Young People: Invest In Your 401{k}

Young people please invest in your 401{k} plan if you have one at work!  Business Insider recently ran three scenarios that showed the powerful advantage of compounding assets over time.    They used a long term average growth rate of five percent.  Here's their three scenarios:

We have three investors who take different approaches to retirement saving:

• Our first investor starts saving $300 per month at the age of 25 {Purple Line}
• THe second follows Altucher's advice, waits ten years, and starts saving $300 per month at 35 {Orange line}
• The third investor waits even longer and starts saving at 40, but in order to try to catch up, puts $600 into her account each month {Blue Line}

This works because of the long term advantage of compound interest growth.  That is if you start with $100 dollars and earn 5% then next year you start with $105.  Assuming that same 5% growth rate, by the end of that first year, you end up with $110.25 as opposed to just $110 if you had a simple interest calculation.   It may not seem like much at the beginning but over time that little difference works out to a lot.  If you want to see what a lot is, take a look at the chart above based on Business Insider's calculations.  

If you apply these calculations on your own remember a couple of things.  

Business Insider in their post assumes a 5% rate  of return.  Your returns will depend on your asset allocation.  Your asset allocation will depend on where you fit in the risk return profile.  The more aggressive you are in your assets the higher potential return but also a higher potential for loss and higher volatility.  {More on asset allocation at some later time}.

The great thing about starting young is that you have the ability to let the power of compounding work over a very long period of time-nearly 40 years if you plan to retire when you are 65.  The other great thing is that you have a much greater ability to withstand the inevitable periods when your assets decline in value due to a bear market {yes you will see a few of these in your lifetime}.

Finally the other great thing is that the money in your 401{k} under current law grows tax deferred.  That is under current law you're not taxed on any of the gains in the account it until you start to withdraw it sometime later on.  There are rules about when you can withdraw and at what age but for now what you need to understand is the power of tax deferral.  Let me show this by using an example.  I think most young people should for the most part use diversified investments in 401{k}s, preferably ETFs or if not these, then mutual funds.  But let's say in this example you invest $100 and buy 1 share of company XYZ.  XYZ is the next big thing.  It's stock takes off on a multi-year run.  By the time you are 50, that $100 investment has ballooned to $1,000,000.  You then sell the stock.  Under today's rules if that sale was in a non-tax deferred vehicle you could pay capital gains taxes of between $150,000 and $200,000.  {Rate depends on your income level and again there's a bit more to this than what I'm showing in this simple example, but it's enough to get my point across.}.  In a 401{k}, under current rules, you pay no taxes until years later when you start to withdraw the money.  At that point what you're required to withdraw is based on actuary tables and what you have to pay in taxes is based on your current income tax bracket.  Assuming that many people are in a lower bracket when they retire, this is a huge potential lifetime savings.

So save that money youngsters!  Not sure you should count on things like social security by the time you get ready to leave the work force.  Also pay off your student loans if you have them as fast as you can.  That's a subject for another time.

Back Monday.

Link:  BusinessInsider.com:  Actually Young People SHOULD Invest in their 401{k} Plans.