If you can contribute to a 401(k) at work, you might want to consider doing so, even if you can't max it out. This type of account has many benefits, like tax-deferred growth, and using it is fairly simple.
But more importantly, consistently investing into your 401(k) every year could also help you save $1 million or more for retirement. Here's how.
How your money could grow
In 2021, you could add up to $19,500 into your 401(k). The amount that you can contribute has increased over the years from its initial amount of $1,500 in 1974, and it probably will in the future. But even if it stays at $19,500, here's what your account could grow to in 30 years with these different average rates of return, before taxes.
Between the years 1926 and 2020, you could've gotten a 6% annual rate of return on average with U.S. investment-grade bonds, according to Vanguard. And if you owned 100% large-cap stocks, you would've earned a 10% average return. Holding 40% in stocks and 60% in bonds would've yielded an 8% rate of return.
Contributing almost $20,000 to your accounts every year is a lot, though, and it's possible that this goal isn't feasible. But you can still accumulate a lot over time with lower amounts, especially if you earn a higher rate of return. The table below shows how much different contribution amounts can grow over 20, 25, and 30 years if you earn 10% each year on average.
Make sure to consider your risk tolerance
When you contribute to your 401(k), you'll be given the option of investing it. And that will involve choosing the mix of stocks and bonds that is best for you. Owning nothing but stocks can help you earn more on average and, as a result, grow your accounts by more. But this increase in performance comes with an increase in risk, too. You can see below the worst years of investment performance for each of these portfolios, according to Vanguard's portfolio allocation models.
Average Rate of Return
40% stocks, 60% bonds
It's for this reason that how your investments are allocated between stocks and bonds should take into account more than just the average rate of return that you could receive.
If the thought of losing 43% of your money in one year makes you uncomfortable, then a 100% stock allocation may not be a good fit for you. Instead, accepting a lower return on average in exchange for lower potential losses could help you stay better invested in the long term.
Things you can do if you're still coming up short
You might still find that adding $5,000, $7,500, or $10,000 each year is difficult. One of the major benefits of a 401(k) is that it reduces your taxable income, so you'll see that your paycheck is reduced by less each period than your 401(k) contribution amount. The table below gives some examples of what this might look like if you are in a 30% tax bracket.
Increase in Contribution
Decrease in Pay
Because of this dynamic, increasing your contributions might be easier than you originally thought. And if you can cut some of your expenses, you could reach your goal with less money than if you used an account that didn't have this benefit.
You can create a budget by listing your monthly spending and labeling your expenses as either essential or discretionary. You can't get rid of things like your rent or mortgage. But if you spend a lot on unneeded subscription services or dining out, you can reduce those costs and redirect your savings to your 401(k).
There is also the possibility that your employer will give you a company match, up to a certain percentage of your income. As long as you contribute the same amount, your company will, too. So if you make $60,000 and have a 5% match, your employer will add up to $3,000 to your 401(k) if you do, too. Combined with your contribution, you could add $6,000 to your account each year.
Saving enough for retirement might seem like a daunting task, but it doesn't have to be. And the more time you give yourself, the more attainable it could be. Having a plan and being consistent are crucial to your success. And if you have access to a 401(k), it could be the perfect tool for helping you reach your goals.
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