Has your employer invited you to participate in their 401k plan? If this is your first job or you’re new to retirement planning, then naturally you’re going to have some questions.
The first thing to know about 401k plans is that they are now one of the most popular ways that Americans save for retirement. 59% of companies now offer them and you have to work at a place that offers one to sign-up.
However, only 32% of employees are actually utilizing them. That’s unfortunate because in many ways this plan could be helping more people to become millionaires and prepare for a financially secure future.
In this post, I’m going to share 5 important reasons why a 401k is a good way to save for retirement and how it can help bring you closer to financial freedom.
1. Investing for Long-Term Compound Growth
The main reason you’ll want to use a 401k plan (or any type of retirement account) is that the money you save will be invested and have the opportunity to compound over time.
Compound growth is the magic that takes place when you earn money on not just your contributions but also on any previous earnings. It’s how your nest egg doubles, triples, and multiplies beyond any amount that you could have saved into a normal bank account.
For example, consider an employee who saves $500 per month in their 401k. After investing for 30 years and getting an average annual return of 10 percent, their balance would grow to be worth $986,964. You can try this for yourself using this free calculator here.
Note that you only contributed $180,000 of that balance. The remaining $806,964 is the money that compounded on top of your savings. All you had to do was give it time to accumulate.
Particularly with 401k plans, most will let you pick from a pre-select list of mutual funds that invest in stock and bond-based funds. Securities like these are the bread and butter of any good retirement plan. The sooner you start investing in them, the more compound growth can be put to work on your behalf.
2. Tax-Deferred Savings Adds Up
Another one of the biggest reasons to use a 401k plan is because of how it reduces your taxes.
With a 401k, the money you elect to save is automatically deducted from your paycheck before the taxes are calculated. That means you get to skip paying taxes on those earnings.
Even though that might not sound like a big deal, these tax savings can really add up over time. Think of it this way: For every dollar you save, you’ll avoid paying the IRS 22 cents (assuming you’re in the 22% tax bracket) and instead keep the whole dollar for yourself. The more you save, the fewer taxes you’ll have to pay.
Consider if you were to save up to the IRS maximum contribution of $19,500 per year. That means you’d effectively be saving an extra $4,290 more than you normally would with after-tax money.
Thanks to compound growth, that extra $4,290 is going to make a huge impact. Again, over a 30-year career and 10 percent average returns, it will add an extra $705,679 to your bottom line.
Eventually, when you retire, you will finally have to pay taxes on the money you withdraw from your 401k to use for living expenses. However, there’s a good chance you’ll be in a lower marginal tax bracket, so the amount of taxes you’ll pay will most likely be lower.
3. Free Money from Employer Contributions
With a 401k, you won’t be the only one contributing to it. As a way to get employees to participate, most employers will make what’s called “employer matching contributions” to your 401k. Basically, you’ll get free money just for being a saver.
Amounts will vary from employer to employer. For every dollar you save, they might contribute $0.25, $0.50, or sometimes even dollar for dollar. There are no set rules or requirements. However, most employers recognize the importance of getting their workers to save and match an average of 4.3% of a person’s annual pay.
Just like the money you save, employer matching contributions are also tax-deferred. That means you won’t pay any taxes on them when they enter your account or as they grow inside your 401k.
4. Seamless Automatic Contributions
One of the hardest parts about saving for retirement is just simply doing it. Even though we know that saving money for the future, humans are really good at coming up with excuses to use their money for other reasons.
That’s the beauty of 401k contributions. Because they are taken out of your paycheck automatically before you ever get paid, you’ll hardly even realize that the money is missing.
This can help you overcome the mental pain of having to part with your money. Because these contributions are “out of sight, out of mind”, you’ll eventually come to think of them as a tax or required expense and accept your net pay for whatever it is.
5. Your Account is Yours for Life
401k plans are not the like pension plans that our parents and grandparents used for retirement. Back then, if you left your job, you would no longer be eligible to participate and receive pension checks for the rest of your life.
However, with a 401k, that won’t be a problem. The money you save into your 401k plan is yours to keep forever. If you leave your job, you can:
- Roll it over into an IRA
- Transfer it into your new employer’s 401k plan
- Leave it right where it is in the old 401k plan
To clarify, you get to keep the current value of everything you’ve ever contributed. That means if you saved $100,000 and it’s now grown to $120,000, then the whole $120,000 is yours.
As for any money your employer contributed, this will depend on something called “vesting”. Vesting is a waiting period until ownership of these gifted contributions transfers from your employer to you.
Some employers’ rules are that you have to wait seven years to become fully vested. Others don’t make you wait at all and allow you to become 100% vested right when you start. Again, this will vary from employer to employer.
If investing in a 401k is starting to sound like a good way to save for retirement, then what you’ll want to do is maximize those contributions as much as possible. To do this, you’ll have to adjust your living expenses so that you’re comfortable living off of a lower paycheck. To help with that, use a budgeting app like Buxfer.
Buxfer downloads and keeps track of all your bank and credit card transactions. This information then gets consolidated into one easy, real-time report. That way, you’ll always know where your budget stands and if any adjustments need to be made.
Click here to find out more about how Buxfer can help your budget so that you’ll have more to contribute to your 401k.
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