The Real Importance of Your 401K

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Do not throw away free money.” When writers and financial advisors talk about 401Ks, that’s usually the first thing they say. And they’re completely right—not signing on for your 401K is one of the worst mistakes you can make, and interestingly the mistake is more grievous an error the younger you are.

Does that seem counterintuitive? It probably seems like saving money becomes more important the older you get, but actually, the earlier you start saving, the more bang for your buck those savings will have. This is because of compound interest.

What’s Compound Interest?

Compound interest is the key to making a million dollars, which is the amount of money people often estimate that one needs to save for retirement. Or if not a million—because, to be honest, that’s a pretty arbitrary figure—it’s the key to making your savings become something you can actually count on. Compound interest means that the money you put away will accrue interest and grow every year, and that new, larger amount will then accrue interest the following year, which will be even greater because the principle amount has grown, and so on and so on.

JP Morgan Asset Management’s “2014 Guide to Retirement” illustrates this point beautifully with a set of three people who all have the same annual return on their savings but save in different ways. Check this out:

jpmorgan diagramRemember when we said that savings are counterintuitive? It seems like Susan, who only invested $5,000 a year for 10 years, would have less money than Bill, who invested $5k a year for 30 years, but because Susan started ten years earlier, she actually winds up with more. And Chris, whose actual investment sum (as taken from his paycheck) amounts to only $200K, somehow winds up with over a million in the end. Crazy, right?

Your Money Grows Up Too

The reason you need to get your money into your 401(k) as quickly as possible is that it grows. We also love this story from CNN Money blogger Katie Lobosco: Lobosco started her job at CNN Money, put part of her paycheck into her 401(k) (as all her coworkers told her to!) but didn’t contribute the full amount. Here’s what she said:

“Why would I voluntarily kiss goodbye a bigger chunk of my paycheck while I’m still paying off a student loan and paying expensive New York City rent? Because I ended up cheating myself out of $23,992.”

If Lobosco had contributed that extra $142 a month to her 401(k), CNN would have contributed an extra $1,704 a year, and assuming an annual return of 5%, with compounding interest that would have been $23,992 by the time she was 67. 

The moral here? Not only will your money grow over time, but not contributing the maximum amount is, as we said, rejecting free money.

401(k)s

It used to be that everyone in America would ensure the security of their retirement through a pension plan—the company they’d worked for for most of their lives would give them a stipend every year. Today, pensions are rare, and the 401(k) is the new standard.

The 401(k) started as an obscure regulation that allowed workers to set aside pretax money for their pensions, but it swiftly took over the retirement world when employers realized they could substitute 401(k) matches for the more-costly pension plans. Unfortunately, fewer than half of US workers even have the option to contribute to a 401(k), and those numbers are even lower for employees of small businesses—only 45 percent of companies with fewer than 100 employees had 401(k)s as of March 2015.

If you are offered a 401(k) plan, you’d be wise to contribute a portion of your salary even if your employer doesn’t match it because that money is taken pre-tax from your paycheck, amounting to an instant tax break, and as we discussed earlier, those savings will grow. 

No 401(k) plan at all? We’ll address that in our next post! And if you want more advice about how to manage your money and save for retirement, your first step should be creating a financial plan with the Earn It Use It e-books!

E. Scott Erickson’s vision is to empower Americans through financial education. For the last 30 years, he has been a successful financial advisor and avid public speaker in the Pacific Northwest.

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