A 401(k) is an employer-sponsored retirement plan that allows you to save for retirement in a tax-advantaged way, often referred to as a defined-contribution plan. Generally, you can contribute a portion of your salary by having your employer withhold it from your paycheck automatically. In addition to your own contributions, your employer will likely match your contribution.
Starting a 401(k) in your 20s is one of the most powerful steps you can take to prepare yourself for retirement. That’s because the earlier you start, the longer you have for compound interest to work in your favor and grow your savings to a sizable balance.
The estimated average 401(k) balance of Americans was $141,542 in 2021, according to the most recent data from Vanguard, one of the largest 401(k) administrators in the country. For those below 25, though, it was $6,264 as they start their careers and $37,211 for those ages 25 through 34.
Alternative data from 401(k) administrator Fidelity, however, suggests that the average account balance for those ages 20 to 29 is $10,500—a contribution rate of 7%.No matter the averages, learn how to start saving early and in a way that works best for you.
- Starting a 401(k) in your 20s is one of the most powerful steps you can take to prepare yourself for retirement.
- A 401(k) is an employer-sponsored retirement plan that allows you to save for retirement in a tax-advantaged way.
- Contributing to your 401(k) in your 20s allows you to take advantage of an employer match, which is an amount deposited to your retirement account by your employer.
- Contributing early also allows you to maximize the power of compounding, which is the interest earned on your interest.
Contribute to Your 401(k) Early
When you are a young adult, there are probably a lot of aspects regarding your career that you can’t help but think about, like salary, benefits, location, and upward mobility. These are all relevant issues to weigh when considering job offers, but you should also consider a company’s 401(k) plan.
Many employers will offer to match your 401(k) contributions by a certain amount, and each organization will have its own matching formula.
Often, an employer’s 401(k) match is stated as a percentage of your contribution up to a maximum amount of your salary. One of the most common matches is a dollar-for-dollar match of up to 3% of an employee’s salary.
How a 401(k) Employer Match Works
Let’s take a look at the impact an employer’s match can have on saving for retirement.
Suppose you are offered a $40,000 salary at a company you are interested in and the employer offers to match 50% of your contributions up to 5% of your salary. For every $1 you contribute to the 401(k), your employer will throw in an additional $.50. In this case, 5% of your salary is $2,000, and to maximize the employer match, you would need to contribute the full $2,000 to get a $1,000 match. You can contribute more than 5% of your salary if you wish; however, your employer won’t match any contributions beyond that.
An employer may also match 100% of your contribution. Again, say the offer is a $40,000 salary, and the employer will match up to 5% as long as you contribute $2,000. In that scenario, an additional $2,000 will be added to your 401(k). An additional $1,000 per year seems better, but to determine if it actually is, it’s important to check how the amount would grow by the time you retire.
Many companies have policies that allow you to be vested in your 401(k) plan, giving you ownership over a certain percentage of the funds. While all of the money you personally contribute is yours to take if you choose to leave your place of work, the terms often vary when it comes to your employer’s match of the amount, with many companies’ policies ranging from three to seven years until you are 100% vested.
How Contributing to a 401(k) in Your 20s Compounds
Let’s compare the effects of the two employer-matching plans. Let’s say you are 25 years old, will earn $40,000 per year without a raise until you turn 65, and earn a steady 6% on your savings while contributing 5% of your salary to the 401(k) annually. How much will you have saved under each matching arrangement?
- With a 50% match, your savings would grow to $464,286.
- With a 100% match, your savings would grow to $619,048.
That’s a difference of $154,762—nearly four years' worth of your salary. Thinking of it in those terms should make it seem like a much bigger deal than an extra $1,000 per year. But if starting early is so important, how would waiting affect your savings? Under each plan, if you wait until you are 35 to start saving, you’d have the following:
- With a 50% match, your savings would grow to $237,175.
- With a 100% match, your savings would grow to $316,233.
By waiting 10 years to start matching your contributions, you’d be losing about half of what you could have gained in retirement savings. That’s the difference of saving a mere $2,000 per year for 10 years, for a total of $20,000.
In other words, starting early and contributing to your 401(k) in your 20s allows you to take advantage of the employer match, which is free money. However, contributing early when you're young also allows you to maximize the power of compounding, which is the interest earned on your interest over the years.
Maximize and Automate Contributions
Knowing how much to contribute to your 401(k) in your 20s can be challenging since your salary in the early years of your career may not be that high. If you are able, it is a good idea to put away as much money as possible into your 401(k), up to the maximum amount allowed by the IRS. For 2021, the annual limit on your own contributions is $19,500. This amount has increased to $20,500 for 2022.
If you are just starting out and make $40,000 a year, it will be difficult to contribute the maximum amount. Be sure to consider your need to pay for food, housing, and other necessities, in addition to saving for retirement.
Increasing Your 401(k) Contributions
It’s also a good idea to consider increasing your contribution each year. Two common ways of increasing your contribution are:
- Increase the percentage of your salary that you save each year, say by 1%. So, if you start by saving 5%, then the next year, you would save 6%. This can help you increase your savings gradually so it doesn’t feel so abrupt.
- Save a larger portion of any raise. Suppose you start by saving 5% of your $40,000 salary but then receive a $5,000 raise, and decide to save half of it each year. That’s an additional $2,500. You would now be saving $4,500—plus the match—of your $45,000 salary, which is a 10% savings rate.
In the fourth quarter of 2020, the average employee contribution rate for 401(k) plans reached a high of 9.1%.
Automating Your Contributions
Both methods outlined above allow you to increase your savings without feeling like you took a huge chunk out of your income. Once you decide on a method of choice, you can automate your contributions, allowing the employer to automatically contribute part of your wages to the 401(k) on your behalf.
In other words, you won't see your contribution amounts in your paycheck since they'll be deducted beforehand and deposited in your 401(k). Automating your savings ensures that you maximize the benefit of saving early while you're in your 20s.
Even if you only contribute just enough to take advantage of the employer match, you can use your youth to your advantage since you have many years until retirement, allowing for compounding to work in your favor.
Optimize Your 401(k) Allocations
A 401(k) is an account type, not an investment. Once you contribute money, you’ll need to decide how you want to invest it by choosing an investment option available in your 401(k) plan. Typically, 401(k)s don't offer individual stock investments. Instead, you'll likely have a choice of several mutual funds, which are investments that contain a basket of stocks and bonds. You’ll need to determine how you want to divide your money between the different funds—a process called asset allocation.
There is no universally correct allocation for everyone, as it depends on your risk tolerance and investment goals, which may change over time.
When you are young, you can afford to invest a little more aggressively and take advantage of potentially high returns. In other words, investing in your 20s means you have a long time horizon before retiring, allowing for a higher risk tolerance since you have many years for your 401(k) investments to bounce back from any market downturns.
As a result, you may opt for a more aggressive growth strategy by investing in stock funds versus bond funds, which are usually deemed a safer option.
Saving for Retirement While Paying Down Debt
When you're in your 20s, the reality is that you'll be making student loan payments, paying credit card bills, and juggling debt. As a result, making regular contributions to save for retirement can be challenging. To devote the proper amount of attention to your savings and not put it off, you'll need to be mindful of your budget.
Consider following a structure like the 50/30/20 rule of thumb, which calls for allocating 50% of your paycheck for needs, 30% for wants, and 20% for goals. The 20% dedicated to goal spending includes both making debt payments and saving for retirement. Whatever method you decide to use, it's important to choose a budget plan that is right for you. If you don't follow through with your plan, you risk falling behind on your retirement savings.
Alternatives to a 401(K)
Not every employer will offer a 401(k), so you may not have it as an option. However, that doesn’t mean you can’t save on your own and still take advantage of compound growth.
If your employer doesn’t provide access to a 401(k), you may want to consider an individual retirement account (IRA) or Roth IRA. These accounts let you save for retirement while offering some tax advantages, but they don't offer the benefit of a company match. Also, IRAs have lower annual contribution limits than 401(k)s. For example, the maximum annual contribution amount is $6,000 for 2022.
Frequently Asked Questions
How Much Should I Contribute to a 401(k) in my 20s?
How much you should contribute in your 20s can depend on your income and financial situation. However, it's best to start early and contribute enough to qualify for any employer matching program.
How Much Should I have Saved in my 401(k) in my 20s?
According to Vanguard, a leading 401(k) provider, the average balance in a 401(k) in 2021 for those under the age of 25 was $6,264, and for those ages 25 through 34, the average balance was $37,211.
What Are some Tips for Boosting my Contributions to my 401(k)?
If possible, take advantage of your employer matching program, and automate your savings, allocating a percentage of your income each pay period to your 401(k). Also, saving early, even a small amount, allows you to benefit from the power of compounding.