After talking to people in my classes, I find that few know very much about something called a 401(k). How we use it will determine who among us are millionaires at retirement and who will live in poverty. Our grandparents got pensions and worked for the same employer for 30 years. We will be given the option to use one of the most powerful financial tools ever created for retirement, but some will succeed wildly and some will fail miserably. When you go out and get a job after graduation, funding a 401(k) should be near the top of your priority list.
A traditional 401(k) is a special account for retirement. Almost anyone who has a job will have one, especially people with the kinds of jobs that college grads go into. Money you put into this account is tax free, and grows tax free until you retire when withdrawals are taxed. Most employers will also offer a match for each dollar you put in the account. A typical number is a 4-percent match. This means that if you enroll in your company's 401(k), you will receive $1 for every $1 you put into the account for up to 4 percent of your pay.
This is free money! It's unbelievable that anyone chooses not to do this. By signing up for your 401(k), you are saving 8 percent of your pay while only chipping in 4 percent. This is all tax-free, so it actually costs even less after taxes.
To illustrate my point, let's assume that we have two Gator engineering graduates, Jorge and Joe, who both get a job with Boeing upon receiving their degrees. Let's assume that both make $100,000 per year for 40 years (just to make the calculation simple). Jorge is smart with his money and contributes $4,000 per year from his paycheck to his 401(k). Boeing matches it with another $4,000, so his total savings is $8,000 per year. Let's also assume that he puts 60 percent in a Total Stock Market Index Fund and 40 percent into a Total Bond Market Index Fund and gets a rate of return of 8 percent a year.
Because he's investing in his 401(k), this return is tax-free. Joe is very intelligent, but unfortunately, those book smarts don't extend to personal finance. He doesn't have time to think about retirement so he opts out of Boeing's 401(k). To build savings, he decides to put away $4,000 in his bank account in a 3-percent CD, but after taxes, he finds out that he is only able to save about $3,000 per year, and that since interest is taxed he only gets a 2-percent yield. After 40 years, Jorge has a balance of $2.25 million, and Joe has a balance of $187,000. That's a huge difference.
Most people our age forget about retirement until they're in their 40s and then realize they have to save half their income to not work into their seventies. If Joe decides to start contributing to that 401(k) getting 8 percent per year with 20 years until retirement, he would have to save a total of $45,000 per year just to end up with the same balance as Jorge. What do you think will be easier over time: contributing $8,000 per year to your retirement over your career or $45,000 per year when your family needs money for college, housing and automobiles?
So the moral of the story is to start saving for retirement early through your employer's 401(k). Every dollar you invest for your retirement now is worth at least four times what a dollar invested in your 40s will be. During your orientation, have an energy drink and force yourself to go to the human resources department and make sure you are signed up for your 401(k). You want to ask them to deduct enough from your paycheck so that you can get 100 percent of the employer match. You won't miss the money, and it will make the difference between retiring at 60 and retiring six feet under.
Travis Hornsby is a statistics and economics senior at UF. His column appears on Mondays.
