Congratulations, you've graduated from college! Good news: You have the potential to amass millions of dollars by the time you retire if you're in your early to mid-twenties, like most college graduates. It will require hard work, discipline, and an ability to stick to a budget, but it can be done. Using a time value of money formula, $111 per paycheck invested at average rates of return over a typical career could turn into more than $4 million in wealth and hundreds of thousands of dollars a year in passive income.
Learn how a portfolio of stocks, bonds, mutual funds, real estate, and other assets can keep your family living comfortably during your lifetime and serve as an inheritance for your children and grandchildren (or, perhaps, your favorite charity).
- Tax-advantaged retirement accounts allow young investors to reduce their tax burden while saving for retirement.
- Many employers will match some amount of contribution to these types of retirement accounts, which can help build your wealth.
- Compounding gains multiply all of these other benefits over longer timeframes—the longer the money stays in the market, the more the gains compound and grow.
Set Aside Savings
To illustrate your possible path toward wealth, let's try a math exercise.
Imagine after graduation you go to work for a company such as Starbucks and earn $40,000 a year in salary (which is considerably less than the average food service manager salary of $59,820).
The coffee giant matches 401(k) contributions dollar-for-dollar up to either the first 4% or 6% of your salary, depending on the year. Further, imagine your effective combined tax rate for federal, state, local, and payroll taxes is 28%.
You decide you want to put aside 20% of your earnings each year, which is ambitious but not extreme. That's $8,000 per year. However, most 401(k) plans are pre-tax, traditional 401(k)s (as opposed to Roth 401(k)s, which use post-tax money). That means you're going to get $2,240 taken off your tax bill at tax time. In effect, you actually only need to save a net $5,760 out of your pay each year, or less than $111 per weekly paycheck, as the government subsidizes your good behavior.
This means you've instantly leveraged your out-of-pocket savings by 38.89% as you get to keep the extra $2,240 to invest as a sort of interest-free loan from the government for the next 30, 40, or even 50 years or more.
Leverage Your Money
That's not all. With the varying 401(k) matching schedule, in some years, Starbucks is going to deposit $1,600 in tax-free matching contributions, while in others, it will kick in $2,400 in tax-free cash. This results in a total of $9,600 to $10,400 in fresh money being added to your account every 12 months, even though you've only parted with $5,760 out of your own pocket.
How Your 401(k) Helps
As long as the money remains within the protective confines of your 401(k), the dividends, interest, rents, and capital gains you earn aren't subject to taxes. Rather, you pay taxes on withdrawals, as if they were a paycheck, when you enter retirement.
If you attempt to tap the money early, you are subject to a 10% penalty on top of the regular tax hit, although you can take a 401(k) loan or hardship withdrawal if absolutely necessary. The government requires you to take distributions at age 72 to keep you from perpetually compounding the money within the tax shelter. But before that, you can get nearly a half-century of tax-deferred growth.
If you were to find yourself in bankruptcy court, it's possible some or all of your 401(k) could be protected from creditors, as the courts have been hesitant to invade retirement principal. This is one of the reasons you should not draw down your retirement account balances without talking to a qualified adviser first.
The Power of Compound Interest
In a typical year, your 401(k) would receive an average of $10,000 in fresh cash. Your net adjusted out-of-pocket savings is $5,760; a much smaller chunk of your salary.
That $10,000 will be invested in the securities or funds you select, with the interest compounding until you retire or you reach the age of 72, at which time the government requires you to take distributions.
Imagine you opt for a low-cost equity index fund approach. Take the long-term historical equity returns earned by large, blue-chip stocks (which dominate index funds) and figure a 9.5% annualized rate of return, on average, with dividends reinvested.
Remember that past performance does not guarantee future results when investing. Also, carefully note the costs and expenses of your own particular portfolio, which can affect your returns.
Say you invest like this for 40 years, between the ages of 25 and 65, and never, in all that time, enjoy a meaningful raise. You fail to get promoted. You forget about adjusting your contributions for inflation. In other words, your contributions remain exactly the same for 40 years.
How would you fare? Ignoring any other assets you accumulated in life—your home equity, savings accounts, cars, personal investments in a brokerage account, annuities, businesses you started—your 401(k) balance could contain about $4.2 million after 40 years. That's $10,000 a year (or $833 a month), compounded at 9.5% interest annually, for 40 years. If your funds did exceptionally well and earned 12.5% a year in interest, you'd have about $9 million. If they only averaged 6.5% a year, you could expect about to have $1.9 million. If they managed 3.5% average annual returns, you'd still have more than three-quarters of a million—$885,757.
Because of the nature of compound interest, it helps to start as young as you can. An investment of $10,000 a year earning 9.5% a year for 20 years (instead of 40) would be just over $600,000, compared to the possible $4 million you could see with 40 years in the market.
Plus, by the time you reached 65, you'd statistically have another two decades or so in life expectancy to enjoy the money.
Alternatively, if you had built other wealth along the way, you could attempt to hang onto the 401(k) cache by using a rollover IRA for as long as possible so your children, grandchildren, or favorite charity ended up with the amount as it continued to grow. Then, they could extend the tax benefits upon your death using an inherited IRA.
All from only $5,760 net out-of-pocket savings per year, or $111 out of each weekly paycheck.