With the "magic" of compound interest on money invested before-tax and tax-deferred, even lower-income persons can become wealthy. The key is regular savings and time.
Table 1 shows what a person investing in a 401(k) plan can accumulate per $1,000 of income when he invests 5% of his earnings each year. In this example, the individual gets a 3% annual increase in his salary or wages. There is no matching funds from the employer.
The table shows the accumulation for 8%, 10% and 12% earnings and growth on the money invested. It also shows the amount accumulated after 5 years, up to 40 years, in 5-year increments.
For example: The employee is 20 years old, earns $20,000/year, will get a 3% annual increase in his paycheck, invests 5% of his pay in a 401(k), earns 8% on his investment and works for 40 years.
Under 8% and across from 40 years in the table, the figure is $20,565.31. That's the amount our example person would accumulate for each $1,000 of earnings he has at the time he starts investing -- $20,000 in our example.
Therefore, his fund would grow to $411,306 ($20,565.31 x 20).
If he invests more than 5%, earns a higher return on his investment, or has a higher income, the amount could be considerably more.
Many people get concerned about tax-deductible savings and tax-deferred growth. They argue that, "Someday, I'm going to have to pay the tax and I might be in a higher tax bracket then. Why not just pay it now?"
Table 2 shows why not. The before-tax amount is from the previous table for 8% interest. The after-tax column shows how much savings could be accumulated if tax - at only 20% (assuming a 15% federal income tax and 5% state tax) - had to be paid on the money before you invested it. If the employee is in a higher tax bracket, the difference would be even more dramatic.
The 8% interest rate has also been lowered by 20% because the earnings would be taxed each year, too.
The key is that, with before-tax savings, you are using money you would have otherwise paid to Uncle Sam in taxes to earn interest for you.
You could pay a pretty high tax rate when you take the money out and still be ahead with tax-deductible and tax-deferred savings.