Welcome to Two Minute Money, Yahoo Finance’s new personal finance series offering quick explanations for some the the most important questions involving your money.
Congrats. You’ve just scored a great job! And you’re earning a steady paycheck—finally.
But…
It’s never too early to plan for your retirement.
Think of your retirement accounts as rewarding yourself for being patient. Persistence pays off! The earlier you invest the easier retirement will be.
401(k)’s are popular because they’re easy to manage and sometimes your employer chips in. And yet 1/3 of eligible millennials aren’t signing up for free money.
Most companies offer 401(k) plans. Like health care, you might be auto-enrolled when you start your job. Later opportunities for enrollment come once a year, around December.
Here’s how 401(k)’s work…
A fraction of each paycheck gets invested in your retirement fund—before taxes are deducted.
Did I mention free money? Because in addition to tax savings, your company might match a portion of your annual contribution. Say you invest 3% of your income—some employers will match you dollar-for dollar. Say you make $55,000 a year. At 3%, what comes out of your yearly paycheck is $1,650, but what goes into your 401k is $3,300. A generous company will match a higher percentage. An extremely generous, lovable company will match your contributions up to 6% of gross income.
What should you invest in? 401(K)s give you options. A good reason to enroll now is you can confidently invest more of your savings in index fund based mutual funds and target date funds —with potentially greater payouts. But you can devote most of your savings to more stable bonds as you get closer to retirement.
Is there a catch?
Yes, severe tax penalties if you cash out before 65. So don’t cash out early. Patience pays off play the long game.
There’s an upside if you do and here’s what you get: a break on your tax returns. A quarter of your annual contributions—roughly—can be written off each year tax-free interest for decades. While your 401(k) matures, earnings compound tax free.
401(k) earnings are taxed after withdrawal. But 401(k)s are still better than your typical savings account. Say you have an average salary of $100,000 over a 40-year career. If you set aside 10% each year, and your employer matched 5% the contributions would grow tax free, every year. An average 5% rate of return means that your earnings from each year would be added to the balance that earns 5% next year. In 40 years, you’d grow an extra $900,000! And retire with a balance of $1.5 million!
If you had put 10% into a savings account instead, you’d have invested $300,000 and paid taxes along the way. A typical 1% return could only grow about $150,000 after taxes. Your 401(k) could allow you to retire with three times as much money as a savings account!
If you’re a millennial, your retirement is a long way away — which is great news because that means more time to save.
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