How to Find an Extra $2 Million in Your Coat Pocket

December 21, 2012

A few things happened today and somehow when I pieced them together, it all made sense (to me, at least).  As I was putting my coat on this COLD morning (for the first time in nearly a year), I found a $20 bill in the pocket.  Talk about a great way to get your day started!!!  I was thinking that it was going to be a good day. 

Then, as I was eating lunch, I was surfing the Internet and saw this story about what may be newly discovered planets, with one of them perhaps being inhabitable.  How cool would it be to take a quick vacation getaway to another planet?  What would that kind of jet lag feel like?  Would I have to carry over PTO days to make that trip?  It was fun to think about the possibilities, especially with a newfound $20 in my pocket.

Right after lunch, I met with someone who is early in her career and wants to find a way to set herself up for success. We reviewed her income (first post-college job so her income is relatively low) and expenses (furnishing an apartment with a roommate and paying rent and student loans so expenses are high), her assets (an old car and a few contributions into a 401k) and her liabilities ($60,000 in student loans and $4,000 in credit card debt).   When we put all of that on paper, she looked a little bit discouraged.  But, we know that life is a long journey and what she is doing now is simply positioning herself for the long term.  She’s about where you’d expect a newly hired college grad to be.  So, what could she do to improve her situation?

We talked about increasing her 401k contribution to 6% from the 3% level that she was automatically enrolled for.  When we looked at how little it would actually cost after it flowed through her paycheck, it seemed relatively minor to her.  So, why 6% you might ask…Well, her company matches dollar-for-dollar up to 6%.  So, by contributing 3%, she is leaving 3% of “free money” on the table. I have a rule about free money.  When someone offers it, I try to accept!  The 6% level allows her to pay her bills, have a small amount ($10-20/paycheck) direct deposited into a savings account, and have a little bit left over for a personal/social life.  It is sustainable but seemingly without the ability to make major progress.

At some point during the conversation, I remembered the $20 in my coat pocket and the article about the potentially inhabitable planet.  It made me think that she would be okay if she continued on her current course of action, but she wanted to be better than just okay.  She really wanted to set herself up for success over the long haul.  But, she was doing all she could given her current situation and 6% was the most that her budget would allow her to contribute to her 401k.

But, like the planet and the $20 bill, there was something that had previously not been visible to her.  And it can be a complete life changer!  Here’s the secret to her future success.  Each year in the spring, she will get an annual salary increase.  It will probably be in the 2-4% range each year.

We looked at what it would mean in her paycheck every 2 weeks and if she gets a 3% increase this spring, she could buy one large pizza with the increase in each check.  Not exactly a game changer!  But, what if she directed 2% of that 3% increase into her 401(k)?  She could increase her contribution from 6% to 8% when she gets her raise.  She will still have a small pay increase (a pack of M&M’s instead of a pizza), but 8% of her income will now be going toward her retirement and it won’t have felt painful.  In 5 years, her contribution will have gone from 6% to 16%.  In 10 years, it’s a 26% contribution rate.  And it all happens without ever reducing the take-home pay by an amount that is noticeable.  If I asked her to increase from 6% to 26% today, she would probably assume that I need to be drug tested.

But, she can do it over time!  And, if she continues this throughout her career, she will reach the annual maximum ($17,000 this year, $17,500 next year) eventually.  With money that wouldn’t have ever been noticed.  Using a conservative growth estimate (6%) over her lifetime, this strategy for her could result in nearly $2,000,000 in additional money in her 401(k) at age 65.

Here’s the hidden gem…many 401k plans allow YOU to do this very thing right now.  There’s a feature called “auto escalator” or “contribution rate escalator” in many plans that allows you to automate this process.   I think it’s the most important feature in this person’s plan.  How do you think she’s going to feel when she wakes up on a cold morning at age 65, puts her coat on, and finds an extra $2,000,000???