401k compound interest vs other compound interest

Question

Whenever I see the presentations or documents imploring me to invest in 401k and retirement, it always shows a nice graph showing a 7% compound interest and how less money saved earlier in your 20s grows to be higher than money starting to get saved in your 30s.

Here's a nice article in Business Insider explaining this. I've attached the graph similar to one in many 401k presentations (from the same link).

I understand the importance of investing in a 401K, particularly if the company offers matching, but two related questions:

1. Why would the compounding interest for a 401k be different from any other type of compound interest? Example: if I invest in a S&P500 index or something that has annualized returns of 7% annually, I get the same effect of compounding interest, correct?
2. What happens if the 401k loses money? This isn't just a rhetorical question, it actually happened to me this year. 401k's are tied to real world events (such as the stock market), and it is possible for them to fall and lose money along with the rest of the economy, isn't it?

Answer 1

A 401K (pre-tax or Roth) account or an IRA (Deductible or Roth) account is a retirement account. Which means you delay paying taxes now on your deposits, or you avoid paying taxes on your earnings later.

But a retirement account doesn't perform any different than any other account year-to-year. Being a retirement account doesn't dictate a type of investment. You can invest in a certificate of deposit that is guaranteed to make x% this year; or you can invest in stocks, bonds, mutual funds that infest in stocks or bonds. Those stocks and bonds can be growth focused, or income focused; they can be from large companies or small companies; US companies or international companies. Or whatever mix you want.

The graph in your question shows that if you invest early in your adulthood, and keep investing, and you make the average return you should make more money than starting later.

But a couple of notes:

• unless you are investing in something similar to a certificate of deposit I can't predict what your returns will be this year. And nobody can say with certainty what anybodies returns will be 10 years from now.
• Unless you are investing in CDs or something similar you can't talk about compound interest. You can make 10%, 20 % or more in the best years, and lose as much in the worst.

So to your exact questions:

1. An S&P 500 investment should perform exactly the same this year if it is in a 401K, IRA, or taxable account With a few exceptions:

   • matching in a 401K
   • no taxes immediate taxes this year on dividends and capital gains in the 401K or IRA.
   • taxes on the deposits going in, or the withdraws in the future.

2. Yes any investment can lose money. The last 6 months have been volatile and the last month and a half especially so. A retirement account isn't any different. An investment in mutual fund X in a retirement account is just as depressed a one in the same fund but from a taxable account.

Answer 2

Growth in a 401k dodges taxes, which means more of the gains get reinvested. Effectively, it's a boosted return rate.

Like any investment, a 401k can lose value. During the period before retirement, lower stock and bond prices actually help you buy more shares than you could if prices were high, so the real question is what the funds are doing at the time you start pulling money back out. That concern is why investors generally, not just 401k investors, should change their investment mix over time, to balance oossible risk against time to recover and possible reward.

And if your employer matches 401k contributions to any degree, that too improves your effective gains and buffers you against some of ghe risk. Hence the general advice that if you don't fund your 401k at least enough to max out the company match, you're leaving free money on the table.

Answer 3

1a. It isn't. Compound interest is compound interest. It works no different within a 401(k).

1b. Yes. 401(k)'s are made up of the same underlying assets that you could invest in with a regular brokerage account.

2. The same thing that happens when a brokerage account loses value. The value of your portfolio goes down. Keep in mind that it's only a loss on paper until you sell.