401(k)

What is a 401(k)?

A 401(k) is an individual retirement account that is often provided by employers. 401(k) accounts gained popularity in the 1980’s and have become the main driver for individual retirement accounts. Since pensions are now generally only offered for government or public jobs, 401(k) has become the main method that Americans use to prepare for retirement. So what is it?

401(k) accounts allow you to contribute money from your salary to an investment account. This money can be invested freely until age 59½, at which point you can begin to withdraw from the account. Usually, employers will offer some sort of match. This means that they will contribute to your 401(k) account up to a certain percentage of your salary, usually up to about 5% of your annual salary. You can invest the money how you choose, whether you choose index funds, target date funds, individual stocks. Your strategy is your own.

401(k) accounts are tax advantaged

There are two types of 401(k) accounts, traditional and roth. Traditional 401(k) accounts allow you to contribute from your salary tax free. You then pay taxes on your withdrawals as if they are income when you are in retirement. Roth 401(k) accounts do the opposite. You pay the income tax now, but when you withdraw, you do not pay any taxes.

Generally, you should invest in Roth 401(k) early, if you think you will be in a higher tax bracket when you retire. However, there are some other considerations, if you are very early in your career, there is an argument to be made about the power of tax free compound growth. It also might be worth considering if you think tax rates will go up while you are in retirement. It could be worthwhile to pay your taxes now, rather than later.

Are there limits to how much I can contribute to my 401(k)?

Yes, the limit for individual annual contribution in 2024 is $23,000. If your company contributes as well, your combined contribution cannot exceed $69,000. This number bumps up to $76,500 if you’re older than 49.

So great, we know all about 401(k) now. How much do I need to invest to retire? That all depends on when you start. There’s a little thing called compound interest in investing and the most important aspect of this is time. The average return of the stock market is somewhere between 7% and 10% annually. If we estimate for a 7% return, and the same monthly contribution, you’ll have more than twice as much money when you retire if you start at 20 years old, than you will if you start at 30 years old. Even though you still have more than 30 years until retirement if you start at 30, the difference is still significant.

So how much would it take to have $1 million saved before I retire?

Once again, this depends largely on time, but I’ll point out a few examples for starting at the beginning of each decade from 20 to 50. This is with a 7% annual return.

Are the above numbers even realistic?

I believe so, for the small end. Sure, the general cost of living is rising, but with a $15 an hour wage, $400 a month, is 16% of your pre-tax income. While a significant chunk, this isn’t as bad as housing is. And, even if you can’t hit that $400 a month, every little bit helps! Even if it is only 50$ a month. You can always increase contributions as your income increases, or as you find ways to cut expenses.

On the other hand, $14,000 a month is a ridiculous amount of money. This goes to show how important it is to start early. It is incredibly difficult to save up enough to retire if you wait until your 50’s or 60’s.

If you’d like to plug in your own numbers, I made an investment calculator in google sheets, so you can plug in your numbers and see if you’re on track! Or you can experiment to see what it would take to reach your goals. Find it here:

Good luck, and start early!