Leverage The Power Of Your 401(k)

If you work for a company that offers you a way to leverage your savings, it pays to learn as much as possible about how that works. By leverage I mean using a tool to make it easier to achieve your retirement savings goals. It just so happens that a company 401(k) is such a tool. When you understand 401(k) leverage, you will see that the 401(k)’s impact on “the future you” cannot be overstated.

Your 401(k) & “The Future You”

To evaluate leverage, you need to think ahead into the future, and who wants to do that? Figuring out how to finance retirement may be absolutely necessary if you are say 60 years old, but realistically, what 20 year old wants to think 40 years ahead? And, yet, that 20 year old will one day be 60, regretting not having started planning earlier. We know that from survey data.

It helps to start with the end in mind.

When you retire, your paycheck will stop. You will need other sources of income to pay your bills from then on. Some money will come in from Social Security retirements benefits. That’s usually not sufficient to pay ALL of your bills. (Social Security was not designed to replace your salary in full.) As a result, you’ll have to have funds set aside to cover those living expenses. And, those living expenses will increase in dollar amount over time due to inflation.

To avoid regret, it’s best to look into the future to make a plan.

To help you prepare, take a look at a resource from FINRA, the Financial Industry Regulatory Authority’s “The Beginner’s Guide to 401(k)s.” The publication touches on “the power of compound interest (essentially the interest you earn upon interest),” adding that “the growth can be significant.” Another resource is the J.P. Morgan 2023 Guide to Retirement.

Now, Let’s Focus on Time

To truly understand why acting now is better than acting tomorrow has to do with the power of compounding.

I’m going to take you through three examples of how time can be used by you to build retirement wealth. To do that, let’s review basic compounding. (In my next post, we’ll look at leveraging 401(k) matches.)

Compounding

Let’s look at how compounding can affect results over different time periods.

So, let’s start with a very simple scenario with three people each saving $500 a month for five years ($30,000 total). Jim (age 45), Jerry (age 35), and Jenny (age 25) will not add to those savings ever again. Jim will retire in 20 years; Jerry will retire in 30 years; and Jenny will retire in 40 years, each having saved a total of $30,000 and nothing more.

All three invest in an S&P 500 Index Fund, which is a common option for 401(k) plans. Their results will depend on market conditions during their time in the market.

Guess Who Wins

Before giving you the figures, you can probably guess the results based on understanding that compounding needs time to fully actualize. Interest on interest in early years is not dramatic. But interest on interest on interest on interest on interest over longer periods builds wealth — it’s just how the math works.

20, 30, or 40 Years?

Let’s assume that all three invested in an S&P 500 fund during the median 20, 30 or 40 year historical period (going back to the 1920’s).

Over 20 years, Jim’s $30,000 investment would have grown to $192,ooo at age 65, a tidy sum indeed.

Jerry’s $30,000 was at work for an additional 10 years, leaving him with $524,000 at age 65, or more than $332,000 more than Jim’s age 65 balance.

And, Jenny’s $30,000, with 40 years of compounding, would have grown to $1.6 million by age 65.

Keep in mind that the dollars invested and the investments themselves are identical in all three cases. The only difference is time. $30,000 grew to $192,000 or $524,000 or $1.6 million based solely on the additional time period after identical five years of $500 a month investments were made.

Shorter compounding periods lead to lower ending balances. Longer compounding periods lead to higher ending balance. Again, that’s just how the math of compounding works.

Inflation & Taxes

While we’re talking about compounding to grow assets, you also need to be aware that moneys you’ll need to spend also compound, but at a much lower rate based on history. You have capital growing over time and you have expenses increasing due to inflation over time. You also have to address taxes after you start withdrawing from your 401(k). That just confirms that it’s important to start compounding as early as possible.

Can’t Afford To Contribute To Your 401(k)?

Well, let’s see if that’s really true. Read my earlier post on the subject before deciding to sit on the sidelines.

Your 401(k) Story

If you want to tell your personal 401(k) story — how you got started, what you learned and how you applied that knowledge, I’d love to hear about it. The mechanism is a national essay contest that is currently underway (there is no charge to participate). The 401(k) Champion competition is a pro bono educational initiative that I created, fund and sponsor in my role as a proponent of financial literacy. My goal is to encourage 401(k) participants to share their knowledge and enthusiasm through the contest. One of the 2022 401(k) Champions, Kevin Alexander, put it this way in his essay: “I’ve received a lot of advice over the decades. . . . The best advice I ever received? Start a 401(k) and do it today.”

Questions

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