How Does a 401(K) Grow?

Building a nest egg to live off of during retirement takes time. Consistently contributing to a retirement account like a 401(k) and allowing that money to grow over time is the best way to maximize the amount of money you’ll have when you retire. There’s a little more to it than just joining your employer’s 401(k) plan and having an amount automatically deposited to it each paycheck. So how does a 401(k) grow into a sizable nest egg to get you through your twilight years?

Your 401(k) grows from the contributions you make from your paychecks, your employer’s matching contributions, the types of funds your 401(k) is invested in, and the compounding interest your 401(k) earns.

Each factor affects how much a 401(k) grows differently. Contributions are essentially face value; however, compounding growth from the performance of the funds can have a drastic impact.

Contributions

The one thing you can control is how much and how often you contribute to your 401(k). It’s highly advised to start contributing towards your retirement as young as possible. To be eligible to join an employer’s 401(k) plan, you must be at least 21 and have at least one year of service with that company.

Once you’re eligible to join your employer’s 401(k) plan, you should do so immediately. This will allow you to maximize the amount of time your 401(k) has to grow throughout your working years until you retire.

The IRS allows you to contribute up to $19,500 annually towards your 401(k). Once you reach 50, you’re allowed to contribute an extra $6,500.

A bonus to your contributions towards your 401(k) is that they are tax-deferred. Meaning the money you put into your retirement isn’t taxed until you withdraw it. This allows you to contribute more each paycheck to your 401(k) and reduces your tax burden during your working years.

Employer Matching Contributions

Another factor that helps your 401(k) grow is matching contributions made by your employer. Many employers who provide a 401(k) plan to their employees provide some sort of a match. The average matching contribution is about 3.5% of the employee’s annual salary.

By receiving a match on a portion of your contributions, you’re essentially doubling that portion.

Over time, these matching contributions your employer has made will add up to a significant amount by the time you retire.

It’s important to note that employer matching contributions are not always available immediately. Many companies have long vesting schedules that require employees to remain employed at the company for a specific amount of time in order to keep the matching contributions. If you’re fired or quit before the match is “fully vested,” you could forfeit that portion of your 401(k).

Investment Options

Once you’ve contributed money towards your 401(k), it must be invested into an investment fund in order to grow.

Many 401(k) plans default to a target-date fund. These funds contain a mixture of stocks and bonds and are reallocated yearly to match your risk tolerance as you near retirement. Using your estimated retirement date—or target date—the fund shifts more of your investments towards less-risky bond funds to limit your chance of losing money right before you retire.

However, many 401(k) plans provide many more options for their participants to invest their money. The average plan has about 19 different investment funds to choose from, ranging from mutual funds and index funds to international stock funds and bonds.

In order to move your money around to different funds, you’ll need to access your 401(k) plan’s online portal or contact your 401(k) plan’s administrator.

Compounding Interest

Perhaps the most impactful of all of the factors in growing your 401(k) is compounding interest. Compound interest is the interest on a loan or deposit calculated based on both the initial principal and the accumulated interest from previous periods.

Essentially, compounding interest is the act of reinvesting the interest your 401(k) has earned back into your investments. Then that growth earns additional interest the following year. Each year, the growth your 401(k) has earned gets reinvested and continues to compound on top of each other.

It’s easy to visualize just how much of an effect compounding interest has over a span of decades. But to illustrate how compounding works let’s look at an example. 

Suppose you save $10,000 your first year after joining your company’s 401(k) plan. In the first year, your 401(k) earned a modest 5% interest annually. After the first year—or compounding period—the total in the account has grown to $10,500, reflecting $500 in interest being added to the $10,000 principal. In year two, the account realizes 5% growth again on both the original principal and the $500 of first-year interest, but you also contributed an additional $10,000, resulting in a second-year gain of $10,025 and a balance of $21,025. After ten years, assuming you didn’t withdraw any money and earned a steady 5% interest rate, your 401(k) would grow to over $132,000. Incredibly, after 40 years of just contributing $10,000 annually, earning a very modest 5% annual return, your 401(k) would grow to over $1,268,000—only $400,000 would be from contributions, the other $800,000 would be from growth!