Recently a parent asked us about a common dilemma facing many young people entering the workforce. Their companies may offer a 401(k) or similar retirement plan, but they feel they have to defer retirement saving until they have paid off a student loan or taken care of other everyday expenses.
Clearly this is not a simple decision, but we strongly advocate starting to save for retirement as early as possible. Here are some compelling reasons for participating in a 401(k) or other retirement account:
REASON NO. 1: PRETAX SAVINGS GO FURTHER
First, there are attractive tax benefits. If you are in a 25 percent tax bracket (roughly $30,000 to $60,000 in annual taxable income), a $1,000 contribution to a 401(k) account only "costs" $750 in terms of take-home pay. Also, when you invest in a tax-advantaged account, you defer paying taxes on any investment gains or income until you begin to withdraw the money. In the case of a 25 year old, that's likely to be at least 35 years -- a substantial time horizon offering the potential for substantial investment growth. You'll be able to start withdrawing your 401(k) money when you're 59 1/2, although you're not required to begin doing so until you are 70 1/2.
REASON NO. 2: DON'T TURN DOWN "FREE" MONEY
An employer match makes a 401(k) even more compelling. A match of 25-50 percent for a portion of the contribution is not uncommon. Some companies even match dollar-for-dollar or more. Typically, a company will phrase it something like: "We'll give you a 50 percent match on your 401(k) contributions up to 5 percent of your salary."
In fact, this may be one of the only opportunities you'll ever have to turn $1 into $1.50 or more, an immediate and virtually risk-free return. Of course, your company may have restrictions for the match, so that you have to complete a certain period of employment in order to be fully vested in the company match portion of your 401(k) account. It's also important to understand that your investment choices themselves (i.e., the mutual funds offered through the 401(k) plan) could lose value, especially in the short term.
REASON NO. 3: YOUR BIGGEST ASSET IS TIME
Even a small amount invested over a period of 30 or 40 years has the potential to become a substantial asset. Put another way: For young people, time is a tremendous asset. If you're 25 years old, you're probably not going to retire for at least 35 years. Even if you can only afford the minimum contribution to your 401(k), 1 or 2 percent of your salary, that long-term timeframe gives that small investment great potential to grow.
In my book "It Pays to Talk," I cite the example of a hypothetical pair of twin sisters to illustrate the power of starting early. One sister diligently invests $2,000 in her IRA every year between the ages of 25 and 35. The other puts off her IRA contributions until she turns 35, when she begins putting $2,000 into her IRA annually and keeps doing so until she turns 65.
Cumulatively, the first sister invests a total of $20,000; the second, $60,000. Both earn a consistent 10 percent annual return. But because the first sister started a full decade earlier, she is able to retire with nearly double the assets of the sister who waited until she was 35 to start funding her IRA. In my experience, I've seen too many people turn 40 and realize that for years they've been saying, "Next year, I'm really going to buckle down and start to save for my retirement." But like the diligent sister, they would probably be in a better position if they started earlier, even if the amounts they're putting away are relatively small. The power of compounding puts a premium on starting young.
TODAY'S WANTS VS. TOMORROW'S NEEDS
For many people, but especially young people, today's desires trump thoughts of the future. For example, paying off student loans is an admirable idea, but unless the debt burden is especially oppressive and you don't have an immediate need for cash, you may very well be able to contribute to your 401(k) as well. Another example: Ask yourself if you "need" a nicer apartment or do you "want" a nicer apartment? Obviously, if you're living somewhere unsafe or in a place that's too far from work, you might justifiably want to change your living situation before investing in your retirement. But I'd be willing to bet that if you can summon the fortitude to start contributing to your 401(k) through an automatic payroll deduction, you may not miss the money much. And like the diligent sister, you'll be very glad you started early as you get older.
NEED MORE CONVINCING?
If you need more encouragement, talk to your peers. In my conversations with people currently entering the workforce, it's become clear that a surprising number of 20-somethings understand that they are going to be responsible for their own retirement. They're not counting on Social Security; in fact, they're actively discounting Social Security. They know that few jobs include the traditional pension plan of the past. So they're taking an active role in planning for their retirement, and maxing out their contributions to their 401(k) is a key part of their strategy. Advice from some friends may sway you more than advice from others.
If you decide that the 401(k) is a good idea, you should also understand the benefits of investing for growth. With a long time horizon, you can afford to be quite aggressive now and become more conservative as you near retirement.
Carrie Schwab Pomerantz's columns are now available via RSS feed on Schwab.com. To subscribe, go to: http://www.schwab.com/public/schwab/research_strategies/market_insight/news_insight_subscription