For building retirement savings, 401(k) plans have become one of the better deals. Traditional 401(k)s allow you to save pre-tax dollars—before you get your paycheck—to build a retirement nest egg. Since 2006, a Roth version of the 401(k) has been added to many workplace plans; using after-tax dollars, it allows you to build savings that you can withdraw tax-free in retirement as long as you meet certain prerequisites. Many employers provide matching contributions to employee plans, making them an even better deal.
There are many 401(k) savings calculators available, and all of them demonstrate how your retirement account balance can grow over time. Even a modest level of savings that is allowed to grow over a period of many years can grow into a significant sum of money.
- Even a modest level of retirement savings can grow over the years into a significant amount of money.
- Traditional 401(k) plans allow you to save pre-tax dollars for retirement before you get your paycheck.
- Funded with after-tax dollars, Roth 401(k) plans allow you to build savings that you can withdraw tax-free in retirement if you meet a set of requirements.
- Many employers provide matching contributions to 401(k) plans, which makes them an even more effective savings tool.
- Compounding allows your retirement savings to grow faster as more time passes.
The Benefits of Compounded Savings
One of the greatest advantages of a long-term savings plan is compounded growth of earnings. This benefit of compounding is that returns generated by savings can be reinvested back into the account and begin generating returns of their own. Over a period of many years, the compounded earnings on a savings account can actually be larger than the contributions you have made to the account.
This potentially exponential growth of earnings is what allows your retirement savings to grow faster as more time passes.
The Benefits of Starting Early
One of the greatest assets any investor has is time. The longer your account balance has to grow, the greater your chance of achieving your savings goals. How much you put aside to save is, of course, important—but when you start saving may be more important.
Here's a look at two different investors. Investor A saves $5,000 a year between ages 25 and 35, then stops saving altogether. Investor B saves $5,000 a year between ages 35 and 65. Investor B has saved three times as much as Investor A.
However, Investor A will have a larger balance at age 65. The reason that Investor A comes out ahead is the effect of compounded earnings over time. Investor A has given her account an extra 10 years to grow, and the compounded returns that the account experiences actually outweigh any future contributions that are given less time to grow. Starting early gives you the best chance to save for a secure retirement.
Or consider this example from Peter J. Creedon CFP®, ChFC®, CLU®, chief executive officer of Crystal Brook Advisors, New York, NY:
A 25-year-old who invests $5,000 a year with an 8% average annual return for 43 years should have approximately $1.65 million. If you started saving 10 years later and invested $5,000 per year with the same 8% average annual return, after 33 years the result is approximately $729,750. Not magic, just the time value of money. The 35-year-old would have to invest approximately $11,290 a year to achieve the same amount as the 25-year-old under the same time and averages.
How a 20-Year Savings Plan Can Yield 6-Figure Savings
Given a 20-year time horizon, how large can a 401(k) balance grow? It depends on the scenario. Let's assume that you start with zero 401(k) retirement savings and earn a $50,000-per-year salary. You save 8% of your salary and receive a 3% matching contribution from your employer. You also receive 2% annual salary increases and can earn a 7% average annual return on the savings. You can modify these inputs based on your actual situation, including changing interest rate levels.
You would build a 401(k) balance of $263,697 by the end of the 20-year time frame. Modifying some of the inputs even a little bit can demonstrate the big impact that comes with small changes. If you start with just a $5,000 balance instead of $0, the account balance grows to $283,891. If you save 10% of your salary instead of 8%, the account balance becomes $329,621. Extend the time frame out to 30 years instead of 20, and the balance grows to $651,306.
In 2021, you can put away as much as $19,500 into a 401(k) retirement account, increasing to $20,500 in 2022. And if you are age 50 or older, you can contribute an additional $6,500.
"The greatest assets we have available to grow our retirements are compound interest and time," says Carlos Dias Jr., founder and managing partner of Dias Wealth LLC in Lake Mary, FL. "Always think of the Rule of 72, which is the time value of money and how long it takes for $1 to double to $2. In theory, if you obtain a 6% rate of return (although it won’t be constant), it would take 12 years for your money to double."
The Bottom Line
In most cases, even modest savings can grow significantly over time. In the example above, you would have contributed roughly $97,000 to your 401(k), but the account grows to more than $263,000.
"Taking full advantage of your 401(k) so that you receive the employer match is crucial," says Mark Hebner, founder and president of Index Fund Advisors, Inc., in Irvine, CA, and the author of Index Funds: The 12-Step Recovery Program for Active Investors. "On average, receiving the full employer match increases an employee’s overall savings rate by almost 40%, which is substantial."
Time and compounded growth are two of your biggest allies. Take advantage of them to help build a secure retirement.