We know you have diligently been contributing to a 401(k) plan, and you have probably enjoyed seeing your net worth grow each year. For many Americans, a company-sponsored 401(k) account will be the most valuable piece of their retirement income pie someday.
There are several reasons behind the success of 401(k) plans, including the fact that they are funded with pre-tax money. But the single most powerful force in your retirement plan is not tax deductions, not even saving more for that matter.
It is easy to think that the key to retirement success lies in a rapidly appreciating stock market. Stocks do matter to your portfolio, of course, and we are certainly advocates of well-managed investment funds. But counting on a perfectly timed bull market is a dangerous way to approach the retirement problem. The true key to retirement success is the magic of compounding – it’s what makes retirement happen.
By definition, compound interest occurs when the interest that accrues to an amount of money in turn accrues interest itself. Retirement accounts like 401(k) and Roth IRAs– because they are actively invested — have the potential to make the most of this benefit. The key to maxing out this potential? Two things: income and time. Why? Because of compounding. Here’s a simple way to think about it.
- If you invest $100 and get a 7% return, after a year you have $107. And here is where the magic kicks in. From there, instead of working for money, money begins to work for you. That extra $7 is growing as well. Let it compound for 30 years without adding anything and you end up with $802.
- Imagine instead you set aside $20,000 by age 35 and added nothing to it. Over 30 years at 7% your money grows. Slowly at first. At Year 10 the number is a bit over $40,000 – a double with no effort. At Year 20 the figure has doubled again, to $80,128.
- Wait just 10 more years and the magic of compounding really kicks in. That modest amount you put to work at age 35 has grown to an impressive $162,384 in 30 years. If you can wait 10 more years, you double again to $321,024. All assuming a rather sensible growth rate.
And all of this can happen for you if you do not dip into your account!
Resist the Urge to Take Out a 401(k) Loan
If you have a pressing financial concern and a balance in your 401(k) account, you may be tempted to take the cash out in the form of a 401(k) loan. After all, the money is just sitting there, and you would be paying interest back to yourself if you took out the cash.
But while that might sound like a smart financial move, in reality the money already has a job: it will help you afford food, housing, and hobbies when you are enjoying retirement. Even taking relatively modest amounts from your 401(k) before you retire can have serious consequences for your standard of living in retirement. And here is why: You will miss out on the compounding your investments would have otherwise generate
For example, if you take a $10,000 loan from your 401(k) account 20 years before retirement, then take five years to repay the loan at 5% interest while you were otherwise earning 8% on your investments, you’d lose about $2,625 in earnings, assuming you repaid the loan on time
You could, of course, lose much more depending upon the movement of the market. If you took out a 401(k) loan during the financial crisis in 2008 and sold all of your investments when they were way down because of the market crash, you very well could have had to buy back your investments at a much higher price and would have missed out on much of the market recovery.
And, of course, there is also a risk that you won’t put the cash back at all…which could end up costing you decades of compound interest and which could result in that $10,000 loan having a cost of more than $62,000 in savings by the time you reach retirement.
We Get It We’re in a Bad Place Right Now…
As we write this, the coronavirus (COVID-19) outbreak is crushing the U.S. economy. The stock market’s volatility is unlike anything we have seen in our lifetimes, businesses are shuttering, unemployment claims are exploding, consumer spending is tanking, and recession fears are rampant.
It will take time for our government agencies and institutions to stop the bleeding and get the economy – and our lives — back on track, but action is being taken.
One of the ways Congress has decided to help people affected by the coronavirus mess is to allow them to get money out of their retirement plans. Specifically, the stimulus measures include a waiver of the 10% penalty for early withdrawal from a retirement account. If you want to borrow from your 401(k) account, you could take out 50% of your account balance, up to $50,000. Most loans must also be repaid within five years. Taxes on these withdrawals would be spread out over three years.
But 401(k) Plans Were NOT Intended to be a Kind of Piggy Bank – DON’T TOUCH YOUR 401(k)!
Your 401(k) account is without argument one of the best options you have to save for your retirement, so it is smart to leave it alone unless you face an extremely serious hardship. While the Feds have loosened the rules about withdrawing 401(k) money prematurely, your 401(k) is still a valuable – maybe the most valuable — piece of your retirement income strategy. Allowing it to thrive is much more important than you might think.