Everything the Younger Generation Should Know Before Starting a 401(k)

From a young person’s perspective, the ideal 401(k) strategy is usually to start as early as possible and maximize employer match if it’s available. Compound growth is a hugely powerful tool in retirement savings, which means dollars saved in a person’s early 20s will have significantly greater impact than dollars saved in one’s 60s. Four decades of growth, if wisely invested, can have dramatic effects on retirement savings.

How Compounding Works

Compounding is one of those concepts that makes sense once you grasp it, but isn’t necessarily intuitive to young people who have little to no experience using financial tools. Modern high schools don’t exactly prioritize teaching financial literacy, and unless a student is taking business classes, they may not be exposed to this powerful investment topic in higher education.

If a young investor saves $1,000 when they’re 22 years old and manages to maintain a modest six percent annual growth on that $1,000 until they reach retirement at 62, that $1,000 will be worth $10,285.72.

That’s assuming they don’t keep saving throughout their working years. In a scenario where that young person managed to save $6,000 a year at the same rate of return, they’d retire with $744,286.10.

Many young people are familiar with saving as a strategy to get what they want. A 10-year-old with an allowance might save to buy a new game system 12 months in the future. However, the child’s savings account might only have about 0.23 percent APY and the amount they are saving is so small that they would earn literally cents over the course of a year (if they even qualify for interest given minimum balance requirements). The value and utility of saving for a large purchase is still an incredibly valuable lesson, but it doesn’t teach the young person about the power of compound growth.

A 401(k) is very likely a young adult’s first experience with compounding, and it often takes a calculator and some time to truly grasp its potential. What is far easier to understand is the concept of free money.

Not Taking Advantage of Matching Is Leaving Money on the Table

Maximizing matching contributions seems like a no brainer. For all intents and purposes, workers can give themselves a raise simply by saving the appropriate percentage of their income each pay period. A typical 401(k) in today’s market often offers 50 cents matching on the dollar up to six percent of a worker’s salary. If the worker makes $60,000 a year, they could max their matching by putting $3,600 in their 401(k). Their employer would then add an extra $1,800 to their 401(k) on an annual basis.

In essence, that worker can increase their income to $61,800, but their take home would be reduced by $3,600 annually. And therein lies the rub.

Young professionals, especially those in white collar careers, are frequently fresh out of college. A little over half of university students take out student loans, the vast majority of which is federal student loan debt.

Young people in the Phoenix metro area are somewhat fortunate in that the cost of living here is significantly better than in some other major metro areas – but it’s still not cheap. Their budgetary constraints will also be influenced by the quality of life to which they’re accustomed, their spending habits and any other debts they may have (car loans, credit card debt, etc.).

Sacrificing $3,600 a year might not be a feasible option, especially since their take home will be whittled away by a variety of other things in addition to their 401(k) (withholding, health care, dental, vision, life insurance, etc.).

Young people should do an honest cost-benefit analysis and dispassionately analyze their budget before choosing to forego free 401(k) matching dollars. That’s often easier said than done, especially if you’re a 20-something Gen Z-er enjoying your early years of freedom from school and parents while also coping with the hassles inherent with your first nine to five job.

Get Help with Your Retirement Savings in Phoenix

Whether you’re a young person just starting down the path toward retirement savings or you’re in your 50s or 60s and finalizing your retirement plan, getting professional guidance from a retirement planner can be invaluable. The team at Fullerton Financial Planning is always ready to provide the tools and advice retirement savers need, regardless of where they’re at in their journey.

Call us at (623) 974-0300 to speak with an advisor today.