When does it Make Sense to Participate in a 401k Plan

When does it make sense to participate in a 401(k) plan? Now! Time is of the essence. Most people think of retirement planning as a means of buying that mansion on the hill and living the good life. Hopefully that is the case, but consider that your retirement may be the difference between living in a nursing home verses having quality health care in your old age.

Participating in a 401(k) plan provides you with tax savings. Every dollar you invest lowers you taxable income, so you are saving by deferring payment of your taxes, and you are not feeling the full dollar out of your paycheck. If you are normally taxed 28% on your money, for example, when you invest in a 401(k) every dollar adds to your retirement later while it only feels like you spent $0.72 cents.

If your employer does any kind of matching, this is even more an incentive to participate now, as it is effectively an addition to your salary. Failure to invest means your throwing that money away. Money, which may not seem much, now can be worth a lot later.

It is all based on the time value of money (F = P(1 + i)^n). That formula is the key to compounding interest. A little money now will grow into large sums later. Time is your greatest contributor to that equation (n = number of periods to compound, or essentially time). Therefore the earlier you start the better.

Just to give you an idea of how important it is to invest now, consider this rule of thumb: In order to retire and not run out of money before you die, you need twenty times what you need to live on in a year. So, if you need $50,000 a year to survive, 20 X $50,000 = $1 Million is the amount you need to ensure you have an annual income of $50,000 no matter how long you live. Why this works has to do with the average return on the stock market and essentially setting up of a trust fund or endowment.

So, if $5.35 is the minimum wage, and there are 2080 work hours in a year, then an annual minimum wage is $11,128. Twenty time that is, $222,560 that is the amount you need saved up by the time you retire if you want to live like someone making minimum wage! Now you know why there are so many older people greeting people as they walk into Wal-Mart, sad but true.

Start now, and you can avoid that. Investing $200/month, starting at age 20, and at a 10% return, will make you a millionaire at age 59. If you can afford more, you’ll be a millionaire at a younger age. If you can only afford $100/month, you can still be a millionaire by age 66. The point is, start as early as possible. If you delay starting by only five years (age 25), means you have to now invest $330/month instead of the $200/month to become a millionaire by 59.

Time is important, and the earlier you start the more you can earn and the less you need to save, although maxing out the IRS limits never hurts. If you waited, now is still the best time to start, especially since the clock is still ticking and you’ve already wasted too much time. Remember, it’s not always about living the high life when you are too old to enjoy it, this may be the only thing that keeps you in your own home and hiring someone to stop by now and then to change you diapers vs. being in a nursing home and hoping someone changes them for you.