Personal finance can be overwhelming. There are so many steps, dos and don’ts, behaviors to adopt, what have you. Once in a while it would be nice to have a fail-safe, simple solution to follow to make sure you have enough for retirement.
As Mr. ThreeYear and I struggled to pay off our debt and become more financially responsible, I met with a personal finance instructor who taught at a local college. I showed her the ins and outs of our finances, and I remember her saying, “you’re not even maxing out your 401K?” We weren’t, at the time. We were only contributing enough to get the match, because we were saving for a house downpayment. We’d contributed more in the past, but never maxed it out.
It took us another two years to completely max out Mr. ThreeYear’s 401k, but when we started to do so, I realized that for many people, this was the simple key they were looking for to save for retirement.
Maxing out your 401K is the single best way to save for retirement, lower your tax implications, and spend less, all in one fell swoop.
Does it work for everyone? No, like any “one size fits all” rule, there are those for whom it won’t fit. Some people don’t have access to a 401k (or its non-profit sister, the 403b). Some people want to spend too much in retirement to only save $18,000ish per year.
But for the vast majority of Americans who work in a job where they have access to a 401K, maxing out this retirement savings vehicle makes a lot of sense.
Let’s look at the math.
We’ll take a hypothetical saver, Meredith. Meredith is fresh out of college, and is 22 years old. She has a new job where she earns $40,000 per year. She has access to a 401K and healthcare benefits. Let’s say she lives in New Hampshire, like me (that means she has no state taxes–good for her).
If she’s paid bi-weekly, then she’ll bring home $1538.46 gross. Let’s subtract $317.26 for federal taxes, Social Security, and Medicaid, and $50 for subsidized healthcare premiums (for a single person, the average would be $41.19 a paycheck. I rounded to $50).
That means, after taxes, she’ll bring home $1171.20.
What if she opts in, all in, for her 401K? She contributes $692.31 per paycheck, which should be allowed by her company as it’s less than 50% of her gross pay.
Because she’s lowered her federal tax implications by such a large amount, she’ll owe $213.41 in taxes, $50 in healthcare, and bring home $582.74.
Yes, that is about half of what she was making. And for most people, living on roughly $1150 a month would be very difficult. But, what if she could swing it? She finds a room to rent with some friends, pays $300 in rent per month, drives her beater car, and makes it work.
Eventually, she and her boyfriend get married, he starts working, they get raises, and their income rises to $100,000 combined per year. Let’s say, for the sake of our hypothetical argument, that he never contributes a dime to a 401K. Meredith works for 40 years, and never saves more than $18,000 per year in her 401K (for simplicity’s sake). Also, her employer never gives her any type of match. And she never saves in any other vehicle. But she faithfully maxes out her plan each year.
If she works for 40 years and retires at age 62, then with a return rate of 5%, she will have accumulated $2,283,115.73.
That gives her family over $90,000 per year in living expenses, more than enough to retire on, since they’ve only been living on about $60,000 per year after taxes.
If Meredith only works for 30 years, and retires at age 52, then with a 6% rate of return, she’ll have accumulated $1,508,430.19 in her plan.
If she and her husband withdraw 4% per year, they’ll have just over $60,000 to live on per year. After taxes, that will be $48,640 per year, which they could supplement with a part-time job, her husband’s income, or eventually, Social Security.
But let’s face it. Most 22 year olds aren’t going to max out their 401Ks. They’re making too little, have student loans to pay, and are not thinking 40 years into their futures.
Just like Mr. ThreeYear and me, they’re thinking about paying off their debt, saving for a house downpayment, or buying a new car.
But what if we try another scenario? What if Meredith starts contributing just 10% of her salary to her 401K, and then each year, as she gets a raise, she ups her contribution by 2% more?
At age 62, with a 6% return rate, Meredith would have $1,1105,200 in her retirement portfolio.
That’s assuming she never contributes more than $18,000 and never receives an employee match.
That’s still over a million dollars Meredith will have in her retirement account.
What if her husband follows the same path? He begins his working career making $40,000 and saving 10%. Then he increases his contributions by 2% per year as he gets a raise. They’ve had to learn to live on even less, because their contributions are taken off the top of their paychecks.
But they’ll also have paid less in taxes and will have over $2 million in their retirement portfolios at age 62.
The Grand ThreeYears
Ok, enough with the hypotheticals. Let’s take a real-life example. My parents, whom I’ll affix with the awkward moniker the Grand ThreeYears, never contributed to 401Ks during the majority of their working years (as a small business owner, my dad had a SEP Plan and my mom worked for the state and contributed to a pension). However, when my dad sold his pediatric practice a couple of years ago and became an employee for the first time, and my mom started running her own business, they finally succumbed to my constant lectures and began to fully max out their 401Ks. While they have significant retirement savings (and pensions) already, let’s see what these contributions can do for them.
They each started maxing out their accounts at ages 62 and 63 (they’re a year apart). They’re saving the maximum, which is $18,000 per year each plus the catch-up contribution, an extra $6,000 each, since they’re over the age of 50.
That’s $24,000 per year each.
Their taxable income is lowered by $48,000 per year, they’re spending $48,000 less per year, and they’re saving and investing $48,000.
In 10 years, with a 6% rate of return, they’ll have an extra… $670,638.85!
That is significant dinero. And because it’s automatically taken out of their paychecks, they don’t miss it. They’ve learned to live on less, get to watch their 401K accounts grow, and enjoy paying less taxes at tax time.
Like anything in life, a 401K has its downsides. First of all, the investment options available for employees are usually much worse than investment options you’d get on the open market. Fees are higher, which of course eat into your returns.
What I recommend is to search your plan for the S&P Index Fund option, if there is one, and put all your money there.
Isn’t that putting all your eggs in one basket? Well, no. It’s like putting all your eggs in 500 of the top, ever-rotating baskets in the Standard and Poor. And usually, these index fund options have the lowest expense ratios.
Mr. ThreeYear’s employer uses Principal for investing, and our best option is the LargeCap S&P 500 Index.
We pay .18% (18 basis points) in fees, which is by far the lowest expense ratio that Principal offers us.
We’ve seen a ridiculously high rate of return this year, thanks to the bear market that just won’t stop (not complaining, mind you).
My own i401K is held by Vanguard. I have a mix of VTSMX (Vanguard Total Stock Market Index Fund) and VFINX (Vanguard 500 Index Fund) and pay expense ratios of .15% and .14%, respectively (Vanguard doesn’t offer Admiral shares in its i401K plans, unfortunately). But this is another reason why i401K plans are so appealing–you can invest with the company that you choose. Read my post here for a step-by-step guide to set up your own i401K.
It’s VERY important to make sure that you’re invested in low-expense, passively managed funds in your 401K. But keep it simple. Find the best index fund or exchange traded fund offered, put your money there, and don’t mess with it too much.
In a Nutshell
If you’re floundering financially and just trying to get your feet under you, I recommend that you start contributing the minimum needed to get an employer match, if you work for a company that has a 401K or 403b. Even if you have a huge amount of debt to pay off, the psychological implications of growing a nest egg are profound (read The Richest Man in Babylon for a vivid reminder of why).
I’d love to hear from you. Do you have a 401K or 403b? Do you max it out? What have been some challenges along the way?