“So, Stephanie, if compound interest is so amazingly wonderful, how come people wait to invest? How come people don’t think about like, 401(k)s until they’re in their 30s?”
“My guess? People don’t realize just how amazingly wonderful compound interest really is. And they think they’ve got all the time in the world. Also, it’s not like this stuff is taught to us in high school – you either are lucky enough to learn it from a parent, or you sort of fumble your way through it, or you get some initiative and seek out the information yourself.”
“Alright, so, let’s say you were more awesome than you are. You’re what, 20 years old? Let’s say you had a tasty job with a nice 401(k) package. And let’s say that nothing else about your life changed – you still lived with your parents, so your expenses were minimal. What would happen?”
“Well, in that scenario, I’d be able to completely max out my 401(k) – assuming I made more than $15,500 a year at this imaginary job. That’s the 2007 contribution limit for a 401(k), by the way.
So anyway, I’ve got very little expenses and I’m making, let’s say… $25,000 at Imaginary Job. So I decide, yeah, I can max out that 401(k), put the full $15,500 in and use the remaining $10,000ish for my minimal expenses.”
“That sounds pretty nice… but how much does that translate to? In retirement.”
*calculator fun* “Well, assuming an 8% annual return on that, which is probably what we can expect… that’d be $494,766.97 when I’m 65.”
“What? Seriously? Maxing out your 401(k) now would mean half a million in retirement?”
“It only gets better. You said ‘nice 401(k),’ so we can assume there’s a company match to that money. So let’s say that company match is 50% up to 6% of my salary. That means if I contribute 6% of my salary (which I am clearly going above and beyond), the company will kick in 50% of that 6%. So that’s an extra $750 that they kick in. Doesn’t sound like much, but it’s free money, and let’s see how it affects the final number….”
*more calculator fun* “That’s $518,707.30 when I’m 65. That’s an extra $24,000 just because of the $750 that the company kicked in. And we can play with it a bit further – say we do just a teeny-tiny bit better with our return, and got 9%.”
*again with the calculator* “$785,318.40.”
“Are you kidding me? One percent point puts on like… another quarter million dollars?”
“That’s right. Want to take a guess at what a 10% return would get me?”
“… it’s gotta be more than a million.”
“Smart cookie. One last thing. Say instead of just doing the 401(k) for one year, let’s say I maxed it out again the next year. We’ll drop the rate back down to 8%, though – keep it as realistic as possible. So ok, I max it out two years in a row, with company match. How much do I have at 65?”
“Let me guess – a nice cool million?”
*calculator strikes again* “$998,991.84. And at 10%… it would be $2,261,261.60.”
“I’ve gotta get me a 401(k)!”
“You and me both, buddy. You and me both.”
I hate to be a Debbie Downer, but you have to remember that inflation chugs along at 3-4% as well, so a million dollars isn’t going to give you a million dollars worth of buying power. If you want to go with that 8%, it’s really closer to 4%. Remember how much difference that 1% made going from 8% to 9% and 9% to 10%? Well now it’s working against you since you just lost 3-4% off the top. That makes $15,500 really worth about $90,500 after 45 years. That’s still a nice salary for a year though right? Well you have to pay income tax on that. At 28% you’ll be left with around $65,000. There are some 401k administration fees and mutual fund fees along the way and this will bite into the profits more.
I’m not trying to scare people from saving, they should definitely max out their 401Ks. However, I want to save people from thinking as I once did – you can just invest for 2-3 years and then retire rich with your millions, never having to contribute another penny.
If there is no match, you may be better off foregoing the 401k and investing in a Roth IRA. This is especially true if you are in a low tax bracket now and expect to be in a higher one in the future (as the example seems to indicate).
One thing I’m unclear on, since I don’t get a match… is the $15,500 limit a contribution by yourself or does that include your company’s as well. If the account is limited to stop at $15,500, then you be getting more than that, you’ll just be contributing less.