There are many different types of accounts that you can use to save for your retirement, and they all have pros and cons.
This could make planning for this milestone a little overwhelming or confusing. But if you have access to a 401(k) at work, it could be the best vehicle for reaching your retirement goals for these three reasons.
1. A company match
If your company provides a 401(k) match program, it's free money for you. Your employer will match a certain percentage of your salary up to a maximum amount. For example, if you make $50,000 and your company has a 6% match program, it can contribute up to $3,000 a year to your account. As your salary goes up, the size of the match can go up as well.
But it will only make that contribution if you do, too — it only adds as much as you do. If you only put $1,000 into your plan, that's what gets matched. The table below — based on that theoretical 6% match with a $50,000 annual salary — shows how this can help your account grow more than with just your contributions alone when invested over 30 years at different rates of return.
Average Annual Return
The money also might not belong to you immediately. Instead, you'll probably be subject to a vesting schedule where the match gradually becomes yours over time as long as you work there. One common provision is called three-year cliff vesting, where as soon as you reach three years of service, all of the match — and any investment gains it generated — become yours.
2. Tax-deferred savings
With a traditional 401(k), you don't pay taxes on the salary you put into it when you contribute. Without that slice taken out of your pay, it helps make bigger contributions possible.
You will eventually owe taxes on the contributions into your 401(k). But for the average person, this will usually be at a lower rate than you would've paid while you were working. The table below shows the hypothetical difference in taxes paid on various dollar amounts under a 25% tax bracket while working versus a 15% tax bracket when retired. The higher these contributions are and the longer you make them, the bigger the tax savings could be.
25% tax rate
15% tax rate
3. Dollar-cost averaging
Dollar-cost averaging means regularly buying a pre-determined amount of a certain investment over a period of time. One of the main benefits of this strategy is that in some months, you pay a lower price if there is a stock market correction or crash. Other months, you will be buying your shares at constantly increasing prices in a bull market.
But you won't be trying to guess when to invest at the best moments — which is incredibly hard to do and could result in you missing out on growth. Your 401(k) is already set up for dollar-cost averaging — each paycheck, the same percentage of your income is deducted and put directly into the investments that you've designated.
This is also a great way of prioritizing saving. Coming up with the money for the future can be hard because it takes away from your current needs. But if it comes out of your paycheck before it lands in your bank account, there's less chance you'll miss making contributions than if you're adding to your savings accounts after paying all your expenses. And the fact that your paycheck is decreased by less than your actual contribution amount because of the tax deferment could make the hit to your income less painful.
If you start investing in your 401(k) when you start your first job, you could become a millionaire by the time you retire. And the power of compounding combined with consistency means this could be accomplished with just a few hundred bucks a month. That is why this powerful tool is one that you should absolutely use if you have one at work — it could be all you need to reach your retirement goals.
The $16,728 Social Security bonus most retirees completely overlook
If you're like most Americans, you're a few years (or more) behind on your retirement savings. But a handful of little-known “Social Security secrets” could help ensure a boost in your retirement income. For example: one easy trick could pay you as much as $16,728 more… each year! Once you learn how to maximize your Social Security benefits, we think you could retire confidently with the peace of mind we're all after. Simply click here to discover how to learn more about these strategies.
The Motley Fool has a disclosure policy.