I think it’s fair to say that we all know that saving for retirement is a wise decision. If you’re looking to follow the traditional retirement path, you’ll need a couple briefcases full of cash when you finally let go of your career and sail/walk/ride into the sunset. You could simply place it all in a savings account for the next 30 years, but a 0.15% interest rate isn’t going to make anyone rich.
So, we know we should invest, but other questions may remain. That’s what we’re going to tackle today. We’ll discuss 5 of your biggest 401(k) questions and do a couple quick math problems to determine the answers.
Yes…math. And there will be a test. The grades are pass and fail, and the final results won’t be known until it’s too late. So, this is one math class where you need to pay attention.
The 5 biggest 401(k) questions
1. When should I start investing?
Everyone has their own idea on this topic, but here’s mine for what it’s worth. I believe that our first priority should be saving enough for an emergency fund, or as I call it – an “Uh Oh Fund.” You never know what’s coming around the bend, so it’s best to be prepared and have at least 6 months of income sitting in a savings account, ready to act if necessary.
Once your Uh Oh Fund is up and running, I would crush your credit card debt using the snowball method. The interest rates are super high and if you’re not allocating most of your extra income to paying them off they just might live forever.
If you’ve done both of those things already, then my answer to the “when should I start investing” question would be “right this minute!” Compound interest works best when given plenty of time. Want the simplest, most elementary example of this the world has ever known?
Let’s say you were holding a nickel in your hand and someone came along and said that they would double your money every 20 seconds for as long as you can hold your breath. I’m not sure why they volunteered to do this, but let’s just go along with it.
If you could hold your breath for only 1 minute, you would end up with 40 cents.
$.05 x 2 x 2 x 2 = $0.40
What if you could hold your breath for 3 minutes?
$.05 x 2 x 2 x 2 x 2 x 2 x 2 x 2 x 2 x 2 = $25.60
It’s only 6 extra intervals, but it makes a huge difference.
What if your name was Tom Sietas, the world record holder in this category, and you could hold your breath for 15 minutes?!
$.05 x 2 x 2 x 2 x 2 x 2 x 2 x 2 x 2 x 2 x 2 x 2 x 2 x 2 x 2 x 2 x 2 x 2 x 2 x 2 x 2 x 2 x 2 x 2 x 2 x 2 x 2 x 2 x 2 x 2 x 2 x 2 x 2 x 2 x 2 x 2 x 2 x 2 x 2 x 2 x 2 x 2 x 2 x 2 x 2 x 2 = $1,759,519,000,000
Congratulations, you now have nearly 2 trillion dollars.
Again, I know that’s a ridiculous example because there aren’t a whole lot of investments that will continue to double your money for 45 years, but compound interest becomes more powerful with time. Make sure you give it as much time as it needs.
Here are some more realistic examples.
(Each of these examples assumes a 7% rate of return on your investment. It also assumes that you started with a $40,000 salary at age 25 and have had a slight 3% annual increase in your salary ever since.)
If you begin contributing 10% of your income at age 25, you will have $1,282,088 when you’re 65.
If you do the same thing, but wait until age 35 (with a salary that has increased nearly $15,000 by the way), you will only have $773,728 when you’re 65.
If you begin contributing 10% of your income at age 45 (your salary is up to $72,244 now), you will only have $396,174 when you’re 65.
You can see how much time matters. Even with a much larger salary and, therefore, a larger starting contribution at age 35 or 45, there is virtually no way to make up for lost time.
Each of the above examples was calculated using the 401(k) calculator at Bloomberg.com.
2. What’s the minimum amount I should invest?
If your employer matches a portion of your contribution, and many do, ALWAYS contribute the maximum amount that they’ll match. Otherwise, you’re literally leaving free money on the table. And that’s never a good idea.
Take a look at those examples in Question #1 again. Those were without any kind of employer matching, but let’s say that your employer is kind enough to match the first 4% that you contribute. So, if 4% of your paycheck is $150, they’ll contribute another $150 just because they like you.
If that were the case, the 25 year old would have an extra $512,835 when he/she retires (a total of nearly $1.8 million). Not bad for free money.
If your employer is greedy and doesn’t contribute toward your retirement, it’ll be up to you to figure out what your minimum is. Invest as much as you feel comfortable with. Every dollar counts – as we’re about to see.
3. Does an extra dollar or two really matter?
What if I invested an additional $20 per pay check? Let’s say I get paid every two weeks and normally I contribute $100 ($2,600 per year) into my 401(k) (no employer matching). If I were 25 at the time, I would end up with $833,357. If I decided that I could spare an additional $20 per paycheck and started investing that portion as well, I would gain an additional $166,000 (a total of $1,000,028)!
Even an extra $10 per pay check would net me an additional $83,000 during that time.
Every dollar counts.
4. How do I know how much I’ll need for retirement?
How much you need/want to live on annually during retirement multiplied by the expected inflation rate the number of years of retirement that you’re planning on being around for adjusted for inflation and rising medical expenses as you age.
It’s the inflation that makes things tricky.
We need to remember that if I’m talking about an event 30 years in the future, prices and incomes will be MUCH different. The average annual inflation rate since 1913 in the U.S. is 3.24%. It doesn’t sound all that bad until you start to analyze what that really means. At that rate, cost will double about every 20 years and something that costs $100 right now will cost nearly $300 by the time I’m ready to retire. It’s the same principle that makes compounding interest work to our benefit in our 401(k)s. Except this time, it’s working against us. Remember all those stories that your grandma told you about buying milk for a nickel? That’s inflation at work.
Here’s a calculator that will do the hard work for you and determine how much you need to invest to reach your retirement goal.
5. What other options do I have if my employer doesn’t offer a 401(k) program?
IRAs, Roth IRAs, and SEP plans are a few of the ways that you can plan for your retirement without the aid of a 401(k). You could also just go it alone and create a stock and mutual fund portfolio using Etrade or another service like it. No matter what you choose, investment is an important part of staying ahead of inflation and securing a sound retirement.
I’m not a retirement plan expert. I’m not a professional financial planner. I don’t know what stocks you should invest in for 2013 to get the best return on your investment. But, the point is that you don’t have to be an investment whiz to save money for your retirement. They make it pretty easy now-a-days. You can make it as simple or complex as you’d like, but make sure you are thinking ahead. No one likes to get caught with their pants down – especially at 65.