Compound interest is not a simple concept. The best way to understand the power of accumulation is by visualizing it. So, most of this blog is going to be charts to help you visualize the concept.
Hopefully this will hit home, as I am not trying to sell anything. It’s one thing to hear this from someone that is going to make a profit from investments. I am an independent person with no dog in this fight.
First let me say that contributing to a 401(k) might not be the best use of everyone’s money, as every situation is different. A new-to-the-workforce employee’s money may be better suited to pay off student loans. But the benefits of contributing early to a 401(k) plan are tremendous.
The benefits of contributing early to a 401(k) plan are tremendous.
Another advantage to saving early is that the money set aside for a 401(k) is tax deferred. If you invest a dollar in your 401(k) plan, then the whole dollar earns interest and stays in that account to earn interest until you withdraw it.
Kaitlyn is a 22-year old new college graduate starting her first job making $30,000. She is trying to determine if she should contribute to her 401(k) plan. Chart 1 shows how much her retirement balance could be by contributing something. We’re looking at account balances at age 67 because if you recall, most people are not retiring at age 65 anymore. Soon, the social security normal retirement age will be 67.
She needs to contribute only $28,950 to accumulate $170,280. As a 22-year old, converting her annual contribution to per paycheck, is about $8 per pay period in post-tax dollars. Not to sound like a commercial, but that turns out to be a little over 50 cents a day!
Your company is offering free money, so employees should take advantage of that. If your company offers a match and employees do not invest in your 401(k), they are throwing money away.
Chart 2 shows the value of starting early versus delaying contributing by 10 and 20 years. The money shown is assuming Kaitlyn is making $30,000 and contributes 3% of pay with an employer match.
Another way to look at it is:
Kaitlyn’s opportunity lost:
If she starts at age 22 her balance is $510,841
Delaying 10 years, her balance accumulates to 70% of $510,841
Delaying 20 years, her balance accumulates to 46% of $510,841
If Kaitlyn would like to aim for that $510,000 balance that starting at age 22 provides, she would need to contribute 8.5% starting at age 32 or 13% starting at age 42 to accumulate to that balance!!!
To accumulate $510,000, Kaitlyn would need to contribute:
8.5% of her salary starting at age 32
13% of her salary starting at age 42
Chart 3 shows the different account balances at age 67, depending on when Kaitlyn starts to contribute.
Chart 4 shows the effect the contribution percentage has on the account balance.
Kaitlyn’s employer matches 50% of the employee match up to a 3% max, which is a very common employer benefit. I am calling this out because of the severity of how much can be missed. If she contributes 6%, then:
Kaitlyn only needs to contribute $173,702 in her lifetime to accumulate $766,261. In today’s dollars, this equates to roughly $3.50 a day after taxes.
Putting financial information like 401(k) contributions into simple, real-life examples helps everyone understand the implications of their decisions and increases participation.