Retirement often seems like some distant landmark on the horizon that never gets any closer no matter how long we march towards it – and that is why saving for retirement can be such a daunting task. It requires us to make a sacrifice in there here-and-now so that we can be prepared for some abstract vision in the future. This is one of the reasons why a third of Americans have less than $5000 saved for retirement. However, if you are serious about your personal financial independence you need to start saving for your retirement now and your 401(k) is a key component to that strategy.
How did so many people end up financially unprepared for retirement? To answer this, we need to take a stroll back in time. In the late eighteen hundreds and early nineteen hundreds companies started to offer defined benefit plans (i.e., pensions) whereby an employee and employer would contribute to a fund that would pay them a fixed (usually inflation-adjusted) amount throughout their retirement. This allowed workers to amicably leave their jobs once they became too old to consistently perform manual labor and in the event of their death it prevented their widows and children from falling into poverty. In the United States the earliest pensions were put into place for veterans of the Revolutionary and Civil Wars.
Pensions continued to steadily grow in popularity until World War II when wage freezes prohibited outright increases in workers’ pay – at that point they started to become a truly standard job benefit that everyone came to expect from America’s largest employers. These plans were an essential tool in helping companies compete for workers. It wasn’t uncommon for these plans to continue to pay an end-of-career salary for the duration of a retiree’s life (and often their widow’s life as well). This meant that companies needed to relentlessly grow in order to fund retirement benefits. This was beyond the scope of most companies, which is partly why defined benefit plans have largely disappeared except for government agencies. Something had to change.
Birth of the 401(k)
In 1978 there was a tectonic shift in how Americans were asked to plan for retirement – congress passed the Revenue Act of 1978, which created the workplace 401(k). This allowed employees to save money while deferring the taxes that would be due on that income. Employers were also able to pay into these plans on their employees’ behalf without that money being taxed. This moved the burden of funding retirement from the company to the worker. Although this may seem unfair, in many ways it gives workers more control and security. Imagine if you were promised a pension only to see your employer go out of business like some of America’s most iconic brands have (take a look at Sears – a former retail icon). The 401(k) separates your retirement savings from the employer, making it more secure for the employee, and in many cases employees have significant control over the style of investment (e.g., growth, low-risk, etc). Additionally, unlike many pensions, 401(k) plans are fully transferrable and you can take it with you when you go (depending on vesting).
However, like with all shifts there has been an adjustment period where we have moved from a mindset where your company would take care of you in exchange for years of service to a mindset where you have to be self-sufficient. Unfortunately, this has left many workers with retirement savings that will be too small to allow them to retire with the lifestyle they currently have or want for the future.
How can you avoid a savings shortfall in retirement?
The key is to start early and take advantage of one of the best investments you’ll ever be offered – your employer’s 401(k) matching. If you have a workplace 401(k) and you don’t know about matching you should contact your HR department or benefits person immediately, because most companies offer to match a portion of your contributions – and in many cases this is a one-to-one match or a fifty percent on the dollar match. In short, that means even if you put it in cash you’ll have a return that you can’t find anywhere else.
Let’s look at an example. Let’s suppose you make $50,000 per year, and your employer will match your contribution up to 5% of your income. This means if you contribute $2500 (0.05 x $50,000) then your employer will also contribute $2,500. If you compare this to investing the money outside of your 401(k) that means you’d have to find an investment that returns 100% just to be even – and if someone tells you that they have something that can do that, then I advise you to run away… fast!
This becomes even more potent when you combine it with the effects of compounding interest. Over 10 years if you contribute $2,500/year, or $25,000 in total, and earn a 7% annual return, then you’ll have almost $74,000 in savings. If you add in a 3% annual raise to your salary and you continue at the 5% contribution level you’ll have nearly $85,000 at the end of a decade. Do this for 35 years and you’ll retire with over $1,000,000 in your 401(k) and best of all, only 15% of that will be money you put in!
Are there ever times I should skip my contributions?
The answer is almost always no. However, there may be times when you should pause your contributions. For example, if you find that you’ve recently had an emergency and your emergency savings isn’t enough to get you through it and you are forced to choose between your 401(k) contribution and missing a house or car payment, you’ll need to temporarily re-prioritize – with the key word being temporary.
Your 401(k), especially when it is super-charged with a company match is a wealth generating machine that cannot be overlooked. Take advantage of your company match, and if possible max it out every year. Doing so will allow you to build wealth for retirement faster than any other method, product, or investment that is out there.
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