Estimated reading time: 4 mins
I’m going to tell you a story, one that I’ve been kicking myself for since the day it happened. It was my big mistake, and one that will cost me dearly in retirement. The mistake? Not paying enough into my 401k in my early career.
When I started out in my career, I had just graduated university and was looking forward to making some money, but thinking about retirement seemed so far away; it felt like something to worry about later on, not now. So when it came time to start putting money into a 401k plan, I only paid what I thought would be sufficient. Little did I know how much of an effect compound interest could have on the growth of investments over time.
But before we dive into the effects of compound interest and why not paying enough into a 401k can really hurt you financially down the line, let’s take a look at what exactly a 401k is first. A 401k plan is an employer-sponsored retirement plan which allows employees to save money for retirement while also offering tax advantages such as pre-tax contributions or tax-deferred savings (meaning your taxable income will be lower). This means you can pay less taxes now and have more money saved up for when you retire later on – sounds great right?
And here’s where compound interest comes in; this is where your investments grow exponentially over time thanks to the ‘interest earned on top of interest’ concept – essentially meaning you’ll earn interests on both your initial investment as well as any returns earned from those investments over time. For example, let’s say you invest $1,000 today at 5% compounded annually – at the end of year 1 you’d have $1,050 without having added any extra funds (the extra 50 being 5% return on your initial investment). Fast forward 10 years later and that same $1,000 invested at 5% compounded annually would now be worth $1,628 – almost double what it was initially due to compounding! Now imagine that same scenario with larger sums of money invested over longer periods of time – those returns become even more impressive!
So if compound interest can help make our investments grow so much faster than regular non-compounded investments then surely not taking advantage of this when investing in our 401ks must be hurting us right? Absolutely! By not contributing enough into our 401ks we’re missing out on all those gains from compounding and potentially leaving thousands (if not hundreds of thousands) behind by retirement age. Here are some examples based off real life scenarios:
- Manuella invests $100 per month into her 401k account with 3% annual return rate compounded monthly – by age 65 she would have accumulated close to $220K
- John invests twice as much ($200 per month) but with 6% annual return rate compounded monthly – by age 65 he would have accumulated nearly double what Manuella did ($417K)! Ker-ching!
- Finally Jack decides he doesn’t want to contribute anything until his late 30s/early 40s so he waits until then before investing twice as much ($400 per month) but with 6% annual return rate compounded monthly – by age 65 he would still only accumulate about half what John did ($210K).
All three were investing equal amounts each month after Jack caught up but because Jack didn’t start earlier he ended up accumulating far less than Manuella and John despite having invested more each month due to missing out on all those gains from compounding earlier in his career!
It’s important to note here too just how small contributions can add up over time too; even if you don’t think you’re able to afford large amounts every month it’s still better than nothing (as seen with Jack above!) As long as your employer offers matching contributions then make sure you contribute at least enough each month so get maximum benefit from their match – for example if they offer a 50% match up to 5%, make sure contribute at least 5%. Even small contributions will add up significantly over time thanks again due to compound interest!
I wish someone had told me all these things back when I started out; knowing how important small contributions are combined with compounding could have made such a huge difference for my future finances! And yet here I am today regretting my big mistake – not paying enough into my 401k early in my career – something which has cost me dearly ever since. My advice? Don’t let this happen to you too; research everything carefully before deciding how much should go towards your 401k each month and whatever happens don’t forget about its potential power through compounding!