Explaining the Benefits of a 401(k) to Young Adults Entering the WorkforceSubmitted by Eric Nichols, ChFC, AIF® | Empowering Your Financial Future on March 9th, 2021
If you have a child graduating from high school or college and entering the workforce, they may have the opportunity to open up a 401(k) through their new employer. In some cases, that employer will also offer matching contribution funds up to a certain percentage. While it sounds like a no-brainer to take advantage of these benefits early,many younger employees do not participate in their employer's 401(k) plan.
It’s essential to teach your children the benefit of saving early and often to set them up for success in the future. Here are some key benefits of starting to contribute in a 401(k) in your early 20s.
Retirement Plans Offer Tax Breaks
One of the most important reasons to start participating in a retirement plan early is the tax breaks that come with it. Every young person remembers the feeling of getting their first pay stub and seeing a large percentage of their pay taken out for taxes. By participating in a 401(k), your child can save money before those taxes are taken out.
The money they put away now has growth potential due to compound interest and will not be taxed until they begin taking distributions from their account during retirement.
Potential Employer Contributions
Another incentive of participaring in a 401(k) from a young age is employer contributions. Every employer is different, but many will offer some type of matching contribution for those who choose to participate in their sponsored retirement plan. Employer contributions are essentially “free money” for your child’s retirement savings.
Say your child’s employer will match contributions one-to-one for up to 4% of their paycheck—anything they contribute up to 4% will be doubled. In this scenario, they should aim to contribute at least 4% of their paycheck in order to take full advantage of what many people consider to be “free money.”
Not only is opening a 401(k) a smart idea, it’s also very easy to contribute to one. Contributions are taken from your child’s paycheck pre-tax and deposited directly into their retirement account. If they start saving early on, they probably won’t even notice a difference in their take-home pay. Most 401(k) plans also make it easy to automatically increase contribution rates each year—something that many financial professionals suggest to effectively compound retirement savings.
Comfort in Retirement
Lastly, the earlier your child starts to save, the more likely they’ll be able to comfortably retire when they get older. Compound interest builds over time, so the longer their account is open, the greater potential for substantial growth. And starting now will allow them to build a good habit of saving a little bit every month. Even if they stop contributing because of unemployment or financial strain, the money they’ve already contributed has the ability to continue to grow.
Alternative Options for Retirement Plans
If your child’s employer doesn’t offer a sponsored 401(k) plan, they should consider an IRA plan instead. IRA plans offer similar benefits to traditional 401(k)s—they gain interest over time, can take automatic contributions from paychecks and involve tax benefits. Your child can choose from a traditional IRA, which is tax-deductible, or a Roth IRA, which is not tax-deductible but has the benefit of non-taxable distributions during retirement.
Since these are independent plans, your child can keep them open even if they start a new job that offers a 401(k). Many financial professionals even recommend keeping retirement savings in more than one type of account.
Whatever career path your child chooses, saving for retirement is an important step in their adult life.
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