If you’re middle-aged, would you like to more than double your 401(k) balance by retirement? If you’re a millennial, how would you like an extra $830,000 in your retirement account? Either goal can be reached by taking specific, practical steps.
[ibd-display-video id=2567460 width=50 float=left autostart=true]Yes, one step requires you to increase your 401(k) contribution. But the key is to make the increase more affordable and psychologically easier. How? By breaking it down into smaller, easier increases spread out over time.
If starting with a 10% annual contribution level “seems too overwhelming, it can help psychologically to start smaller and commit to incremental steps to boost your contribution over time,” said Rob Williams, managing director of financial planning, retirement income and wealth management for the Schwab Center for Financial Research.
And the small steps add up to a big benefit. “The numbers sound small, but the steps add up a lot over 20 or 30 or even 40 years due to compounding, especially if you start early,” said Gary Kleinschmidt, director of retirement sales at mutual fund complex Legg Mason. “The earlier you start, the easier it is, and the smaller your annual contributions can be.”
So what are the steps you should take? Here are four key ones:
- Participate. If your workplace offers a 401(k) plan, join it. A traditional 401(k) plan lets whatever you contribute not count as taxable income. That means you get a tax deduction for saving. And as traditional pension plans offered by private businesses become more and more scarce, 401(k) accounts have become the main retirement savings tool for millions of Americans.
- Contribute enough. OK, how much is enough? Many 401(k) plans that automatically enroll workers set their contribution rate at 3% of their pay. But retirement experts are virtually unanimous in warning that that’s too little over your entire work career.
“Three percent is a great first step,” said Schwab’s Williams. “But it won’t let you save the amount you need for the lifestyle you want at retirement.”
Legg Mason’s Kleinschmidt advises boosting your contribution rate by 1 percentage point a year until you’re kicking in 10% to 15% of your pay, including any company match.
Another tactic is to boost your contribution rate every time you get a pay raise or bonus, Williams says.
How much added benefit is a contribution rate of 10% compared with 3%? Suppose you are 25 years old, starting your first job. Let’s say you’ll earn $45,000. (That’s a reasonable assumption. It’s less than the $50,232 average U.S. wage for 25-to-34-year-olds in 2016, says NerdWallet.) Let’s also say that you’ll average a 1% annual pay raise until you retire at age 70. Between now and then, you’ll contribute 3% of your pay each year to your 401(k) account, which will earn an average of 7% annually.
Your balance at age 70 will be $453,761, according to the Bankrate.com 401(k) calculator.
What if you follow Kleinschmidt’s advice and boost your contribution rate by 1 percentage point a year? By the eighth year of your career, your contribution rate will be 10%. Your pay will be $48,246. By age 70, your 401(k) balance will be $1.28 million.
That’s nearly an additional $830,000 in your nest egg.
If You’re Middle-Aged
What if you’re not a millennial? What if you are already middle-aged and have less time to lift your contribution rate and benefit from compounding? Boosting your contribution still pays off.
Let’s say you are 45 years old, earning $70,000. You are just starting to save for retirement. By the time you reach age 70, if you’ve been socking away just 3% of your annual pay, your 401(k) balance will be about $150,520, given all the same assumptions we made above about pay raises and annual investment returns.
But look what happens if you jack up your contribution rate by 1 percentage point a year until you reach a 10% annual rate. Your age-70 balance will top $371,200.
That would more than double your retirement nest egg built with 3% annual contributions. It would be a hefty 147% increase. Who wouldn’t want that?
And there are more steps. Step No. 3 is this:
- Don’t ignore your company match. Most companies contribute money to your 401(k) if you do. The most common formula is a 50% match up to a maximum of 6% of your pay.
“A company match is free money,” said Schwab’s Williams. “A company match gives you more money, more compounding, a bigger balance at the end.”
Look at our example of your account balance’s progress when you start to work at age 25. Even at a 3% rate of contribution, a 50% match up to 6% of pay means that your nest egg balance at age 70 will be nearly $681,000.
That would be 50% greater than the $453,761 balance without a match.
If you work your annual contribution rate up to 10%, the 50% company match up to 6% of pay boosts your age-70 balance by nearly $291,000 to $1.57 million. That’s a 23% gain.
Here is the final step you ought to take.
- Choose the right investments. Target-date funds have soared in popularity because they help many workers avoid a strategic blunder that used to be more widespread: parking their 401(k) contributions in cash and bonds to avoid market volatility.
“The trouble with cash and bonds is that (your money) won’t grow enough over time,” Schwab’s Williams said. You avoid short-term volatility, but you lose out on long-term growth.
Unless you are willing to invest time and effort into choosing investments that suit your needs, consider target-date funds as part of your solution.
IBD’S TAKE: If you are a newcomer to stock investing who wants a few pointers, check out IBD’s introduction to stock investing or IBD’s mutual funds section for tips and strategies.
Target-date funds put most of your money to work in growth-oriented stocks when you are young and over the years can help your portfolio rebound from the market’s inevitable downturns.
The funds shift more and more of your money into less volatile bonds and cash as you approach and enter retirement.
Just remember: target-date funds provide a generalized approach. Consider using additional funds and securities to custom-tailor your portfolio to your risk tolerance, needs and time horizon, says Skip Johnson, founder and partner of Great Waters Financial in the Minneapolis area.
If you can put up with market volatility to pursue higher market returns, consider also investing in securities like aggressive target-risk funds, S&P 500 index funds, or emerging market stock funds. And if you want less volatility, consider adding conservative funds to your account, he says.
You Need This Much Retirement Savings At Your Age And Income
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