A fact of life for many young people is that they are thinking more about paying their bills than saving for retirement. I know–as a parent of three young adults between the ages of 20 and 24, I hear their concerns about the job market and housing costs, along with the expenses of cars, phones and medical insurance as they start out on their own.
Small wonder that young people are participating in 401(k) plans at a lower rate than their older co-workers. Participation rates are 43% for workers under 25 and 62% for workers aged 25-34, compared to 74% for workers between 55 and 64. Not surprisingly, a similar pattern occurs according to income and job tenure—the lower the income and shorter the job tenure, the lower the participation rate.1
A 20-something landing his or her fist job at an entry-level salary naturally falls into all of these categories. For a new worker presented with the option of participating in the company 401(k) plan, it is important to think about a 401(k) contribution as something more than just cutting into precious disposable income. There are good reasons that contributing to a 401(k) plan is considered a financial bonanza, especially for young people:
— Your 401(k) contribution is pre-tax and will reduce your taxable income and tax bill now.
— That contribution will grow tax-free until you begin withdrawals in retirement.
— Or, if your employer offers a Roth 401(k) option, you can make after-tax contributions, which don’t give you the deduction now but which grow tax-free and are tax-free at withdrawal.
— If you are fortunate enough to work for a company that matches your contribution, that is free money to you, increasing your total compensation, even if you don’t receive it immediately.
Young people who take the message to heart will make saving for retirement a lot easier on themselves. One calculation shows that a person who starts saving at age 25 and retires at 65 will have to save 15% of income compared to 41% for a person who starts saving at age 45.2
Don’t Forget the Power of Compounding
Psychology may be the biggest challenge. Retirement seems distant when you are 25 years old, and planning for it lacks the urgency it does for a 50-year-old. But young people can take best advantage of the power of compounding. Even making small contributions will give you a leg up. As an example, a modest contribution of $100 per month compounding at 5% annually produces $153,338 after 40 years. Start 20 years later and a meager $41,375 is the final result.
Take Advantage of the Company 401(k)
Automatic deductions from your paycheck are an easy way to save. Contribute from the beginning, and you won’t miss it. If you don’t, it is too easy for your spending to expand and absorb all of your available income. As your salary grows, you can increase your contribution. At this time, you may begin to work with a planner as your financial life becomes more complicated. The important thing is to begin the process of making saving a life-long habit. The tax-advantaged 401(k) vehicle designed to encourage it is a great place to start.