When it comes to retirement planning, perhaps the most important step is to take advantage of your employer’s 401k plan.
The 401k is named after an obscure section of the federal tax code. It allows you to set aside dollars on a pre-tax basis into an account for retirement.
So, lets say you make $1,000 a week and contribute 5% of your pay into your 401k. This comes out to $50 a week. But since it’s taken out pre-tax, the net effect on your take home pay is only $42.50 (if you’re in the 15% marginal tax bracket). This is because that $50 contribution lowers your taxable income. Now you can’t avoid paying taxes on this entirely, but you won’t have to pay them until you withdraw funds at retirement.
One of the best features of the 401k is that the majority of companies match a portion of your contribution. For example, my employer matches my contribution up to 4% of my salary. In other words if I contribute 4% of my salary, the company kicks in another 4%. This is essentially free money from my employer. I know that not all employers have a match and that not all matches are that generous, but every little bit helps.
Another great feature of the 401k is that contributions are automatic. You don’t have to consciously decide to contribute every payday. We all know that it’s a lot easier to spend money than it is to save it. With automatic contributions you can make sure that you are investing regularly. And what’s better is that after a while you get used to the size of your paycheck. You’re a lot less likely to think, “My paycheck is $42.50 less” after a month or two of regular contributions.
The power of time:
The earlier you start investing, the more you’ll have for retirement. This idea is intuitive to most people. People understand that they’ll have more by starting earlier. If I invest $5,000 a year for 20 years it equals $100,000. If I invest $5,000 a year for 30 years it equals $150,000. But there’s more to investing than just your contributions. No, it’s not magic… It’s compound interest, and we’ll explore that in the next post.