Retirement Planning: Why Setting Up a 401(k) in Your Twenties Is Crucial

Did you know that the 401(k) retirement savings program turned 40 on Election Day? This provision from the 1978 Revenue Act has become the foundation of retirement planning. And the 401(k) continues to be the most common tool to save for retirement. Anyone who collects a paycheck should take advantage of 401(k) savings, and with the cost of living continuing to rise, saving early can make all the difference when it comes time to retire.

The 401(k) plan was created as a way for employees to set aside part of their paychecks for retirement. That money is tax deferred, meaning that it is not taxed until the money is actually withdrawn or the funds distributed. 401(k) plans are considered defined contribution plans, which means employees contribute to the fund and employers can match or add to the funds (although it is not required). Employers often use 401(k) matching funds as an incentive to attract new talent.

There are limits to how much you can put aside in a tax-deferred 401(k). For 2019, the amount has been raised $500 to a maximum of $19,000, although workers aged 50 and older can make catch-up contributions up to an additional $6,000. The maximum joint contribution by both employer and employee is $56,000 for 2019. 

Critics complain that 401(k) plans were never designed to be the focal point of retirement planning and are a poor substitute for pension plans that offer a fixed payout at retirement. However, fewer Americans have pensions, partly because of the growing popularity of 401(k) plans. Because of 401(k) plans, it’s easier than ever to set aside retirement savings, which is why more people are saving—and you should too.

Save Now and Eliminate Hardship Later

Very few young professionals entering the workforce think about retirement planning. When they start getting their first regular paycheck, they become concerned with other costs such as rent and student loans. However, the ideal time to start thinking about retirement planning is when you get your first paycheck.

A common trap that many recent graduates fall into is establishing a lifestyle that matches their paycheck—every month, they spend all their earnings. When establishing a budget, you should include retirement savings, as well as a little money set aside for emergencies. If you continue to live paycheck to paycheck, you won’t be able to get ahead, and you’ll be in real trouble if you lose your job. 

It’s hard to think long-term when you are in your twenties, but you have to consider what life might be like when you are ready to retire. Social Security will probably be around in some form or another, but without a tidy nest egg, you will have to keep working to pay your bills. The earlier you start saving, the more you will have for retirement. In fact, if you start setting aside money when you are 25, you will have twice the savings at age 65 than if you started saving at age 40.

Benefits of a 401(k)

There are other reasons you want to start saving with a 401(k) as soon as possible:

1. You get free money: If your employer is matching even part of your 401(k) retirement savings, it’s like getting money for nothing.
   
   
2. You save on taxes: All 401(k) money is tax-deferred, which means it is not counted as part of your income. So even though you are putting money away, it will lower your taxable income.
   
   
3. Automatic payments force you to save: When you have money in your pocket, it’s hard to think about savings. With a 401(k), you can set up automatic payments so the money moves into your retirement account without you needing to think about it.
   
   
4. You can choose your investments: One of the advantages of a 401(k) plan is you get to choose how to invest your money to maximize earnings. The process doesn’t have to be complex—basically, you want to choose diversified funds or investments with no fees or very low fees.
   
   
5. You save more than you can with IRAs: There are other ways to save as part of retirement planning, including IRAs. However, an IRA plan has a contribution limit of $5,500, which is substantially less than a 401(k). Of course, you can invest in an IRA and a 401(k) plan to increase your retirement savings and reduce your taxable income even more.

When you are just starting out, money management can seem daunting. For example, is it better to try to pay off or refinance your student loans in order to save money or should you put money in investments? Although other types of financial strategies could pay off in the long run, be sure to start by taking advantage of the matching funds and tax benefits of a 401(k). Most people in their twenties have fewer family obligations and expenses, so they have more liquid cash—it’s the perfect time to start retirement planning. If you are not sure where to start, you can always confer with one of the financial advisors in Investment & Retirement Services, available through CFS* here at iQ Credit Union. We’re always here to help you plan for your future.

*Non-deposit investment products and services are offered through CUSO Financial Services, L.P. (“CFS”), a registered broker-dealer (Member FINRA/SIPC) and SEC Registered Investment Advisor.  Products offered through CFS: are not NCUA/NCUSIF or otherwise federally insured, are not guarantees or obligations of the credit union, and may involve investment risk including possible loss of principal. Investment Representatives are registered through CFS. The Credit Union has contracted with CFS to make non-deposit investment products and services available to credit union members.