We've mentioned the importance of starting to save for retirement as early as possible, not waiting for a year, two years or longer to begin. Procrastination, even among people with access to a tax-deferred savings plan like the one offered by your company, is a common response and can be a costly mistake. How costly?
Consider a 30-year-old worker who plans on retiring at age 65. Although his company offers a 401(k) plan, the worker believes he has plenty of time – more than three decades! – before retirement and is in no hurry to start investing. Five years later, at age 35, the worker does start saving in his employer's 401(k). For the next 30 years, the worker contributes $400 every month, earns an annualized return of 8% and retires with a portfolio worth $567,041. That's a pretty impressive nest egg.
But this worker could have done a lot better. Starting to save just five years earlier, at age 30, with the same contributions and annualized return, the worker could have seen his retirement assets grow to $898,480 – a $331,000 windfall for choosing to invest in his company's plan as soon as he could.
You can't control how the financial markets perform. But as the example above illustrates, you can control how much you invest and, perhaps most importantly, how long you invest.
The power of tax-deferred growth
Another potentially positive factor is tax deferral. In your 401(k) plan, taxes on the growth of your assets are deferred until you start taking distributions. Because that money stays in your account and continues to grow (if all goes well), tax deferral could help you accumulate savings faster than with a regular, taxable account.
Here’s an example. We’ll compare the growth of regular contributions, $400 a month, in a tax-deferred account – which doesn’t have to pay taxes on dividends and capital gains each year – to growth in a taxable account, which does have to pay taxes on its gains.
Both accounts earn a gross return, before taxes, of 8% a year. But while the tax-deferred account continues to grow at an 8% annualized return, the taxable account grows at a slower rate of 6.50%, due to the effect of taxes.
This example is hypothetical and your own results will be different. But the principle is clear: a tax-deferred plan can grow your retirement savings much faster than a taxable investment providing identical returns. In many cases, the difference can be substantial.
Diversity with asset allocation
We noted earlier that, as an investor, you can’t control the markets. But you can still take steps to potentially manage short-term volatility.
Your employer-sponsored retirement plan can help. By offering a broad selection of investment options, your 401(k) lets you “diversify” your portfolio through a process called asset allocation. That means spreading your money among stock and bond funds that invest in many different industries and companies – in other words, not putting all your investment eggs in one basket.
When one “asset class” hit a rough spot, the other asset classes might rise in value, smoothing out volatility in your portfolio. (Diversification and asset allocation do not guarantee a profit or protect against a loss.)
Some studies have shown that asset allocation has a far greater impact on investment performance than stock selection, market timing or other factors. But asset allocation doesn’t have to be overly complicated; your company’s retirement plans makes it fairly simple to create a diversified portfolio.