Before we get started with what you should do with your 401(k), let’s conduct a brief overview of retirement savings accounts. We’ll start at a high level and work our way down from there.
Crash Course in Retirement Accounts
Overall, there are many different retirement savings plans defined by Uncle Sam. Some examples of these plans are 401(k), 403(b), Individual Retirement Account (IRA), or Roth IRA. We’re going to call these different plans accounts. Retirement accounts all have one big advantage: taxes–or lack thereof. 401(k), 403(b), and IRA accounts let you deduct contributions from your taxes now, but you must pay taxes on the distributions. Contribution is the term for the money you deposit into the account. Distribution is the term for money you withdraw from the account. You usually can’t take distributions from retirement accounts until you’re 59-1/2 years old and if you take them before that, you’ll be penalized. Like all things though, there are a few exceptions.
Roth IRA or Roth 401(k) accounts work oppositely in tax terms. You’ll pay your normal income tax on contributions, but distributions will be tax free. In other words, if all of your retirement money was in a Roth IRA, you would be paying nothing in income taxes on this money when you begin to live off of it.
Nearly all account types allow your money to “grow tax free”. When people use this term, they mostly mean that the dividends in those accounts are not taxed. Dividends are a portion of a company’s earnings that is paid out to shareholders. Dividend payouts occur on a quarterly basis.
Within the different types of retirement accounts, you’ll invest in mutual funds. Mutual funds are investment programs that invest in many different companies that are the same size, in the same type of work, or same geographic location. Mutual funds use the power of diversification, which is spreading your money across different companies so that you don’t risk losing it all on the next Enron. The companies within these mutual funds are how you earn your dividends.
Think of accounts like umbrellas. Different umbrellas (accounts) protect your mutual funds from different types of weather (taxes).
Let’s Get Back to Your 401(k)
The 401(k) is the most common type of employer-sponsored retirement plan in America. If you recall from earlier, 401(k) contributions are tax deductible and will grow tax free until you begin to take distributions.
Almost all employers encourage their employees to contribute to their 401(k) by offering matching. The most common match is dollar-for-dollar up to 6% of the employee’s salary. If your salary is $45,000/year, 6% is $2,700. If you contribute $2,700, then your employer will give you $2,700! This is the equivalent of going to Vegas, putting $2,700 on red, and winning. Every. Year. Do you see how crazy it is not to contribute enough to get your full match?
The effect of this free money has an even bigger impact on your retirement when you start taking advantage of it right away. The number one rule of retirement saving is start early. It benefits to start early because of compounding interest. In a nutshell, compounding interest means you earn interest on an initial deposit. Then you start to earn interest on the interest you earned. And so on. This results in exponential growth, which looks like this:
Cool fact: At an average, inflation-adjusted, annual return of 6% means that every dollar you put in today will be doubled in 12 years.
Example of the Power of Compounding Interest.
Person A and Person B both make $50,000/year and begin working when they are 23.
Person A contributes 6% of his salary to his 401(k) and his employer matches him on 100% of this amount for a total of $6,000 per year. Person A stops saving at 36 years old and retires on his 60th birthday. He contributed a total of $78,000 to his 401(k)–half of which wasn’t really even his since his employer had a great matching program–for only 13 years. On his last day of work, Person A has about $433,000 in his 401(k). Not bad.
Person B doesn’t start contributing to his 401(k) until he is 36 years old because there were more pressing things going on in his young life. Like newer cars, weekends out, and clothes. Similar to Person A, he contributes 6% of his salary and his employer matches the amount. Person B invests this way until he retires at 60 years old; a total of 24 years which is 11 years longer than Person A. Overall, he contributed $141,000 (again, half of that was from his employer due to the match) which is almost two times as much as Person A. Person B ends up with about $329,000.
Despite Person B trying his darnedest and saving for 11 more years than Person A, Person A still has more money! An extra hundred grand. Just for starting early.
What’s truly mind-boggling to think about is that his $433,000 retirement account balance really only cost Person A $39,000 of his own money ($50,000 x 6% contribution x 13 years). The rest was from his employer’s match and the power of compounding interest.
This is what the retirement accounts of Person A and B look like in a graph:
What if you have credit card debt? Shouldn’t you put your money towards paying off the debt? The answer is almost always no. You’re throwing away free money from your employer if you don’t contribute. The graph above shows how big of a difference it makes when you start contributing early in your career.
Which Funds to Invest In
Since this blog is mostly targeted at those with at least 15 years until retirement, a portfolio that utilizes target retirement funds is the way to go, like Vanguard’s Target Retirement Funds. Target retirement funds offer a hassle-free way to invest. They are generally broadly diversified across U.S. and international stocks and have an appropriate amount of bonds depending on your anticipated retirement date.
The biggest thing to watch out for? Choose funds with a low expense ratio. You really shouldn’t be paying more than 0.5% in management fees. Any more than this and you’re getting ripped off. That small difference doesn’t sound like much, but because of the power of compounding interest, it can cost you tens of thousands of dollars over a lifetime.
- Find out what your employer matches on your 401(k)
- No 401(k) or 403(b)? Go straight for the Roth IRA, which is covered in Phase 5.
- If you can’t find out how much this is, your boss or HR would be able to point you in the right direction.
- Go to your account manager ‘s website (Fidelity, Charles Schwab, and Vanguard are some of the most common) and boost your contribution to equal your employer’s match.
- Again, if you’re having difficulty with this then go talk to your HR representative.