Why You Should Participate in a 401(k)

We all know that we should save money for a rainy day, a message we’ve received since we were little ones, but this article covers some more reasons why you should participate in a 401(k) plan, if you have one available.

It’s on you

Back in the olden days when the earth was still cooling, employees could count on (or at least thought they could count on) a pension benefit from their employer upon retirement.  This pension plan provided a safety net that allowed the employee to go into retirement with relatively little concern about whether there would be enough money to live on.

However, the pension plan has gone the way of the buggy whip for most employees these days – relatively few employers offer a traditional pension plan any more, and many times the amount of the pension available has been cut back drastically if not eliminated.  This means that it’s up to you to provide for your retirement income – and one way to do this is to save money in a 401(k) plan.  Saving money into these plans provides you with a tax-advantaged way to set yourself up for the future and ease your mind going into retirement.

A good habit

Saving in any form is generally a good habit.  Saving using a 401(k) plan is a low-impact way to do this, because your money is deducted from your paycheck before you get your hands on it, automatically, every payday.  Once you’ve set up your contributions, you don’t have to remember to make a savings contribution, it’s done for you.

Plus, since it’s not easy to take money out of the plan (generally disallowed while still employed) and can be quite costly if you do take money out, you’re much more likely to leave the money alone until you need it in retirement.  This helps to generate self-discipline with regard to savings – it’s a good habit to get into, thinking of your savings as untouchable during your accumulation years.

Best avenue to success

It might be argued that choosing the best, most successful, fastest growing investment is the best way to grow your retirement account to the greatest amount.  Time and time again, it has been proven that the greatest determinant of your retirement savings success is the amount that you set aside.  If you have more set aside, that fast-growing investment has more to build upon.

Another very important determinant of success in retirement saving is to start early, and maintain the savings habit over time.  This is because time, when used to compound savings, is very powerful.  If your investments return 6% on average per year, after the first year a $1,000 contribution is worth $1,060.  After the second year at the same rate, when you contribute another $1,000 to the account and last year’s money compounds as well, you would have a total of $2,183.60 – from a total investment of $2,000.  After 10 years of this routine, you’ve deferred $10,000, but your account has grown to $13,971.64.

The 401(k) plan is an excellent vehicle to use to take advantage of saving large amounts of money and allowing compounding interest and returns to work hard for your retirement.

Matched funds – free money!

Your employer quite likely provides a match for a certain amount of your contributions to the 401(k) plan – and if you don’t participate, you won’t likely get this free money.  For example, if your employer matches 50% of your contributions up to 6%, if you defer $1,000 of your own salary into the plan, your employer will give you an additional $500.  This is like getting a 50% return on your savings!  And the extra money that your employer provides is added to your compounding “pile”.  After 10 years with the employer match, where again you’ve contributed $10,000 total to the account, at our example 6% return the account will have grown to $20,957.46 – more than double what you deferred.

Dollar-Cost Averaging

The final benefit to investing in your 401(k) plan is that by default you are participating in dollar-cost averaging.  Since you are investing the same amount of money from each paycheck, you are investing in all market cycles.  When the cost of the investments is high, you’re purchasing fewer shares; when the cost is low, you purchase more shares.

For example, if you invest in a stock mutual fund that fluctuates over time, at a rate of $100 per pay period, you might have the following results:

Period 1 – $100 invested @ $10 per share = 10 shares – 10 total shares

Period 2 – $100 invested @ $9 per share = 11.11 shares – 21.11 total shares

Period 3 – $100 invested @ $8 per share = 12.5 shares – 33.61 total shares

Period 4 – $100 invested @ $12.00 per share = 8.33 shares – 41.94 shares

Period 5 – $100 invested @ $15.00 per share = 6.67 shares – 48.61 shares

Over the five periods you invested $500 total, and purchased 48.61 shares, now worth $729.15 at the current rate of $15 per share.  But notice how the number of shares fluctuated with the share price – more shares when the price is low, fewer shares when the price is high.  What’s that old saying?  Buy low, sell high?