Here's How Much You Could Save If You Max Out Your 401(k) for The Next 25 Years

Fidelity Investments estimates that you need at least half a million dollars in retirement, while some investors say you need even more. It might be daunting to think about saving such a large sum, especially during a recession, but it is an inevitable part of market cycles. When you invest in stocks through a brokerage account or 401(k) and IRAs, your money can grow exponentially compounded over decades. We focus on 401(k) because of the high contribution limits, impressive tax benefits, and early penalty-free withdrawal at the age of 59 ½.

It is amazing to note the wealth you can create in 25 years. If you have a 401(k), maxing out every year for 25 years will save you over a million dollars. This is based on certain assumptions like a modest 7 percent returns on your 401(k) stocks and bonds.

What Is 401(k)?

401(k) is a tax-advantaged employee-sponsored retirement plan that allows U.S. workers to invest their pre-tax money in stocks and bonds. No profits or capital gains are taxed until you withdraw the money at 59 ½ years of age or later.

Where Does 401(k) Shine?

Every month, a portion of your paycheck and a matching employer contribution goes into a tax-deferred 401(k) fund that grows with the power of compounding. To understand 401(k) employee matching, imagine you have an annual salary of $100,000 and your employer offers 100 percent matching up to 4 percent of your annual pay. The maximum employer contribution for that year will be $4,000. In a way, your employer is funding your retirement, as well.

Another way 401(k) can save you money is by lowering your annual tax bill. 401(k) contributions shrink your taxable income since that's your pre-tax money at work. If you fall under a higher tax bracket, there'll be even more tax savings if you are contributing to a plan.

Someone who earns $210,000 annually, for example, will fall under the 35 percent tax bracket. If that person contributes $10,000 each year to a 401(k), their tax savings can be found out by multiplying the total annual contribution by the tax rate. That equals to tax savings of $3,500 ($10,000 x 35 percent) every year. The 2021 contribution limit for 401(k) stands at $19,500, and those above 50 can contribute $26,000 annually.

Your Million Dollars Are Mostly From Compound Interest

Employer contributions, high contribution limits, compounding growth, and tax benefits work together to make 401(k) one of the most popular retirement vehicles in the U.S. However, two-thirds of Americans aren't adding or managing their 401(k)s due to a lack of jobs or financial awareness. This needs to change.

You should know that your 401(k) is as good as the stocks you pick and the investment fees you pay over time, which could grow with your assets. Finding low-fee funds and rebalancing should be a part of your research all the way. Before we discuss how you could fine-tune your 401(k), let's take a look at some numbers.

Imagine you are a 35-year-old who recently started building 401(k) assets from scratch. To compensate for those lost years, you can max out by making contributions of $19,500 annually or $1,625 monthly.

It is safe to assume inflation-adjusted modest returns of 7 percent from the stock market over decades. So, in the next 25 years, you would be sitting on $1.2 million worth of assets. Believe it or not, your contributions to the $1.2 million would only be $487,500; the rest comes from interest. If you cash in, your money post-long-term capital gains tax of 20 percent will amount to approximately $1,048,353. To see the real power of compounding, check out the exponentially growing gap between asset value and contributions in the graph below.

Here's how your 401(k) contributions will look like at intervals of five years over the next 25 years.

In 20 years, at the age of 55, you can see that you would have earned more money than you put in. However, you need to keep in mind that compounding only works when your money stays invested for long periods of time. Because of this, those who broke into their 401(k)s during the pandemic have most likely pushed back their retirement plan by years.

Save Approximately $200,000 on 401(k) Investment Fees

Whenever you buy a stock or mutual fund, you need to pay an investment fee. Even though it might not seem much, investment fees grow with your asset value since it is part of the money you use to buy stocks.

Investment fees can easily be understood in terms of expense ratio, which is the fee you pay to invest in a fund. The average expense ratio across actively managed funds in the U.S. stands at 0.66. If you start from scratch and max out on 401(k) contributions in funds that have an expense ratio of 0.66, you would have lost over $200,000 over the next 30 years as investment fees. You can now check how much you are about to pay as investment fees on your 401(k) with this calculator designed by a fiduciary firm called Blooom. They use Artificial Intelligence (A.I.) to visualize and manage 401(k)s and IRAs, helping their clients keep a low average expense ratio of just 0.11.

Employers might be funding your retirement through 401(k)s, but may not be investing in your best interests. The stocks and bonds they pick for you and your colleagues may also come with high returns and high investment fees, which could ultimately slow down the power of compounding over time.

How to Start Building a 401(K) Portfolio

The first step to picking the right funds is to understand your personal aspirations and set a timeline for each one. If you want to retire by 65 and still have 30 years to go, for instance, you could create a 401(k) portfolio that starts paying off by the time you're 60. Generally speaking, your goals should define the stocks and bonds that you pick. Also, keep in mind that 401(k)s need active engagement until you withdraw at 59 ½ years of age.

Try out Blooom's free analysis for a visual representation of how your 401(k) will look with low-fee funds and frequent rebalancing. The strategy of rebalancing is to sell high and buy low. Since Blooom is a fiduciary, they are bound by law to offer the best possible solutions for you.

Get your free analysis from Blooom today.

The contents of this article is for informational purposes only and does not constitute financial or investment advice. It's important to perform your own research and consider seeking advice from an independent financial professional before making any investment decisions.