That’s right: free money. And the earlier you start, the more you’ll get.
It’s fall, so you’ve probably already received that infamous thick packet in the mail. You know, the one that says “401k Retirement Options” in big letters on the front and provides way too much information about a sea of investment choices.
Aren’t these packets overwhelming? They’re too long, and you need a dictionary to understand every other page. Most of us take one look at it and say, “I’ll come back to it later.”
Yet for all its flaws, that packet serves as a good reminder to make sure you’re contributing to your retirement plans.
Retirement?! Already? Isn’t this a blog for young professionals?
Hear us out. Even at the age of 22, you can ensure that your hard work sets you up for later. The earlier you plan, the smarter you’ll look, feel and be when you hit your 30s and 40s and beyond. Young adults lose out on hundreds of thousands of dollars for failing to put money into their retirement accounts. Don’t be one of these suckers.
Instead, know the basics. You have many retirement vehicles at your disposal; 401k or 403b, Traditional IRA, Roth IRA and Roth 401k, to name a few. But the one that’s really special is the 401k.
In simple terms, a 401k account allows you to set automatically aside money from each paycheck into a separate account, one administered by your employer. Once the money is in the separate account, you allocate how you want to invest it, usually in mutual funds.
A 401k account is tax-deductible — it reduces the amount of cash Uncle Sam uses to calculate how much you pay in taxes today, and out of each paycheck going forward. Later, when you retire and want to use that money, you pay taxes. So you don’t get away from paying taxes, you just delay! If you want more technicalities, check the IRS website.
So why is the 401k special?
The really awesome part is when your employer puts money into that 401k at the same time as you. This is called “matching.” In best case scenarios, firms will do “dollar for dollar” matching, meaning that for every $1 you put in, your company will put in $1.
If your firm does this, it’s a Gold Mine! The grandfather of behavioral economics, Richard Thaler, in his book Nudge, says that “this match is virtually free money. Taking full advantage of the match should be a no-brainer for all but the most impatient or cash-strapped households.”
Here’s why this “free money” is such an awesome perk. The charts below show the results of putting money into a 401k, including the employer match. One chart shows what happens if you start immediately, the other shows what happens if you start three years from now.
In both cases, look at the savings you’ll accumulate just from putting 5 percent of your salary in a 401k account. Yes, you will have less take-home money, but the savings you’ll receive are almost three times as much.
Here’s another way to look at it: If you leave your job in three years, you’ll have $17,250 saved up. If you do nothing, look at your total savings: $0. Don’t be a sucker!
So what should you do if you want to take advantage of this “free money?” Here are four easy steps to get started:
1. If your employer offers $1 for $1, or a 100 percent match up to a certain percentage of your salary, put at least that percentage of your salary into your 401k. You double your money at no cost to you — cha-ching! You get more bang for your buck putting money here than paying off your student loan or credit card debt.
2. Ask your employer questions about their 401k plans. Those 401k packets can be daunting, but don’t let that stop you from getting ahead and planning for the future. The packets at least have a number for you to call.
3. Figure out where to put the money. This can also be intimidating, so if you’re unsure, choose one of the pre-selected options offered by your employer. You can always change those investments later. Putting money into the account is the first and most important step.
4. Continue to seek out resources that help young adults plan their finances in a language that speaks to you.
One last tip: The IRS’ 2011 limit for contributing to your 401k is $16,500. If you make over $245,000, then you’re not eligible.
So if your employer offers matching — and even if they don’t — put some money into a 401k. If you’re already doing that, consider increasing your contribution amount.
You’ll thank us down the road when you’re basking in the financial freedom you deserve.
Charisse Conanan, CFA, is CEO & co-founder of Smarteys, which provides web-based software for 20- and 30-somethings to manage their cash and debt. Charisse is a personal finance guru, teaches online financial classes and speaks regularly at industry events.