March Challenge—Don't Miss 401(k) Benefits
This month, reader Cathy, from Flower Mound, Texas, and a member of Metroplex Federal Credit Union, shares her idea:
For a real free benefit in your long-term return on your retirement savings, always contribute the maximum amount to your 401(k) that is matched by your employer.
Cathy says it is amazing to watch your balances grow with the matching dollars, and tells us she retired early using this strategy.
If you already use your company's 401(k) or 403(b) plan, you'll be surprised to learn that only 36% of workers in 2004 participated in 401(k)s and similar accounts when offered, according to a GAO (Government Accountability Office) report.
Cathy's point about free money is this—if you don't participate, you're giving up money that's coming to you in an employer match. This is an employment benefit you cannot afford to pass up.
Time is on your side
That's because of compounding, which really becomes powerful over time. Say you start with a modest amount in your retirement savings plan, and perhaps even only earn a modest dividend on your money. In spite of that, over time, as your account grows, you earn more and more on the growing base. Compounding, and dollar cost averaging, really help you build a sizable retirement fund.
If you don't participate, you're giving up money that's coming to you in an employer match.
Dollar cost averaging is another habit that proves its worth over time. It means you always contribute a stable amount. In times when the market is down, your contribution is able to buy more shares, for example, of the mutual funds you may have selected for your 401(k). When the market is up, you still are contributing the same amount but you are buying fewer high-cost shares.
Start slow, watch it grow
Make it your goal to increase your contribution by at least one percentage point each year until you hit the max. For example, someone who starts contributing 5% of a $50,000 salary annually to a 401(k) at age 30, and keeps the contribution the same for the next 30 years, would have $305,865 at age 60.
But if that person at age 30 increases her contribution by 1% each year for the next 10 years, and keeps the contribution at 15% for the next 20 years, she would have $694,133 at age 60—more than doubling her nest egg. Both examples assume an average portfolio return of 8% with a mix of stocks and bonds.
As you get raises, contribute a higher percentage of your income until you reach the maximum.
Watch those fees
Ideally, your employer plan will have a range of investments for you to choose from for your retirement savings. While you're watching the yield on those investments, also watch the management fees.
The U.S. Employee Benefits Security Administration says that, for someone with 35 years until retirement and a 401(k) plan valued at $25,000, fees make a significant difference. If the investments in an account return 7% annually and fees are half a percent—that's 0.5% of all plan assets—that 401(k) plan will grow to $227,000 by the time the recipient hits retirement age—even if the recipient doesn't drop a single additional dime into the plan.
Now check out what happens if the 401(k) plan fees are 1.75% instead of 0.5%. Then, the plan participant would earn only $150,000. The 1.25 percentage point difference in fees cuts more than $77,000 (34%) of the 401(k)'s account balance at retirement.
2008 Financial Fitness ChallengeWe're calling on you to help us with the 2008 Financial Fitness Challenge. Now it's your turn to share your best ideas for money management with others—winning recognition and maybe some money.
Compounding, and dollar cost averaging, really help you build a sizable retirement fund.
Submit your personal finance idea, as Cathy did, and become eligible for monthly prizes of $50 Visa gift cards—and a grand prize at the end of the year of $1,000.
Until next month ...
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