This is the sixth part of a series on setting up a financial plan.
The beginning of the series is here.
The previous article is “5 Accounts, #4 – Investment“.
The next article is “Financial Tools: Net Worth Tracker/Planner“.
Many times, I’ve heard that “401(k) is free money – you’re mad not to take it!” without really understanding what that meant. After all, a “retirement account” is money that you’re not going to see for 30-50 years… bo-ring. One day, though, you’ll want to retire, and doing so requires a significant investment socked away (current estimates hover around the $1m – $1.5m for true retirement comfort). What does a 401(k) plan get you?
Most plans have some form of employer-matching, so, to take a conservative example (my own company is actually more generous), a 15% employer match means that every dollar you put into your 401(k) immediately becomes $1.15. That means that, even if your 401(k) does nothing at all, you’ve already made a 15% return on your investment on day one. In addition, 401(k) deductions are pre-tax, so a contribution of $500/month works out to appear as a much smaller “dent” in your paychecks (somewhere around $360, depending on your tax situation).
In reality, even a fairly conservative 401(k) portfolio should make 8.5% per year, on average (we’re thinking long-term – 30 years or more here, so individual market ups-and-downs should even out to a good growth rate). This means that in just a year of $500/month contributions, with an employer-match of 10%, your $6000 pre-tax contribution (about $4300 in wages you’re no longer seeing) should be worth in the region of $7150. And the real beauty of this is that the interest you earn is compounded, so as the “capital” in the account grows, every cent is re-invested to begin earning its own percentage gains.
Truly maximising the gains of a 401(k) takes a little more work than this, and year-on-year gains aren’t guaranteed (they rely on whichever underlying instruments your 401(k) is invested in), but over the long-term, stocks have historically appreciated at at least that rate.
In short, if you’ve put off considering 401(k), stop putting it off now, find the “budget room” to make contributions, and start!
It’s also worth taking a look at an utterly brilliant article penned by Philip Brewer over at WiseBread. “Your 401(k) is not an investment” covers good ground on the place of a 401(k) in an overall portfolio, as well as some of the other advantages of retirement accounts. Go read it!
Disclaimer: I’m not a financial advisor, and I’m just sharing my own financial plans because, well, I like to share. It’s also a good exercise in “thinking out loud”. You choose to follow any advice in these posts at your own risk, though – I’m not responsible if you overdraw or suffer other financial calamity…
The “Retirement” photo on this post is from scottwills on Flickr.