How much should a recent college grad be contributing to a 401(k), if anything? How does that even work? I know nothing about 401(k)s AH!
To be honest, any amount you can contribute is a good amount. You can always start small, like 3 percent of your salary, and increase your contributions as your income increases. However, you should definitely invest something.
A 401(k) is basically a pre-tax investment account. Each year the IRS sets a maximum contribution limit. For 2010, the limit is $16,500, with a catch-up contribution for those 50 years old or older, of $5,500. This means you can save a percentage of your wages up to the maximum amount, or $16,500. This money is withheld from your paycheck pre-tax, so you will not be taxed until you withdraw the money during your retirement. This is important because it gives you more money to invest. However, there is another option: the Roth 401(k). Any money you contribute to a Roth 401(k) is taxed when you contribute it, however it grows tax free and when you withdraw it you won’t be taxed. Considering the fact that taxes do go up, this might not be a bad idea. Both the traditional 401(k) and the Roth 401(k) have benefits, and either one is a good idea. If you don’t have a job you can invest in an Individual Retirement Account, or an IRA.
If you do have a job your employer may offer a company match. A company match is when your employer matches what you contribute, at least up to a certain percent. It is always a good idea to contribute whatever your company will match since this is free money. For example, if your employer offers to match up to 3 percent, you should contribute at least 3 percent.
This may sound overwhelming and you may be worrying that you don’t make enough money. Let’s think about this, if you get paid $500 a week, and you contribute 3 percent of each paycheck, that’s only $15 a week. That’s around 4 cups of coffee at Starbucks (less if you get something fancy or the largest size!). Thinking about it this way you’ll see that it is probably possible for you to contribute even more, and the more you can contribute the better. In fact, you can probably contribute up to 15 or 20 percent before you reach the maximum limit, and any amount up to the maximum is advisable.
However, when saving for retirement it’s not only how much you contribute but for how long, this is because of compound interest. Compound interest means that you earn interest on the principal (the amount you are contributing) and interest on the interest. The difference in starting to save at age 25 compared to age 45 can be hundreds of thousands of dollars (depending on how much you save, etc). I recommend trying a Compound Interest Calculator to see exactly how much you can earn if you start saving now versus in five, ten or twenty years. If I could do things over, financially, I would have started saving for retirement right out of college, and if I could offer one piece of advice it is to start saving for retirement as soon as possible.
Investing in a 401(k) can be confusing. You can choose to invest in stocks, bonds or money market funds. Stocks are higher risk with a higher payoff, but if you are investing for the long term (and if you are investing for retirement you are making a long-term investment) you don’t have to worry too much about the risk, the market will go up and down, and over 30 years it should balance out. You can also choose to invest in mutual funds, which are often easier and less stressful. If your company has stock you may invest in it, but don’t ever invest more than 10 percent in any one stock, including your company stock. Your company may have someone who can help you when choosing how to invest your money.
Investing in your retirement is a necessity. Most companies no longer offer pensions and none of us can definitively count on Social Security. Your 401(k) may be your only means of survival when you retire. It can be the difference between living out your life comfortably, or very uncomfortably.