We get it—given the state of the world, it may feel weird to start putting money aside for much later in life. In fact, 73% of Gen Z say the current economy makes them hesitant to set long-term goals. Not to mention, making a good living and building your savings is tough, with expenses like housing and essentials getting more and more costly. Even so, investing in your future is a fundamental practice to ensure you’ll live comfortably down the road.
Luckily, some systems and tools can help make the process smooth. Once you calculate an ideal (and feasible) retirement age, there are a few routes you can take. If your job offers 401(k) benefits, you can aim to save at least 15% of your pre-tax income, the percentage that many financial advisors suggest.
Key Takeaways
- Starting early and contributing to a 401(k) in your 20s is crucial for long-term financial security.
- Aim to save at least 15% of your pre-tax income for retirement.
- Take advantage of employer-matching contributions to maximize your savings.
- Use the 50/30/20 rule of thumb to determine the amount to contribute to your 401(k).
- Increasing your contributions over time can significantly impact your retirement savings.
In some cases, your employer will match part or all of your contributions, which is essentially a way to double your savings. If you don’t have a 401(k) plan through an employer, you can open an Independent Retirement Account (IRA). We’ll explain.
Understanding 401(k) Contributions
A 401(k) is a retirement savings plan offered by many American employers. As an employee who signs up for a 401(k), you agree to have a percentage of each paycheck paid directly into an investment account, and the employer may match part or all of that contribution. If you have a 401(k), you can choose among several investment options, typically mutual funds.
Taking advantage of a 401(k) plan is smart for a few reasons, one of which is the tax benefits. Your investments are pre-tax, meaning you keep a higher portion of each paycheck. Taxes and penalties typically apply only if you withdraw funds from your 401(k) before you turn 59½. You can also deduct any traditional 401(k) contributions from your taxable income, which may reduce the amount you owe in federal taxes.
“It’s like why we buy toilet paper in bulk. A 401(k) is bulk buying,” says Jeanne Sutton, CFP, CPFA, MBA, who specializes in future financial planning. “A bunch of people are banding together and creating an investment account and getting lower pricing for doing that. So in general, a 401(k) should be the first, and for most Gen Z, the only place they have to save right now.”
Factors When Calculating Your Contribution Amount
To understand how much of your paycheck you should aim to invest, you need to consider several factors.
Calculate an Ideal Retirement Age
Start by calculating your ideal retirement age. This is based on your individual goals and circumstances. There are several retirement calculators that let you adjust numerous factors to help determine how much you need to save. They factor in your current age, target retirement age, annual income, annual retirement savings, expected income increases, etc.
Aim To Save 15% Early in Your Career
While it may seem difficult to balance housing, basic necessities, a social life, school, and hobbies all on the same paycheck, there’s still no time like the present to start—literally. These days, twentysomethings are often not saddled with some larger financial obligations such as dependents and mortgages. If we’ve learned anything in our twentysomething years on Earth, it’s that things tend only to get more complicated—the longer you wait, the more you’ll have to put away later in life. It’s smart to start as soon as possible rather than risk running out of money or having to defer retirement.
If you are financially stable—not sweating—you should aim to save about 15% of your annual salary early in your career. The more time you give your 401(k), the more opportunity your contributions have to grow compounding interest—essentially, the interest you grow on your interest.
“We believe that we need a bunch of money to start investing or that we can wait to get started when, in actuality, if we take a relatively small amount of money but allow it to grow and with as much time as possible, that’s the way to do it,” says Tori Dunlap, New York Times bestselling author and founder of HerFirst100k. “So I always tell people that time is more important than the amount of money when it comes to investing.”
Gen Z workers who have been in their 401(k) plan for five years straight saw their balances climb to an average of $29,100 in the third quarter of 2023, according to Fidelity. “With a relatively small amount of money, I can allow it to grow and work harder for me as I progress,” says Dunlap.
Take Advantage of Employer Contributions
Depending on the terms of your 401(k) plan, your contributions may be matched by employer contributions in a few different ways. Employers often match a percentage of employee contributions up to a portion of the total salary.
A typical plan might offer a dollar-for-dollar match of 3% of an employee’s salary. The employer might also offer 50 cents on the dollar up to a certain percentage. Occasionally, employers will elect to match employee contributions up to a certain dollar amount, regardless of the employee’s compensation.
For example, say you are offered a $50,000 salary, and the employer offers to match 50% of your contributions for up to 3% of your salary. For every $1 you contribute to the 401(k), your employer will contribute another $.50. In this case, 3% of your salary is $1,500, so to maximize the employer match, you would need to contribute the full $1,500 to get the $750 match from your employer. You can contribute more than 3% of your salary if you wish, but your employer won’t match contributions beyond that.
An employer may also match 100% of your contribution up to a certain percentage of your salary. Again, say your salary is $50,000, and your employer will match your contributions up to 3% of your salary as long as you contribute $1,500. In that scenario, an additional $1,500 will be added on top of your $1,500 and taken pre-tax from your paychecks. It’s literally free money, so take advantage of it.
Alternative Options for Savings
If you don’t have a 401(k) package in your role, you still have the option to begin your retirement savings. Opening a Roth or traditional IRA is a great way to allocate a portion of your income and invest it for your future self.
A Roth IRA allows you to contribute post-tax dollars, so there are no immediate tax savings, but once you retire, the amount you paid in and the money it earns over time are both tax-free. Conversely, a traditional IRA allows you to contribute a portion of pre-tax dollars. This reduces your annual taxable income while setting aside money for retirement. You will have to pay taxes when you withdraw this money. Similarly to a 401(k) plan, you should allocate the money in your account to ensure that you’re investing these funds instead of letting them sit.
In fact, Gen Z tends to lean in favor of IRAs over 401(k)s. This could be due to the prevalence of the gig and creator economies. Gen Z investors saw a 63% increase in IRA accounts year-over-year, while overall dollar contributions increased 51% in the third quarter of 2023, per Fidelity.
Applying the 50/30/20 Rule
The golden rule for money management is the 50/30/20 rule. In this framework, you spend 50% of your after-tax paycheck on needs, 30% on wants, and 20% on savings. It’s intended to help you get in the habit of managing your after-tax income responsibly, especially to have funds on hand for emergencies and retirement. Every household should first prioritize creating an emergency fund in case of layoffs, unexpected medical expenses, or other unforeseen costs.
Needs include:
- Rent or mortgage payment
- Car payment
- Insurance and healthcare
- Grocery
- Minimum debt payments
- Utilities
Wants include:
- New clothing
- Tickets to events
- Eating out
- Vacations and non-essential travel
- The latest gadget
Savings include:
- Creating an emergency fund
- Making contributions to a 401(k) or IRA
- Investing in the stock market
- Setting aside funds to buy property
- Making debt repayments beyond the minimum
Of course, following this framework can be incredibly difficult—and few actually can. As of January 2024, the average monthly personal saving rate for individuals in the U.S. was just 3.8%. Even if it’s just aspirational for now, keeping this framework in mind will help you set lasting, healthy habits with your money.
Tips To Maximize 401(k) Contributions in Your 20s
Maximizing your contributions may be difficult, especially because most of us in our 20s are not making all-star salaries. If you’re just getting started, it’s good to make sure you have a safety net in your general savings account first. Once you have some emergency funds stocked up, put away as much as possible into your 401(k).
Note
The contribution limit for employees who participate in 401(k) plans was increased to $23,000 at the start of 2024.
It’s best to automate your contributions. Once you decide on what percentage you want to contribute, you can automate your contributions, which allows your employer to automatically contribute part of your wages to the 401(k) on your behalf. You won’t see your contribution amounts in your paycheck since they’ll be deducted beforehand and deposited into your 401(k). Automating your contributions will feel like less of a payout, and you probably won’t even notice the funds absent from your paycheck.
Alternatives to a 401(k)
As mentioned above, IRAs are excellent alternatives to 401(k) plans if you don’t have a benefits package in your role.
Another option is to have your employer match your student loan payments. Under the SECURE 2.0 Act, the IRS authorizes linking 401(k) matching contributions to employee student loan repayment.
While this may seem like an excellent option for many, it’s still good to start saving for retirement soon. Any debt repayments should be prioritized by how high the interest level is: If it’s small, say, under 6%, it may be more financially beneficial for you to contribute to a retirement plan than pay off your loans faster.
What Is the Best Age To Start a 401K?
As soon as possible. Unless you’re barely scraping by on every paycheck, you should take advantage of your 401(k) plan immediately.
Can I Withdraw From My 401K in My 20s?
Technically, yes, though it’s not a good look. If you withdraw before 59½, you’ll face hefty fees and penalties. However, it’s not impossible: Fidelity says that in the third quarter of 2022, some 2.3% of workers took hardship withdrawal. The top reasons behind this increase were avoiding foreclosure or eviction and paying medical expenses.
What Happens to My 401(K) if I Switch Jobs?
You can roll your 401(k) plan over to your new role. If your new role doesn’t offer a retirement savings plan, you can still roll your 401(k) into an IRA and invest it from there.
The Bottom Line
Contributing early when you’re young helps you take advantage of the employer match, which is free money. It also allows you to maximize the power of compounding, which is the interest earned on your interest over the years. By putting away part of your paycheck before taxes, you not only retain more money (rather than put it into a savings account post-tax) but are passively growing wealth each pay cycle.
Read the original article on Investopedia.