If you're saving for retirement, there are a number of different options available to help you reach your goals. A401(k) plan is an example of a popular plan that enables individuals to save for retirement. Many employers provide matching contributions to such plans, making them a particularly strong savings option. The 401(k) is available in two categories:
- The Traditional 401(k): This option allows you to save pre-tax dollars to build a retirement nest egg.
- The Roth 401(k): Added to many workplace plans in 2006, this option uses after-tax dollars to help you build savings. In retirement, withdrawals from a Roth 401(k) are tax-free and penalty-free as long as you're over age 59 ½ and it's been five years since you first contributed to the account.
You might be asking yourself: "How much will my 401(k) be worth in the future?" There are many savings calculators that can help you estimate how much a retirement account balance can grow over time. Even a modest amount of savings can develop into a significant sum of money.
Key Takeaways
- Compounding allows your retirement savings to grow faster as more time passes.
- Traditional retirement plans allow you to save pre-tax dollars for retirement.
- Funded with after-tax dollars, Roth 401(k) plans allow you to build savings that you can withdraw tax-free in retirement if you meet certain requirements.
The Benefits of Compounded Savings
You might be wondering what your 401(k) will be worth down the line. The answer depends on more than just your contributions and interest.
One of the greatest advantages of a long-term savings plan is compounded growth. Compounding occurs when returns generated by savings are reinvested back into an account and then generate further returns of their own. Over a period of many years, compounded earnings on a savings account can actually be larger than the contributions you have made 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 Early
One of the greatest assets any investor has is time. The longer your account balance has to grow, the greater your chance of achieving your savings goals. How much you put aside to save is, of course, important—but when you start saving is just as important.
Here's a look at two different investors. Amanda saves $5,000 a year between ages 25 and 35, then stops saving altogether. Blake saves $5,000 a year between ages 35 and 65. Blake has saved three times as much as Amanda.
However, Amanda will have a larger balance at age 65. The reason that Amanda comes out ahead is the effect of compounded earnings over time. Amanda 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.
Or consider this example from Peter J. CreedonCFP®, ChFC®, CLU®, chief executive officer of Crystal Brook Advisors in New York, New York:
A 25-year-old who invests $5,000 a year with an 8% average annual return for 43 years should have approximately $1.65 million. If you started saving 10 years later and invested $5,000 per year with the same 8%average annual return, after 33 years the result is approximately $729,750. Not magic, just the time value of money. The 35-year-old would have to invest approximately $11,290a year to achieve the same amount as the 25-year-old under the same time and averages.
How a 20-Year Savings Plan Can Yield 6-Figure Savings
Given a 20-year time horizon, how much will your 401(k) be worth? 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 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. You can modify these inputs based on your actual situation, including changing interest rate levels.
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.
In 2024, you can put away as much as $23,000 into a 401(k) retirement account. In 2023, it was $22,500. And if you are age 50 or older, you can contribute an additional $7,500 in 2023 and 2024.
"The greatest assets we have available to grow our retirements are compound interest and time," says Carlos Dias Jr., founder and managing partner of Dias Wealth LLC in Lake Mary, Florida. "Always think of the Rule of 72, which is the time value of money and how long it takes for $1 to double to $2. In theory, if you obtain a 6% rate of return (although it won’t be constant), it would take 12 years for your money to double."
How Does Compounding Interest Help My 401(k) Balance?
Compounding interest helps your balance grow even more than it would if you earned simple interest. This means that you earn interest on the original balance you deposit and on the interest from previous periods. So if you deposit $1,000 and earn $10 in interest at the end of the year, your closing balance would be $1,010. With compounding interest, you earn interest on the entire balance, which helps your balance grow even more as time goes on.
What's the Difference Between a 401(k) and an IRA?
Both the 401(k) and the individual retirement account (IRA) are types of retirement investment accounts.
The 401(k) is an employer-sponsored plan, which means that you must open the account through your employer. (One exception is the 401(k), which is designed for self-employed people.) Deposits are made through payroll deductions, with some employers offering matching contributions. An IRA, on the other hand, is opened through a bank or investment firm. As such, investors have to make deposits on their own.
Another key difference is the amount you're allowed to contribute. A 401(k) has a higher limit ($23,000 in 2024 and $22,500 in 2023 with an up to $7,500 catch-up contribution for people 50 or older) while IRA contributions are limited to $7,000 in 2024 and $6,500 in 2023 with an up to $1,000 catch-up contribution for people 50 or older.
I'm in My 50s. Is It Too Late to Start Saving for Retirement?
It's never too late to start saving for retirement—even if you're in your 50s. If you have access to a 401(k) through your employer, consider signing up. This is especially important if your employer offers a matching contribution. You may also want to take advantage of the IRA options available to you. Be sure to speak to a financial advisor or retirement specialist to guide you through the process.
The Bottom Line
In most cases, even modest savings can grow significantly over time.
"Taking full advantage of your 401(k) so that you receive the employer match is crucial," says Mark Hebner, founder and president of Index Fund Advisors, Inc., in Irvine, California, and the author of Index Funds: The 12-Step Recovery Program for Active Investors. "On average, receiving the full employer match increases an employee’s overall savings rate by almost 40%, which is substantial."
Time and compounded growth are two of your biggest allies. Take advantage of them to help build a secure retirement.
