Most people dream of hitting the $1 million target in their bank account, which should allow them to lead a comfortable life in retirement. In addition to owning a home, becoming a millionaire is also part of the great American dream. However, right now, less than 10% of people south of the border have a net worth of less than $1 million.
At first, achieving a millionaire status from scratch might seem impossible. But you can leverage tools such as the 401(k) plan to build a retirement nest egg over time. Let’s see how.
What is the 401(k) and how does it work?
The 401(k) is an employer-sponsored retirement savings plan. Here, you fund the account via your paycheque every month, which can then be invested in asset classes such as stocks, bonds, and mutual funds.
The amount that you deposit in the account depends on your contribution rate. For instance, if you earn $48,000 a year or $4,000 each month, a 10% contribution rate would mean you allocate $480 each month to this retirement plan.
But there are certain limits to these contributions. For example, you could contribute up to $22,500 towards the 401(k) in 2023, while the number has increased to $23,000 this year. Employees over the age of 50 are allowed to make additional contributions of $7,500 each year in 2023 and 2024.
Use the 401(k) to build wealth
Several 401(k) plans offer a matching contribution, which is basically free money that can easily double your savings. According to a report from the U.S. Bureau of Labor Statistics, the average match for a worker’s wages is 3.5%. Given the median income in the U.S. is about $58,000 a 3.5% match would amount to $2,030 per year, or $169 per month.
While this number may seem small right now you should note that a 10% return will turn a $169 monthly investment to almost $350,000 after 30 years. Keep in mind that this figure accounts for the employer match. After adding your own contributions, the amount should at least double. Further, with salary hikes and career advances, the total amount should be considerably higher over time.
Start investing early
Investors should look to start early and benefit from the power of compounding. Let’s say a 30-year-old earning $75,000 each year contributes 5% of the gross salary to the 401(k) and generates 8% returns annually. If the contribution amount remains the same, the individual will reach $1 million in total savings by the age of 67.
However, if the investment is delayed by five years, the total savings amount would decline to $655,000.
Invest in the equity market
Young investors need to ensure they have a sizeable exposure to equities, an asset class that has derived inflation-beating wealth over time. For example, in the last five decades, the S&P 500 index has returned 10% annually after accounting for dividend reinvestments. Canadian investors can gain exposure to the S&P 500 index by investing in Vanguard S&P 500 Index ETF (TSX: VSP).
Investors below the age of 50 can have a higher exposure to stocks, while those over the age threshold may consider allocating resources to conservative investments such as bonds and gold.
Building a $1 million retirement fund may take several years. But the best way is to start investing early and for as long as possible.
