I have this 401k thing…

Over the past couple of years, I have had so many conversations with friends and acquaintances about their retirement accounts. And, the conversations usually go something like this:

Friend: I have this 401k thing at work. I put money into it every paycheck.

Me: Do you know where the money goes?

Friend: No.

Me: Do you know how much money you put into it every paycheck?

Friend: No.

Me: Do you know why you are putting money into it?

Friend: I think it is for retirement. But, I don’t really know where it goes or what it is doing….

Me: Do you get a statement for the account?

Friend: I think so. I don’t really look at it though.

Hmm…..studies show that Americans are completely unprepared for retirement. Based on my conversations with people about their retirement accounts, this is not surprising. Sadly, we do not get much, if any, education on how to save money or why to save money. Therefore, we have very little incentive to save and, if we are saving money, we do not know what to do with that savings.

So, here are the basics: A 401k plan is a retirement plan set-up by employers. Employees of public entities and non-profit organizations have a similar plan called a 403b plan. A 401k plan and 403b plan are pretty much the same thing, just for different types of employees, and allow you to put money away for retirement tax-free. What does that mean? You are not taxed on the money that you put into a 401k or 403b plan account. Example: If you make $50K and you put $5K into your 401k account for the year, you are only taxed as if you made $45K. The tax-free deduction is a benefit to saving for retirement but you can only pull the money out when you have reached “retirement age,” currently 59 1/2, and the money is taxed when you pull it out of the account. Prior to 59 1/2, you can take money out with a penalty or take a loan from your 401k account. But, that is a topic for another day.

Now, how much should you put away? Putting away any amount for retirement is a good start. And, I would say start with something, even a small amount, to get you in the habit of saving. Once you start saving and see your savings grow, it often makes you motivated to save more.

Then, once you are in the habit of saving, figure out how much you need to save to meet your goal, your goal being retirement. How do you do that? You can do a very simple calculation to just get an idea:

1) Figure out how many years you plan to live in retirement (i.e., if you plan to retire at 65 and think that you will live until age 85, then you will be in retirement 20 years).

2) Then, determine how much you need to live off of in those retirement years and deduct any retirement income you think you may may receive. If you think you will spend $45K a year for 20 years and receive $15K in social security, then you need about $600K by retirement to live comfortably.

3) Once you have that number, figure out how many more years of work you have (you are age 35 and plan to retire at 65, so you have 30 working/saving years ahead of you). Then, estimate how much you need to save each year. Keep in mind that this is a really simplistic calculation and does not take into account inflation (prices of goods and services you buy going up) or the fact that the money you save is expected to earn some return throughout your working life and throughout retirement or compound growth (also a topic for another day).

Again, it is a very simple calculation but it may at least open your eyes and mind to the fact that saving for retirement is important and, the sooner you start, the less per year you will have to save.