Be an Ant, Not a Grasshopper*
Most people know they should invest for the future, but at least half would like to do better. In a Salary.com poll about investments in the company retirement plan, 44 percent of respondents said they contribute, but could do better; 13 percent know they should invest, but have other priorities; and 41 percent said they contribute the maximum. Just 3 percent reported not having a retirement plan.
If you're gainfully employed and reasonably satisfied with your career, there are few good excuses for not taking advantage of this benefit. If you've got access to a company 401(k), 403(b), or other plan, make friends with it now, and you'll thank yourself later. Here's why.
It's not saving, it's investing...
401(k)s and related plans exist to let you invest part of your salary before you or the IRS can get near it. To participate, you, the employee, agree to set aside a fixed percentage of your gross (pretax) monthly salary. In many cases, your employer will reward your efforts by kicking in an additional 25 cents to a dollar for every dollar you contribute. This free gift is called the "company match," something employers do to encourage workers to save, or as part of their general benefits program. They get a tax incentive from the government to do this, because the government wants people to save for retirement. The company match is like an immediate return on investment.
Invest now, pay tax later...
As your contributions build, so do investment earnings, with no taxes due until retirement. This is a far better prospect than a taxable investment because earnings compound without frequent withdrawals to pay for interest, dividends, and capital gains taxes. Ultimately Uncle Sam does get his cut, but much later, when you close the investment out, which you can only do after age 59 1/2.
Do the math...
Say a person who is single, age 25, and earning $3,000 a month opts to invest 5 percent of it, or $150, in the 401(k). Uncle Sam only taxes the remaining $2,850. Then, if the employer matches 50 cents on the dollar, the $150 swells by $75, bringing the monthly contribution up to $225. That's a $2,700 investment per year, money which could otherwise burn a hole in that new pigskin wallet. This person has deferred paying $337 in taxes for the year.
It gets even better, because of interest. If your investment earns 10 percent (the things that have an impact on your return will be discussed in Part 2), that's $270 in interest for the year. Of that, $90 is interest on the employer matching contribution and $34 is interest on money that you otherwise would have paid in taxes. So that's four sources of free money: employer match, tax savings, interest on employer match, and interest on tax savings. And we haven't even talked about compound interest.
An investment for a lifetime
Invest, then leave the money alone. If you withdraw money any earlier than age 59 1/2, you are charged a 10 percent "premature withdrawal penalty" before you've paid a penny of ordinary income tax. But if you leave it alone, you will have a solid source of income after you stop working. Social Security could provide some help, but it is no guarantee, and it is unlikely to cover all of your retirement expenses.
In the example above, if the person has been contributing $150 a month for a year with a 50 percent employer match, and continues to contribute at exactly that rate until 2045, the year of retirement, the account will be worth close to $2.2 million in 2045. (This assumes an inflation rate of 3.5 percent, an annual yield of 10 percent, and an effective tax rate of 18 percent, and a few other things.)
Which are you: grasshopper or ant?
401(k)s are only for long-haul investing. If you're planning career suicide by trekking to Nepal in search of your inner Yak, don't put money in here. It'll cost far too much to break it out when you need it. In your worst financial drought, you might be able to negotiate a loan with the 401(k) plan manager, but only if you've built up enough time and assets.
*In case you haven't heard Aesop's fable of the Ant and the Grasshopper in a while, here's how it goes.
One fine summer day, a grasshopper was hopping through the field, cheerfully singing grasshopper songs without a care in the world. Along came an ant, lugging an enormous ear of corn toward the ant farm.
"Come over hear and sing with me," said the grasshopper, "instead of working so hard. It's a beautiful day."
The ant replied, "I am helping to store food for the winter, and suggest you do so as well."
"Who can think about winter on a day like today?" asked the grasshopper. "There's plenty to eat right now." But the ant continued its heavy labor.
When winter came, the grasshopper had nothing to eat, and was very hungry. But the ants had plenty of corn from what they had stored away over the summer.
Then the grasshopper knew: It is best to prepare for the days of necessity.