A 401(k) is an employer-sponsored retirement savings plan that allows employees to make pretax contributions to the plan, up to a specified annual amount. Employers may also make matching contributions to the plan on the employee's behalf – as much as 10%, 25% or even 50% of the employee's contribution – considered by many to be free money that enhances the plan's value. The 401(k) earnings grow on a tax-deferred basis, though certain penalties may apply for early withdrawals. Certain employers allow participants to direct their own investments, and may provide employees with a group of investment products from which to choose. Other employers may hire a professional portfolio manager to direct and manage the employees' investments. In either case, the goal of any 401(k) plan is to provide the opportunity for employees to save and build money for retirement purposes. (For related reading, see Pick 401(k) Assets Like A Pro.)
TUTORIAL: 401(k) And Qualified Plans
Long-Term Retirement Vehicle
A 401(k) plan is a long-term retirement vehicle spanning decades for some individuals. Like other investments, the value of a 401(k) will experience ups and downs, and focus should remain on the long term. Individuals who start contributing early to a 401(k) plan and who make wise investment choices are able to leverage time and take advantage of the power of compounding, all while reducing taxes. Estimates can be made along the way, and as retirement approaches a more accurate determination can be made regarding how much money will be in the account and what the monthly income will be. Once an individual turns 59.5 years old, he or she is eligible to start receiving distributions from the 401(k), and after age 70.5, they will be required to take minimum distributions.
Save Early and Often
While it is never too late to start saving for retirement, the earlier one starts, the better. Even small contributions and returns can generate substantial savings over the long haul. Imagine a single $5,000 contribution made at age 20. Even if no other contributions were ever made, that initial $5,000 would be worth nearly $160,000 at age 65, assuming an average 8% annual return. If the same investor waits until age 40 to make the single $5,000 contribution, its value will be less than $35,000 when he or she reaches age 65. The size and return of the contributions can be less important than starting early and allowing the magic of compounding to work in to the investor's advantage. (To learn more about the power of compounding, read Investing 101: The Concept Of Compounding.)
How Much and By When?
The wide variety of salaries, benefits, student loans, mortgages and the like make it impossible to put a dollar amount on how much money should be in a person's 401(k) plan at any given moment. As mentioned, the most important factor is starting early to take advantage of time. After that, regular contributions are an integral part of saving for retirement. Using the above example, if the person who made a one-time contribution of $5,000 at age 20 decided to make the same annual contribution until retirement, he or she would have amassed more than $2.2 million at age 65. If the person who waited until age 40 to start making contributions had added $5,000 each year until retirement, he or she would have nearly $430,000 in retirement savings. Time and regular contributions are the most important elements of building a successful retirement savings account.
Even though many people are tempted to take home as much pay as possible, contributions made in a person's 20s can really boost retirement savings. While many 401(k) plans might encourage contributions of 2 to 3%, putting away at least 6%, or 10% if there is no employer match, will make a huge difference when it comes time to retire. To illustrate, assume a person earning $40,000 a year makes a 2% contribution (about $800 each year) for 45 years. With the same 8% annual rate, this account would grow to about $334,000 dollars at age 65. If the same person makes a 6% contribution each year instead (about $2,400 each year), the account would be worth more than $1 million by age 65. Putting away this extra $4.38 each day could triple the retirement savings account. (Check out these Top 5 Easy Saving Tips.)
30-, 40- and 50-Somethings
Many retirement planners suggest increasing the annual contribution by as much as one percentage point each year. As a minimum, people in their 30s should strive to contribute 12% of their annual salaries. In their 40s, this figure should bump up to at least 14%. And in their 50s, most people should be contributing 15% or more. In addition, those in their 50s or older can make an extra $5,000 a year contribution to help "catch up" on retirement savings.
Since many people enjoy salary increases throughout their careers, these increasing contribution percentage guidelines represent even larger savings. For example, 6% of the $40,000 annual salary was equal to a $2,400 contribution. Assuming that person's salary grew to $50,000 in their 30s, the suggested 12% contribution would then be $6,000, providing more opportunity for growth over time.
The Bottom Line
Every year that someone delays saving for retirement is costly: the person who starts at age 20 and contributes $5,000 each year will have saved more than $2 million by retirement age. If that same person waits until age 25 to start, he or she will have to contribute $7,500 each year to match the retirement savings; at age 30, the annual contribution would have to be more than $11,000. While one can start saving at any time, starting early and contributing regularly is the best strategy when saving for retirement. A qualified retirement planner can be consulted to help determine ideal contribution levels, and to clarify retirement savings taxation. (For related reading, see Retirement Planning: Why Plan For Retirement?)