Participating in your employer-sponsored retirement plan can pay off big for young investors.
Legions of college graduates will soon sit through new-hire orientations. If you’re one of them, perhaps you could be forgiven a few yawns amid the firehose of information about company policies and “getting-to-know-you” activities.
But at least one talk is worth chugging coffee for: the explanation of your employer-sponsored retirement plan. Signing up for this plan, called a 401(k), is one of the most important first steps in your new financial life.
Listen for these words: ‘employer match’
That’s the amount of free money your employer is going to pay into your 401(k) account, if you contribute at least that much, too.
For example, if your company offers to give up to 3% of your salary in matching funds, you should contribute at least the same amount. So you would be investing the equivalent of 6% of your wages in retirement savings.
You may flinch at the word “retirement” as you are starting out, but another way to think about it is jump-starting your investing career. Cash invested through retirement accounts can grow by as much as 10% a year, compared with savings accounts, which often earn less than 1% interest annually.
Get the facts — and a lower tax bill
There are many myths and a lot of confusion surrounding 401(k) plans, says Denise Appleby of Appleby Retirement Consulting, a Greater Atlanta firm that helps companies administer employer retirement plans.
You may flinch at the word 'retirement,' but another way to think about it is jump-starting your investing career.
When Appleby started her first job, coworkers warned her against participating in the retirement plan. “They said, ‘they are going to take your money, and you may never see it again, and you can’t get access to it’ — a whole lot of things which made me scared, but wasn’t true,” she recalls. “I later learned, yes, they are going to take money from my paycheck and put it into that plan, but that cash is still mine.”
The money you contribute is still yours — you just have to wait until age 59½ to tap it. (The IRS charges a 10% penalty on any cash withdrawn before then to discourage using the money before retirement.)
The upside for now is that your contributions are taken before being taxed. So your tax bill will decrease by an equivalent amount, and any potential tax refund check may be larger.
Contribute what you can
“A 401(k) forces you to save, and because it’s taken out of your paycheck, you don’t have to think about it, which is great,” Appleby says.
You might feel a slight sting when you first qualify for the program and see the contributions removed from your take-home pay. (Some companies allow you to participate in the 401(k) program immediately; others may require you to work for six to 12 months or more to qualify.) But Appleby recommends participating as soon as you become eligible.
Government rules allow you to contribute as much as $18,500 of your pretax income (and $24,500 if you are 50 or older). That’s how much you can contribute — as far as how much you should contribute, experts recommend saving between 10% and 20% of your income for retirement.
But consider how much you can spare. “You don’t want to put yourself in a position where you are maximizing your contributions and can’t afford to pay for necessities, and begin using a credit card to wrack up debts at a high interest rate,” Appleby advises.
Start with what you can afford — using the amount needed to receive the full employer match as a baseline — and increase your contributions as your salary increases.
Set your portfolio for growth
As a young person starting your investing journey, you have an advantage the most seasoned investor doesn’t: time. The earlier you begin investing, the greater the benefits of compound interest.
The earlier you begin investing, the greater the benefits of compound interest.
For example, say you are 22 and earn $35,000 a year, and your employer matches half of your 401(k) contributions up to 6% of your total salary. If you contribute your 6% to get your employer’s match each year, you’ll have over $1.2 million by 65. (That’s assuming a 7% return and annual salary increases of 3%.)
Equally important: You have more time to ride the market’s inevitable ups and down. For your 401(k), that matters because many plans give you choices of assets to buy. Stocks are the riskiest way to invest, but also have the greatest potential for growth. Bonds and other fixed-income investments are the least risky.
One rule of thumb to decide how much of your portfolio should be in stocks: Subtract your age from 110. So at 22, you might have 88% in stocks, and then over time move more into bonds as your nest egg grows.
No matter how much you save, choosing to participate in a 401(k) is a critical step toward building wealth.