What’s the surest way to become a millionaire? I can tell you right now – max out your 401(k) contribution every year. This is the easiest way to build wealth. The problem is you have to start investing young and most of us didn’t know that when we were young. We spent too much money and didn’t invest enough in our 20s. Even I hesitated to contribute to my 401(k) when I started working in 1996. To a young guy who just started working, retirement was 40+ years away. Why should I put so much money aside? I wanted to go out, have fun, replace my junky old car, and wear nicer clothes. Fortunately, my dad convinced me to start contributing to my 401(k) and saved me from a huge mistake. The compounding effect of investing early is absolutely amazing. It’s too bad so many young people don’t understand this concept and put off investing until later.
Woefully inadequate retirement savings
Can you believe that half of all US households have no retirement savings at all? It’s true. Even households that saved for retirement haven’t saved enough. According to the latest (2016) Survey of Consumer Finance, the median value of retirement accounts for families near retirement age is around $120,000. That’s only the people with retirement accounts. People with no retirement accounts have much less saving.
Anyway, even $120,000 isn’t going to be enough to support a frugal retirement. If you keep track of your annual expenses, you’d know. For us, $120,000 would cover just a little over 2 years of expenses. That’s not long enough. Many people spend 30+ years in retirement. What will they do once their savings are gone? They will have to depend on other sources of income such as Social Security Benefits and part-time work. Unfortunately, they will have to spend less and drastically downgrade their lifestyle.
Luckily, I’m not average and you aren’t either. If you’re reading this, you’re way ahead of the normal households. At least, you’re trying to learn and save.
I have been maxing out my 401(k) for many years now and my retirement savings are in great shape. Let me show you how wealthy you’d be if you maxed out your 401(k) contribution every year since you started working. Hold on tight because you will be amazed by the power of compounding. (Compounding is just another word for compound interest.)
Maxed out 401(k) every year
The graph below shows how much your 401(k) would be worth if you maxed out your contribution every year.
Note: In our scenario, I have our worker contribute the max contribution divided by 12 every month. To make it simple, we’ll invest in VFINX, the Vanguard S&P 500 index fund.
Here is how to read this graph.
- The horizontal axis is how many years you have been working.
- The green line is how much your 401(k) would be worth if you maxed out every year.
- The blue line is how much you have contributed.
For example: If you started working in 2009, then that’s 10 years you could have invested in your tax-advantaged account. If you contributed the max every year, then you should have almost $320,000 in your 401(k) account by now.
I’ve been working since mid-1996 so that’s about 22 years. If I maxed out every year and invested in VFINX, then I should have around … $770,000 in my 401(k) by the end of 2018. Unfortunately, my account doesn’t have that much. I made some mistakes, too. I didn’t max out my 401(k) contribution when I first started working. It took me a few years to increase my contribution to the maximum allowed. Also, I chased performance in my early 20s. That meant my investments underperformed in those crucial early years.
At the end of 2018, I have $604,275 in my 401(k). That’s closer to 17 years worked instead of 22. Those early mistakes amplify as the years go by. If I could go back, I’d tell my younger self to focus on maxing out the 401(k) and put everything in a good index fund. My dad told me to invest in my 401(k), but he didn’t know about index funds. I had to learn from scratch. I’m still thankful that he convinced me to invest in my 401k. You can read more about my mistakes below.
How is your 401(k) doing?
The full table is below. It’s very easy to use. You just need to look at the first column and find the number of years you’ve worked. The Accumulated Value column shows how much your 401(k) would be worth if you’ve maxed out your contribution right from the beginning. The 4th column shows the max contributions for the corresponding years.
You can see the magic of compounding on this table. If you contributed $7,313 in 1988, it would turn into $134,863 today! That’s an incredible 1,840% increase and it will accelerate every year. Time is your best ally when it comes to retirement investing.
It’s clear that maxing out your 401(k) will make you wealthy by the time you retire. If you started working before 1993, you would be a millionaire now. I love my 401(k) and I can’t wait for it to hit 7 figures someday. Unfortunately, most workers aren’t contributing enough and that’s why the median value of retirement accounts is so low.
- Don’t delay maxing out your contributions. It took me a few years before I maxed out my 401(k) contributions. Those early years are crucial and you need to max out ASAP. The longer you wait, the more you’ll lose out with compounding.
- Don’t chase performance. I didn’t know how to invest when I was younger and I just picked the funds with the best performance from the previous year. This is called chasing performance. This is a bad idea and it will underperform in the long run. Funds that did very well the previous year usually underperform the next. It is better to invest in a low fee index fund like VFINX and keep at it.
- Don’t pause investing. I stopped investing for a while after the Dot Com bubble busted. This worked out okay in the short term because the market kept going down. However, it was the wrong move in the long term. If I kept investing, my retirement fund would be worth more today. You need to keep contributing even if the stock market crash.
- Don’t borrow from your 401(k). I haven’t done this because I never had to. It’s the wrong move because your retirement fund will be depleted and you’ll miss out on compounding. Your retirement accounts should be earmarked for retirement.
Those are the main lessons I learned from 21 years of investing in my retirement account. Let me know if you have anything to add here.
Max out your 401(k)
Of course, every 401(k) plan is different. Your retirement plan might not have good investments or the fees might take a huge bite out of your total return. Here is an easy way to see how much fees you are paying – sign up with Personal Capital and use their 401(k) fee analyzer tool. This free tool will help you figure out how much you’re paying. I just checked my 401(k) and I’ll pay almost $5,000 in fees by the time I’m 55. That sounds like a lot, but it is actually very low. All my investments are in low-cost index funds. Anyway, if you’re paying too much in fees, you probably should move your investment over to funds with lower fees.
For most people, maxing out your 401k contribution every year is the easiest way to become a millionaire. You will pay less in taxes and you won’t leave any employer matching on the table. As a bonus, the contribution is auto deducted so you don’t even miss the money. Start investing while you’re young and the magic of compound interest will supercharge your 401(k) and help ensure a comfortable retirement. Don’t wait until you’re 55 to start investing because it will be impossible to catch up.
How is your 401(k) compare to my table? Are you ahead or behind?
If you need help keeping track of your finances, sign up with Personal Capital to manage your portfolio. They have many great tools for investors including the 401k Fee Analyzer and the best retirement calculators on the internet. I log in almost every day to check on my accounts.
Joe left his engineering career behind to become a stay-at-home dad/blogger at 38. Today, he blogs about financial independence, early retirement, investing, and living a frugal lifestyle. See how he generates Passive Income here.
Joe highly recommends Personal Capital for DIY investors. He logs on to Personal Capital almost daily to check his cash flow and net worth. They have many useful tools that will help DIY investors analyze their portfolio and plan for retirement.