Remember when Friday night fun consisted of going to the video rental store to rent the latest “new release?” How about when you had to take a roll of film in to get it developed? Times have changed—and planning for retirement is no exception.
As I look forward 30+ years to retirement, I know that the traditional sources of income have changed. In the past, social security and pension plans made up a large portion of retirement funds.
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Now, pensions are as rare as a VHS movie and the availability of social security is uncertain—so it’s best to take matters into your own hands. The good news is, with a qualified retirement plan, it’s easy!
What is a qualified retirement plan?
A qualified retirement plan is a retirement plan established by an employer for their employees. There are two types of qualified plans—defined benefit and defined contribution. With a defined benefit plan, such as a pension, the employer pays you a set amount when you retire based on factors such as length of employment and salary. In this plan, the employee contributes nothing.
In a defined contribution plan, such as a 401(k), the employee contributes money to the plan (a percentage of their salary) and the employer deducts it from payroll and puts it in your account. Generally employers also offer to match your contribution up to a certain amount, for example, an employer may match your contribution dollar-for-dollar up to 4% of your salary.
Defined benefit plans are few and far between these days, so it’s far more likely you will run into an employer with a defined contribution plan.
There are different names for defined contribution plans depending on the industry you work in, all serving the same retirement saving premise:
- 401(k): corporations
- 403(b): public education and non-profits
- 457: state and municipal employees
- Thrift Savings Plans: federal employees
Let’s take a closer look at how a qualified retirement plan, like a 401(k), is an important vehicle to help you save for retirement.
- Tax Advantages. Contributions to your traditional 401k come out of your paycheck tax-deferred (meaning you’re not taxed on them until you withdraw the money in retirement). This reduces the amount of income you have to pay taxes on, score!
- Company match. Most companies offer a match to the contributions employees make to their 401(k) plan. The company match is free money, so you will want to make sure to take advantage of it. For example, if your employer offers up to a 4% dollar-for-dollar match, you want to make sure you’re contributing at least 4% of your salary so you are getting the full match and the most free money.
- Payroll deduction. Your contributions are taken right out of your paycheck and automatically put into your individual account. Not only is this simple, but the money is being put away before you even have a chance to notice it.
- Investment options. The money you put into a 401(k) is invested in a series of investment options. For the brave, you can pick your own funds—or, leave the work to a professional, and select Target Date mutual funds. Target Date funds align with your expected year of retirement and the fund manager automatically adjusts the investment mix based on the years until retirement with more growth-oriented funds early on and more conservative funds as you approach retirement. All you have to do it set it, forget it and leave it up to the professional!
- Value of compounding interest. You contribute to your 401(k) account for a long period of time—possibly 40+ years—which means you are using the powerful accumulation tool that Albert Einstein called “the greatest mathematical discovery of all time”…compounding interest. Compounding interest is an exponential increase on your money. In other words, it’s when a bank pays interest on both the principle (the original amount of money) and the interest that an account has earned. The earlier you start contributing to your 401(k), the longer you maximize the benefit of compounding interest and the more income you will generate for retirement.
Let’s look at some examples of just how impactful compounding interest can be:
Imagine giving up your daily $4 latte and putting that money into your retirement account. Your $4 deposit adds up to about $125 a month or $1,500 a year.
Now, let’s say your money is earning an average rate of return of 7% compounded annually. If you started this savings program when you were 25 years old, by the time you were 65 your money would have grown to $310,689 thanks to the power of compounding interest.
On the other hand, if you started this at age 35, by the time you were 65 your money would have grown to $147,008. Starting 10 years earlier made a difference of over $160,000 in the end! Because of compounding interest, those key early years of saving more than doubled the final investment at age 65.
As times continue to change, contributing to a qualified retirement plan is a surefire and effective way to fund your retirement without relying on external sources of income.
If you haven’t already, check and make sure you’re getting the most out of your employer’s qualified retirement plan.