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Millennials and Money

The College Grad's Guide to 401(k)s

The College Grad's Guide to 401(k)s

When you first graduate from school, there are plenty of things to stake a claim in your new paycheck. You might have student loans to pay, an emergency fund to save for and new furniture to buy for your new apartment. But you shouldn’t ignore retirement, no matter how far off into the future it seems.

On your first day at your first post-graduation job, you are likely to scrutinize everything from medical plans to flexible spending accounts. And the choices you make are important — and can significantly affect your finances.

There's one benefit that you don't want to overlook: the 401(k).

Many employers match an employee's 401(k) contributions up to a certain percent of salary. If you contribute at or beyond that threshold you take full advantage of the benefit. But if you contribute less than your employer is willing to match, you may be passing up free money.

Unfortunately, many people do miss out. Nearly 27 percent of 401(k) participants contributed below their employer's match threshold last year, according to the Aon Hewitt 2014 Universe Benchmarks Report, meaning millions of workers are leaving money — free money — on the table.

The Value of a Corporate Match

A 401(k) or similar employer-sponsored retirement plan can be a powerful resource for building a secure retirement — and an employer match can add a substantial amount to an employee's nest egg.

Let's assume you are 22 years old, make $40,000 and contribute 3 percent of your salary ($1,200) to your 401(k). And, for the sake of this example, let's also assume you continue to make the same salary and same contribution each year until you are 65. After 43 years, you will have contributed $51,600 to your 401(k).

Now let's assume you get a match from your employer. One of the most common matches is a dollar-for-dollar match up to 3 percent of the employee's salary. Taking full advantage of the match literally doubles your savings, even assuming no increase in the value of your investments.

Instead of having set aside $51,600 by the time you retire, with the employer match you will have set aside $103,200. That's $51,600 in free money. Looked at another way, it's a no-cost way for you to increase your contributions by 100 percent. And that doesn’t even include the growth you can expect from your investment returns.

Not all employers provide matches to employee contributions — so if you are uncertain, ask your company's human resources or benefits department. It's also a good idea to find out what the maximum percent of salary your company will match.

Tax Advantages

On top of that, who doesn’t like to save money on their taxes?

Contributing enough to take full advantage of an employee match will make sure you are taking all free money off the table, and it can also give you significant tax advantages.

With a traditional 401(k), your contributions are made with pre-tax dollars — meaning the money goes into your retirement account before it gets taxed. With pre-tax contributions, every dollar you save will reduce your current taxable income by an equal amount, which means you will owe less in income taxes for the year.

But your take-home pay will go down by less than a dollar. Here's how that works. Building on the example above, the $1,200 you contribute to a traditional 401(k) lowers your federal income tax bill for the year because you owe taxes on only $38,800 rather than $40,000.

If you're single, your total federal tax bill using the 2014 IRS tax rate schedule is $3,848 instead of $4,028 — a tax savings of $180.

In addition, any match your employer provides and any earnings in the account (including interest, dividends and capital gains) are all tax-deferred. That means you don't owe any income tax until you withdraw money from your account, typically after you retire.

The Earlier, The Better

It’s important to understand that even contributing at the match threshold may not be enough to fund a secure retirement. Most investment professionals recommend a savings level of 10 percent or more to generate enough replacement income during retirement.

But if you start saving as soon as you begin working, you’ll be off to a better start than your peers who decide to wait. The sooner you start saving, the more time your money has to grow.

Using the above example, if you are 22 years old, contributing 3 percent of your $40,000 salary with a full employer match, after 43 years, assuming your salary has remained constant and assuming a 6 percent rate of return, your 401(k) could be worth about $487,000.

If you waited to start saving until you were 30, your 401(k) would only be worth about $286,000.

Those numbers can be even higher the more you contribute to your retirement account. Currently, investors under the age of 50 can contribute up to $18,000 a year.