another $57. That is a $1,500 per year raise on top of your base salary!
How to Invest
My friend’s biggest reason for skipping out on the 401(k) was because she didn’t know how to invest the money. Companies usually give you a thick, intimidating book that tells your investment options, but doesn’t make it as easy as it should be.
The easiest and best option for most people is to invest the majority of their 401(k), or all of it, in a target date fund. A target date fund is a mutual fund professionally managed for people your age. If you are 29 years old, your retirement date for your 401(k) withdrawals to begin is around 2050. If you are 29, you should invest in a 2050 target date fund. Adjust the retirement date for your age when you pick a fund.
If you can’t buy into a target date fund, there are other easy options too. If you are in your 20s or 30s, an S&P 500 index fund is great if it is an option, as the S&P 500 is a great performing index over time and those usually have low investment fees. Another good option is a large cap growth fund. A large cap growth fund invests in diverse group of big US stocks on your behalf.
As you learn more about investing, you can always make this more diverse and complicated, but when you are starting out, just keep it simple.
I’m sure you’re thinking, I could really use that $1,500 per year now. I want to buy a new car, or a house, or take a sweet vacation to Mexico. But that is worth a lot more in the future than now.
If you’re making $50,000 per year, saving $57 per paycheck isn’t going to change your life very much. But over the next 35 years, that will be $52,500 assuming you don’t get any raises. With the employer match, your $57 per paycheck becomes $105,000. And that $105,000 is going to be growing with the stock market.
The 25 year median annualized return on the S&P 500 is more than 12% per year. If you can get an 8% return, that $57 per paycheck will be worth $578,000.
Become a Millionaire
Want that $587,000 to become a million? That’s easy math. Instead of 3% per paycheck, put away 9% of your paycheck, or $171. Including the employer match, you’re now saving 12% per year. That 12% will be worth $1,174,000 when you retire.
Remember that the markets have up and down years. If you just keep adding, you’ll see your balance go up and down over time, but the markets have always come back and provided long-term investors with a great gain.
Famed investor Warren Buffet, someone I have always looked up to, told me and a crowd full of Berkshire Hathaway shareholders that the best investment advice he has for someone starting out today is to invest in a low-fee S&P 500 index fund. Over your lifetime, that fund will grow and you can retire a millionaire.
Is a Million Enough?
Remember, when you retire you will want to keep up a great lifestyle. You certainly don’t want to feel poor. When saving, remember that a million doesn’t buy what it used to, so save as much as you can to have a great retirement, not just a mediocre one.
Also think about ideas in addition to investments to generate revenue. Investment properties, side-business income, and other income generating ideas can help build an even better retirement.
Advice for My Friend, And Everyone Else
I am happy to share that now, my friend has changed course. She is steadily saving for her retirement with automated investments through her new employer.
What advice do you have for someone new to 401(k) plans, either yet to get started or recently signed up? Please share your advice in the comments.
Photo by Graham Cook / flickr