5 Ingredients to Become a 401(k) Millionaire – Part 1

What does it take to be a 401(k) account millionaire?  Joining this select group may be easier than you think. Many miss the mark because they don’t save enough. They have a tough time balancing their needs, wants and wishes for today versus the future. Some use ill-suited investment strategies that contribute to bad investor behavior. In this post, we discuss five simple ingredients to become a 401(k) millionaire. They are to start as early as you can, take the employer match, invest for the long-term, save regularly, and catch-up if you can. These same ingredients can be used to get back on track.

Why 401(k) Accounts?

Few people make it in the million dollar club. Yet it should be no surprise to hear of stories of someone having a $1 million 401(k) account by age 52 or $2 million by age 62. This article focuses on 401(k) accounts. In our opinion, 401(k)s often offer advantages over other types of accounts. In general, we believe it is better to save than not saving at all even if it is outside a 401(k) account.

Retirement accounts such as 401(k)s and IRAs are great ways to save.  They get preferential tax treatment so savings can grow faster. Contributions may be tax-deductible. Income and gains are tax-deferred and can be tax-free. 401(k)s have several advantages. They have higher annual contribution limits that allow people to save more. Payroll deductions used for contributions instill discipline. Many employers offer matching contributions, effectively free money, to employees for their participation in 401(k) plans.

To add context, lets consider some facts about 401(k) balances. $9,670 is the average annual contribution for 2014 according to Fidelity Investments. Fidelity is one of the largest providers of 401(k) accounts. The figure includes employee contributions and employer matches. $92,000 is the average balance for all 401(k) accounts at Fidelity as of the end of 2014. $248,000 is Fidelity’s average account balance for employees in a 401(k) plan for ten years or more.

1. Start as early as you can to take advantage of compounding

The earlier you start, the less work you do to become a millionaire. Many of us will be saving and investing for 45 years or more. 45 years is reasonable assuming that savings start at age 22 with our first job and continue until age 67, the current full retirement age for Social Security.

Compounding is how money can do more of the heavy lifting for you. It lets returns on your investments build upon itself. 30 years is the time it will take if you start from scratch, make annual contributions equal to the 2014 average of $9,670, and earn 7.2% per year on your investments. A person that starts at age 22 could be a millionaire by age 52.

Compounding is most effective when left alone to do the work. Withdrawals from the account will reduce its impact. With patience, the growth of your portfolio accelerates with time. You could have over $2 million by age 62 and more than $4 million by 71 if you maintain the savings strategy and earn the same returns.

The time to become a 401(k) millionaire is shorter if you already have savings in the account. It would take about seven years less or 23 years in total if you start from the average 401(k) balance of $92,000. This estimate assumes that you make the same investments and enjoy the same returns as before. More experienced people who have accumulated $248,000 average can expect to reach $1 million in 16 years. We discuss later how contributions and investments can help people get back on track or reduce the time.

Why assume investment returns of 7.2%? First, it lets us use history as a guide, even if history may not represent the future. 7.2% is the return of a well diversified portfolio of 60% US stocks and 40% bonds over the last 10 years. Second, it is a convenient to introduce the Rule of 72. The Rule is a simple way to think about the relationship between investment returns and wealth growth. The Rule of 72 can help gauge how fast a dollar doubles and illustrates the power of time. A dollar earning 10% per year would become two dollars in roughly 7.2 years.  In short, a dollar that grows at 7.2% per year doubles to two dollars in about 10 years. Two dollars become four in the next 10 years and doubles again. In other words, one dollar can become eight dollars in 30 years time.

2. Take advantage of the employer match.

Contributing the average $9,670 every year in a 401(k) may be easier said than done. The employer match can make this goal much more attainable. Many employers will match 50 cents for every dollar employees contribute. In this example, the match counts for one-third of the total contribution. In other words, someone earning $100,000 per year would set aside roughly 6.5% of their annual income. Matches are effectively free money sitting there for you to pick up. Every plan is different. It is important to understand the terms of your plan documents.

To be continued in Part 2