401(k) - Easiest Way to Set Yourself Up for a Great Retirement

Posted on 29. Apr, 2009 by MJay in Investing

As a follow up to my last post, I mentioned I would talk further about 401(k) programs and how to implement them into your overall financial health. I’m going to give a little history on 401(k)’s, how they work, how to get the most of them, and why starting early is the most important thing you can do as a new college graduate.

The History of Company Funded Retirement Plans

To kick things off, I figured the best perspective is to look at the concept of retirement, longevity, and the relatively new concept of life after work. Looking at retirement, it’s not necessarily something that been around for a while. Advances in medical technology have dramatically increased life expectancy over the past century. With the news continuing to pass on phrases such as 40 is the new 30, 50 is the new 40, etc., there came a desire to have a high quality life after one is done working. One of the first retirement plans popularized in the early 1900s was called a pension plan.

The basic idea was that after serving a certain amount of time with a corporation, you’d be rewarded with an proportionate income after making it to a given retirement age. With a growing work force, long life-expectancy, and increasing cost to provide health benefits to the aging work force, pension plans became an extremely expensive tax on large corporations. Today, this is one of the main reasons why the American auto industry is in deep trouble. The idea that they could post-fund all of this money was pretty short-sighted. As you’ll learn in many of my future posts, one of the best ways to fund retirement is by setting aside money in small amounts throughout the course of your working life. What better way from companies to help employees fund their own retirement, while simultaneously dropping the growing costs of pension plans.

The Birth of the 401(k)

The basic premise of the 401(k) is that you set aside certain portions of income and deposit them into an investment account. The deposits, made over periods of several years, will provide huge dividends. At this point it might seem like a basic savings account, but there are two KEY differences that make 401(k)s the absolute best investment you can make.

The money is deducted directly from your paycheck, pre-tax

This has two important features. By deducting this money from your taxable income, you’ll reduce the amount of taxes you pay. Using a simple $40,000 salary, investing 10% of your income into a 401(k) would reduce your taxable income by $4,000. This alone could save you hundreds of dollars a year. Next, by being automatically deducted from your account, the investment takes NO discipline; the money is taken away before you ever see it. Your retirement fund will grow quietly, with only the most minimal maintenance needed. The money will be taxed when you pull it out, but this will be at a presumably lower tax bracket, as you’ll have no other income upon retirement.

Company Match

Nearly all companies offer some sort of incentive for enrolling in their plan. Usually requiring a minimum percentage, the company will then match your contributions. This can be anywhere from a simple percentage match, to a more complex plan. Where I work, with a minimum contribution of 7%, the first $1,000 dollars are matched 100%. After that, the first 7% contributed are matched 75%. Can you tell me of a stock that will pay back 100% overnight, guaranteed? I didn’t think so!

Why isn’t everyone doing this?

Even this is something I can’t even try to answer. I’d like to think that more education is needed, but I think it’s just human nature. We’re naturally short-sided as humans and most see setting aside more for savings as an expense. To keep myself motivated, I like to use tools like the one 401(k) Calculator provided by Bloomberg.

Entering my information as follows:

12% contribution, $40,000 (Average College Graduate), 24 years old, starting balance of $7,400, 4% annual salary increase, 75% employer match, 8% rate of return

Using that information from my current situation, along with assumed rate of returns, I’ll find myself at $2, 252,388 at 60, a full five years before the standard retirement age. This portfolio will even be worth a million dollars by the time I’m 52. Even if I cut the rate of return in half down to 4% results, I’ll still achieve a million dollar portfolio by 60. If you have to pick just ONE retirement account to actively invest in, I highly suggest you start it today!

So I hope this was an informative article for everyone. Feel free to post any questions, interesting links, or other tactics for solid retirement planning. Remember, the most sure fire way to a successful retirement is to start now. Even if your company only match 5%, it’s still worth it. Compounded over the period of several decades, this can fund a good majority of a worry-free retirement.