401(k) savings plans have become one of the better deals for retirement savings. These plans allow you to save pretax dollars right out of your paychecks to build a retirement nest egg. The Roth 401(k) has been added to many workplace plans; it allows you to build savings that you can withdraw tax-free in retirement as long as you meet certain prerequisites. Many employers provide matching contributions to employee plans, making them an even better deal.
There are many 401(k) savings calculators available, and all of them demonstrate how quickly your retirement account balance can grow over time. Even a modest level of savings that is allowed to grow over a period of many years can grow into a significant sum of money.
The Benefits of Compounded SavingsOne of the greatest advantages of a long-term savings plan is the notion of compounded growth of earnings. This benefit of compounding growth is that returns generated by savings can be reinvested back into the account and begin generating returns of their own. Over a period of many years, the compounded earnings on a savings account can actually be larger than the contributions you have added to the account.
This potentially exponential growth of earnings is what allows your retirement savings to grow faster as more time passes.
The Benefits of Starting EarlyOne of the greatest assets any investor has is time. As your account balance has a longer time to grow, you have a greater chance to achieve your savings goals. The length of time that you allow a 401(k) to grow will be an important factor in how much you can save, but when you start saving may be more important.
Consider this example of two different investors. Investor A saves $5,000 a year between ages 25 and 35 and then stops saving altogether. Investor B saves $5,000 a year between ages 35 and 65. Investor B has saved three times as much as Investor A. However, Investor A will have a larger balance at age 65. The reason that Investor A comes out ahead is the notion of compounded earnings and time. Investor A has given her account an extra 10 years to grow, and the compounded returns that the account experiences actually outweigh any future contributions that are given less time to grow. Starting early gives you the best chance to save for a secure retirement.
How a 20-Year Savings Plan Can Yield Six-Figure SavingsGiven a 20-year time horizon, how large can a 401(k) balance grow? It depends on the scenario.
Let's assume that you start with zero 401(k) retirement savings and earn a $50,000 per year salary. You also save 8% of your salary and receive a 3% matching contribution from your employer. You also receive 2% annual salary increases and can earn a 7% average annual return on the savings. These are fairly modest inputs into the equation, but you can modify them based on your actual situation.
You would build a 401(k) balance of $263,697 by the end of the 20-year time frame. Modifying some of the inputs even a little bit can demonstrate the big impact that comes with small changes. If you start with just a $5,000 balance instead of $0, the account balance grows to $283,891. If you save 10% of your salary instead of 8%, the account balance becomes $329,621. Extend the time frame out to 30 years instead of 20, and the balance grows to $651,306.
ConclusionIn most cases, even modest savings can grow significantly over time. In the example above, you would have contributed roughly $97,000 to your 401(k), but the account grows to over $263,000. Time and compounded growth are two of your biggest allies; take advantage of them to help build a secure retirement.
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