Set up 401(k) and never look back

Ever since I started working, I’ve been putting money away into a 401(k), except for the two years I spent in grad school and wasn’t working in the US. I certainly max it out now, although I don’t recall if I was maxing it out in my first few years. I probably was. In any case, it’s almost impossible not to have a million dollars saved in a 401(k) account at retirement age if you regularly max it out throughout your working life.

A 401(k) plan is an employer-sponsored retirement account defined in subsection 401(k) of the Internal Revenue Code. It basically allows you to put away a part of your paycheck before it gets taxed. Eventually, you get taxed on this money when you retire and withdraw the funds, but that’s after years of compounding growth and probably at a lower tax bracket than when you were working and putting this money away.

I love this piece of the IRS code because it comes from an understanding of human nature and helps people develop a very financially healthy habit without much effort.

Here are the key benefits I love:

• My favorite benefit is that once you set this up at work, it will just automatically pay your future self first every two weeks before cutting a paycheck for you to take home.
• The other benefit I already described: it doesn’t take out income tax until later.
• Some employer plans come with an additional benefit of matching employee contributions up to a certain amount. That’s what people call “free money” and most financial advisors would recommend staring with a contribution amount that at least maximizes that match.

The only downside to this kind of account is that you can’t withdraw this money early (before you are 59.5 years old) without a penalty. So, if you wanted to retire early, you better have other savings to last you until 59.5 so you don’t have to get hit with that penalty. I actually think of this penalty as a key feature that helps many people save themselves from themselves. It forces you to keep the money there longer, and time is the tastiest ingredient when it comes to wealth building. So I think the penalty is a feature, not a bug.

Now, how much money can you put away in a 401(k) account? That changes from year to year. In 2020, that amount is $19.5K, and if you are over 50 years old you can add $6.5K more as a catch-up contribution. That’s because those older people are closer to retirement and every dollar they put away won’t have as much runway to grow and compound as a dollar of someone younger. Remember how I said time is tasty?

So, if you put away $19.5K every year for 45 years from the working age of 22 to 67, not accounting for any employer matches or growth and compounding, that adds up to $877.5K. If you assume a modest 5% annual return (conservative for the stock market), compounded annually, you should be able to retire with over $3M. You will still pay taxes on that as you take the money out in retirement, but that’s still a nice number, don’t you think?

Play around with this calculator to get a taste for what delicious time can do.