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Home » Your Money » Retirement » Column

Save Now, Retire Rich

Retirement may seem an eternity away, but if you start saving while you're young, you could have a million -- or two -- in the bank when the day comes.

By Erin Burt
December 16, 2004
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What if you could retire with a couple million dollars, your employer would give you money to make that happen, and you wouldn't even have to remember to make any deposits?

Oh, and you'd have fewer taxes taken out of your paycheck each month.

Sound too good to be true? Well, let me introduce you to your 401(k), or its non-profit and public service cousins the 403(b) and 457. For the most part, all of these "defined contribution" plans operate the same way, so for simplicity's sake I'll refer only to 401(k)s from here on.

Retirement may be the furthest thing from your mind right now, but taking advantage of these employer-sponsored savings plans while you're young can pay off big down the road. And if you are about to receive a year-end bonus or raise in 2005, now may be a perfect time to evaluate your financial situation, set some long-term goals, and set up your first 401(k).

How 401(k)s work

If you haven't already received enrollment information from your human resources department, check your eligibility. Some employers require you to have worked at the company for three months to one year before allowing you to participate in their plans.

A 401(k) is a savings plan that allows you to automatically invest part of your paycheck in a portfolio of mutual funds and company stock. Your choices will be limited to the investments the company offers through its plan, but you get to choose (up to specified limits) how much and where to put your money.

Some employers may even partially match your contributions, say, 50-cents for every dollar you invest, up to a certain percentage of your salary. If you invest at least that much, you are guaranteed a 50% return on your investment.

Your 401(k) contributions also come out of your paycheck before taxes are applied, reducing the amount of money Uncle Sam can tax. And 401(k) returns grow tax-deferred until you withdraw your money in retirement.

So what's the catch? There's always a catch, right? Well in this case, you can't withdraw the money while you are employed before age 59½. If you leave the company and make withdrawals before turning 55, the money will be taxed at your normal rate, and you will be charged a 10% penalty.

You can borrow from your account, though.

Never too early

With 30 or 40 years to retirement, the big day seems a ways off. But if you start saving little by little now, you could retire with a million or two in your pocket.

Say a 25-year-old socks away $200 a month in a 401(k) earning an average 10% annually. By the time she turns 65, she'll have about $1.3 million saved. If her employer offers a 50-cent match for every dollar she contributes, her stash grows to nearly $2 million.

The sooner you start, the more your money will grow over time. If the worker in our example waits until age 32 to start planning for retirement, her savings by age 65 would be half of what she'd have earned if she'd started seven years earlier.

Implementing a savings strategy now can help build your nest egg no matter what career choices you make in the future. Let's say our 25-year-old participates in her 401(k) for five years, then at age 30 decides to start a family and stay home with the kids. If she doesn't contribute a dime more over the next 35 years, her money would continue to grow -- to about $658,000 by the time she turns 65. Not bad for an out-of-pocket outlay of just $12,000.

How much to contribute

If you're ready to start your 401(k), you first need to figure out how much money you want to save each month.

Most employers limit the amount you can contribute to your 401(k) -- usually up to 15% of your salary. And the IRS won't allow you to set aside more than $14,000 in 2005. But otherwise, the amount you save is entirely up to you.

Sit down with your budget and figure out how much you can realistically save each month. Make sure you have room to set aside some money in a savings account for an emergency fund. (You'll want to save enough to cover three to six months of your living expenses.) Once your needs -- and a few wants -- are taken care of, it makes good sense to save as much in your 401(k) as you can.

If you can afford it, contribute enough to make the most of any employer match. If you don't take advantage of the free money, it's like turning down a pay raise.

But even if your budget is tight, it's better to save a little than not at all. Several small deposits can go a long way over time. Without an employer match, a 25-year-old could still save about $500,000 by retirement by setting aside just $75 a month. If he increases his contributions as he progresses in his career and makes more money, he'd build an even cushier nest egg. Use our calculator to see how quickly your 401(k) contributions can add up.

It's important to periodically evaluate your savings plan -- say, once a year -- to make sure it's working well with your budget and your goals. Use our retirement calculator to see if you are saving enough to get where you want to be in 30 or 40 years.

How to invest the money

Your employer will probably give you a list of about 15 to 20 stock, bond and money-market mutual funds to choose from.

Before making your selections, determine your risk tolerance. Most young adults, with a lifetime until retirement, can afford to take on greater risk in exchange for higher returns over time. This means you should focus most of your portfolio on mutual funds that invest in stocks.

Mutual funds are a great way to diversify your investments because you essentially invest in a number of different companies in a variety of sectors. Divide your holdings among these five types of stock funds:

  • Large-cap growth -- fast-growing companies
  • Small-cap growth -- smaller, fast-growing companies
  • Large-cap value -- large companies selling at bargain prices
  • Small-cap value -- smaller companies selling at bargain prices
  • International -- foreign companies

Check out Kiplinger's Fund Portfolios for more ideas on how to allocate your portfolio.

You may choose to start out investing in one fund, and gradually invest in others as your balance grows. Learn more about how to pick a mutual fund, then research your plan's investment options using Kiplinger's Fund Finder.

Most 401(k) plans will also offer an index fund, which is an easy solution to diversification. These funds invest in a basket of stocks to mirror the performance of the overall market, such as an S&P 500 index fund.

If part of your 401(k) is invested in your company's stock, it's also important to make sure that portion of your account isn't overweighted. If your employer goes under, you'd not only lose your job but a good chunk of your retirement savings. (Think Enron.)

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