Tuesday, March 25, 2008

Why Fund Your 401k - Especially If Your Employer Matches

(Note: The following is an email I sent out at work to encourage employees to start funding their 401k. I thought you all might fight it either motivational or informative.

I still feel that if you have a choice between a 401k and a Roth IRA, pick the IRA. The only exception is if your employer matches your contribution, and then you should fund it up to the max your employer matches before you start funding your IRA. My employer does match some, so here's what I said.)

In April, they will be having 401k open enrollment. The email with the details will be going out on April 1st.

This a great opportunity to invest all or part of your salary increase in a 401k.

Also, for every dollar you contribute to your 401k, the company will match 50 cents, up to the first 6% of your salary. If you contributed a full 6%, this would be like getting a 3% raise.

I believe anyone who started working before January 1st will be eligible.

For those of you who don't know, I'd like to explain a little about how a 401k works. If you're familiar with a 401k, and know how great they are, feel free to skip the rest of this Email. But if you don't know what they are or believe they're that good, read on . . .

Saving for the Future

The secret to building wealth is simple: Spend a little less than you earn.

In his book The Richest Man in Babylon, George S. Clason explains it something like this:

If every day, you put 10 eggs in a basket and every day, you only take out nine eggs, what will happen after a year?

Your eggs probably wouldn't fit, no matter how big your basket was.

The same principle is true for money. If, for every dollar you make, you spend 11, you will dig into debt. If, for every dollar you make you spend 9, you will pile up money for the future.

The Power of Interest

If you saved 10% of your income for 10 years, how much would you have at the end of 10 years?

You probably said 1 year's salary. 10 years at 10% equals 100 percent of your salary.

But that's forgetting something important--your money can also work for you.

Think of every dollar you make as a seed. If you plant it in the right place, it will grow, and bloom other dollars. Your money can actually work for you, making you more money, instead of you working for it.

For example, when we plant $255 with one of our good customers, it comes back to us as $300 two weeks later. The same can be true of your money. If you plant it in the right place, it will grow.

Then, if you plant those new dollars, too, then all of that money starts working together to make you even more money.

So after 10 years, you'd have one year's salary, plus all the interest you earned.

How much is that?

Well, at 10% interest per year, you'd actually have a bit more than a year and a half's worth of salary. Pretty good, eh?

Well that's not the coolest part. Think about this: If you had a year and a half's worth of salary paying 10% interest, at that point, the savings would be making more in interest than you'd be paying each year. If you were putting in 1,000 dollars a year, the interest would be more than $1,500. The money in your 401k would now be working for you, growing itself more than you're growing it with your monthly payments.

In fact, in just a couple more years, you'd be earning twice in interest what you were paying in cash. And a couple years after that, triple in interest what you were paying in cash.

By the 20th year, you'd be making half your salary just in interest.

And then, if you're smart you're thinking this:

How much would it take be earning my full salary in interest? If I was making as much off interest as I get paid, I could retire and just live off the interest!

And the answer is, just five more years. By the end of the twenty-fifth year, you could live just off the interest, free and clear. You could quit your job and go to work where ever you wanted, because it wouldn't matter how much you got paid.

(In fact, if you were really smart, and only had a fifteen year mortgage on your home, now you would be receiving your full income, and have no house payment, all without working!)

Sound like it's a long way off? Maybe you're thinking "Erik, in 25 years, I'm going to be 55! That's too long!"

To which I answer: How old are you going to be in 25 years if you don't save your money?

Real Wealth

Now all that talks about is how to retire. What if you want to have real money?

The answer to that is: The longer the money is in the account, the more it grows.

Guess how much it would cost a 15 year old to retire a millionaire? To have $1,000,000 at age 62, how much would a 15 year old have put away?

Really. Guess. If he was to make a deposit on his 16th and 17th birthdays, and never put in another dime, how much would those deposits have to be for him to retire a millionaire?

The answer? $4,000.

If he put in $2,000 on his 16th birthday and $2,000 on his 17th birthday, the kid could retire a millionaire at 12% interest.

He doesn't have much money. What he has a lot of is time.

I said that at 10% savings at 10% interest, it will take you 25 years to save 10 times your salary so you can live the same as you live now. After that, though, it will only take another seven years to double that and have 20 times your income. Then, you can live off twice as much as you're making right now. During those seven years, you would only earn your salary seven times at your job. But would it would mean another 10 times your salary in the bank.

To make another 10 times your salary? Only another 4 years. Another 10? Only 3 years.

So working another 14 years meant the difference between living your same lifestyle and living off four times your income, and having 40 times your yearly income in the bank.

Two more years, and you'd have 50 times your income. That means that someone making a mere $20,000 a year could retire a millionaire if they put away 10% of their income for 42 years (From 20 to 62), even if they never got a single raise.

In fact, if you've got fifty years to save, you could save a mere $1,000 a year (that's less than $100 a month) and end the fifty years with $1,000,000.

Now I know, I know. You're saying, "Erik, I don't have 50 years!"

And you're right. But the moral of the story is, interest means that the longer the time you have, the less you have to save to reach your goals. How much is it costing you to wait to start?

The 401k

In order to encourage people to save their money so they can take care of themselves in retirement, the government wrote a plan to make it easier to save money. It's called the 401k, after the section of the code that made it into law.

A 401k works like this: The government agrees that if you put your money into a special account, you don't have pay taxes on it until you take it out.

That means that all the money you put into your account comes out of your check before you pay taxes. That means that all of that wonderful interest that you earn in that account is all tax free. It is free to grow without Uncle Sam taking any.

You only have to pay taxes on what you take out. That means that 25 years from now, when you retire and take out one year's salary to live off of, you'll just pay one year's worth of taxes, the same way you did before. Even though you have a ton of money in the account, all you pay taxes on is the part you take out to live on.

There only catch is this: You're not allowed to touch the money until you're 59 and a half.

If you take out money before you're 59 and a half, you have to pay a tax penalty. You can borrow against it, as long as you pay yourself back (so you don't have to borrow money from credit unions and banks any more for certain amounts), but to start fully accessing it with only regular taxes, you can't start until you're 59 and a half.

This is because the government knows how tempted we'll be, when we start seeing those dollars pile up in there, to take it out and spend it. But that would be like a farmer burning up all his seeds. To save us from ourselves, and make sure we have as much as possible when we retire, the government makes us leave it in there where it can grow.

Something To Pass On

No matter how much you pay into social security, when you and your spouse die, that's gone. If you work real hard all your life and die the day before you become eligible for social security, the government just keeps the money you would have been paid.

A 401k isn't like that. All the money in the 401k is yours. If you die, you get to decide who gets it--whether it's your kids or your church or your favorite charity. All that money is real, and it's a legacy you can leave behind.

You can even make stipulations about it in your will, like it has to be used for college or something else you determine.

But it gives you the chance to leave your kids something more than funeral expenses.

Not Just More Money In The Future, But More Money Now

The other benefit is that many companies (ours included) will match a percentage of whatever you put in. In our case, the company will match 50 cents for every dollar we put in, up to the first 6% of your salary. If you make $20,000 a year, and contribute 6% to your 401k ($1,200), the company will put an extra $600 in to match it. $600 that you wouldn't get if you weren't putting money in your 401k.

$600 that can start earning you interest and working for you.

Plus, you're paying less taxes, because you're not paying taxes on the money that goes to the 401k. So even though your check is smaller, part of that would have been going to taxes anyway! Why not let it go to yourself instead?

Plus, if you got a raise, if you only put in the amount the raise was for, then the amount of your check won't really go down much at all.

Take Advantage!

When you watch TV, all of the commercials are for things that are going to cost you money. Even the commercials that pretend to be about how to make money, are really just ways for their authors to make money.

Nobody's going to teach you about what will make you money. Those are things you have to start learning for yourself. A 401k is a good start along that road. With a good 401k program in place, you will have the peace of mind of knowing that your future is secure. It takes away a lot of worry and stress about the future. It can be very hard to tighten the budget to afford to put the money in, but the peace of mind that comes from knowing you're taking care of yourself is worth it.

I hope many of you take advantage when the email comes out next week.

You'll thank yourself later.

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