Invest in 401K Early

Two friends started their careers at the same time in a consulting company. Both had about the same income over the years. After 10 years, one has $250,000 in 401K and the other has $0. Don’t be the second guy. Invest in 401K. 

Of course the guy with $0 is me. Me and my friend Rahul started our career at a technology company in our early twenties. After a few years, we moved companies, but we were in touch. When I met him a few years ago, one of the topics we spoke about was personal finance. My jaws dropped when he said he has $250,000 in 401K. 

That night, after I came home, I reflected on where I went wrong. Why didn’t I invest in 401K? Looking back, I was a fool to not invest a little bit into 401K instead of investing all my savings into businesses. 

I have had a love for business since childhood. I always saw myself as an entrepreneur. When I had some money saved, I started a few businesses in India. What I didn’t realize then was that I did not have the skills to run a business nor the time to manage it doing a full-time job here in the US. 

Why did I not invest in 401K?

Knowing the importance of investing in retirement funds, why didn’t I invest in 401K? 

1. I thought I could make more money by investing directly in stocks. 
2. I was going to get paid less. When I calculate, I would have got only 3% less from my take-home salary. 
3. I thought I would not be able to save enough for retirement investing in a 401K.

None of these are good reasons to not invest in 401K. These are excuses. I was overconfident in my skills. I should have diversified and invested first into 401K.  After I met Rahul, I started investing in 401K. 

Calculating Future Returns 

By starting early, Rahul’s money will compound longer.  To understand what I will be missing by being 10 years late, let’s calculate my returns and Rahul’s returns at age 65. 

For the calculation purpose, let’s assume both of us earn $100,000 a year, we contribute 5% to 401K and our employer matches 5%. The only difference is the starting balance. At age 35, he already accumulated $250,000. I am starting with $0. I keyed in the numbers to bankrate.com 401K calculator. Here are the results. 

Rahul’s returns at age 65 with $250,000 beginning balance at age 35

At a 7% rate of return, Rahul will have $3 million dollars at age 65. And I will end up with about a million dollars. By starting 10 years late, I am missing out on $2 million dollars in retirement income. Let that sink in. If you are on the fence thinking whether to invest in 401K or not, go sign up now. At the least, contribute up to what your employer matches. Your employer’s contribution is free money. Let’s look into the pros and cons of investing in 401K

Pros of investing in a 401K

1. Employer Match – The biggest advantage of 401K is the money your employer matches for your contribution. Most employers match 100% up to a certain percentage of your income, usually between 3% and 5%. Don’t leave the free money, set your 401k contributions to maximize your employer’s match. 
2. Tax Advantage – The money you contribute to 401K is on a pre-tax basis. This will reduce the tax you pay as your pre-tax income will reduce your annual taxable income. You will pay tax on both contributions and growth upon withdrawals in the future.
3. Protected by Law – The money invested in 401K is protected by a federal law called the Employee Retirement Income Security Act of 1974 (ERISA). So your money is safe. ERISA also protects your 401K money from your lenders. If you fail to pay your car loan or mortgage, your lender can not go after your 401K money. 
4. Solves our Saving problem – If we have to save and invest every month, most of us will not do it. Because 401K contribution is detected automatically by your employer, you do not have to transfer manually. You just have to sign up once and forget about it. 
5. Diversified Investment – With 401K, we can allocate the savings to various funds instead of chasing the next hot stock. We will have a guaranteed return of about 8% over the long period. 

Cons of Investing in 401K

1. Early Withdrawal Fees – One of the biggest disadvantages of any retirement account including 401K is that you will pay a 10% penalty for taking an early withdrawal before reaching age 59½. This disadvantage turns into our advantage by discouraging us to withdraw the money early. 
2. Limited Investment Options – Most 401K plans have limited options when it comes to the quality and quantity of investments.
3. Limited Guidance – You are left to choose the investments with little to no guidance from the plan provider. 

By investing in 401K you will end up 3% less on your take-home income now. This 3% will grow into millions at retirement. Although 401k’s have their disadvantages, the benefits far outweigh the weaknesses. 401K is a very convenient way to save and invest for retirement. Don’t be a fool like me. Be like my friend Rahul and start investing in 401K early.