The Three Keys to a Healthy 401K
There are various ways to invest for retirement. You can invest at anytime for any purpose, but the tax code allows money that is targeted for retirement to get special tax treatment. There are various ways to shield your retirement from taxes and the 401K is just one of those. There are also IRAs, Roth IRAs, 403Bs and more. But for most people, the 401K is the easiest and the most lucrative depending on your employer.
A 401K is simply a retirement plan set up by your employer that allows you to put money towards your retirement pre-tax. That means the money you put in the account is not taxed as it goes in. It is also not taxed as it grows. Only when you take the money out is it taxed… and it will be taxed at your marginal tax level at the time of withdrawal. They are usually pretty easy to setup because your employer will have a form or webpage you fill out specifying how much money you want to come out of each paycheck and how you want to invest it. That’s it.
1 – Take Advantage of the Company Match
There are several advantages to 401Ks including the ability to take the money with you when you leave the job and you get a tax break on the money you contribute. The biggest advantage is if your company has a matching plan. This means you are getting FREE MONEY! When you put money into the account the company you work for will match those dollars – either 50 cents for every dollar you put in all the way up to dollar-for-dollar match – up to a certain limit of course. That means you will immediately get a 50% to 100% return on your initial investment. You really can’t beat that.
2 – Pre-tax Benefits Means it Costs Less than You Think to Invest
Most people don’t really consider how important the tax benefit of retirement investing can be. When you earn money, a portion of that is taken out in taxes so if you earn $1,000 your paycheck may be for only $700. The rest is taken out in taxes and other expenses. But for every dollar you put into retirement you don’t pay the taxes on those dollars right away, so while your paycheck is smaller, it drops by less than the amount you invested.
Let’s take a look at an example. If you need $200 per month to invest to reach your retirement goal then that is just $100 per paycheck. If your company matches it, then it is only $50 from each paycheck. When you look at the tax break you realize you only have to give up about $35 in spending money each check to put $50 before taxes to get $100 after the company matches to reach your $200 each month. For the sake of our future, most of us can find a way to carve out $35 per paycheck.
3 – Invest in Stock Mutual Funds so Your Wealth Has Time to Grow
So where do you put your money? Some people are so confused or scared they end up not investing at all, which is dangerous for their future. In fact, it is more important THAT you invest than HOW you invest. The key is understanding how much risk you can handle and how long before you are retiring. If you are in your twenties, there is no reason not to have most if not all of your money invested in some type of stock mutual fund. Index mutual funds work best. Some companies also offer targeted funds that are based on what year you plan to retire. This way they start out more heavily invested in stocks and slowly switch over more to bonds as you get closer to retirement.
While stocks are riskier because they go up and down a lot over time they tend to return greater than 10%. Bonds are less risky, but only return around 5%. Over the course of a 30-year career investing in stocks is likely to return three times more money than investing in bonds and over a 40 year career it is four times as much money. $1 million will last a lot longer in retirement than $250,000. So you have to be willing to take some risk and invest in stocks to really grow your wealth.
The key to investing for retirement is to start early and often. The earlier you begin the easier it will be for your money to grow. By regularly contributing from your paycheck, you are slowly building your wealth. As your employer matches it only grows that much faster. How much you put in is up to your own personal goals, but most people will need to ultimately invest 15% of their earnings, even though they may not be able to afford to start that high. At a minimum it is best to try and max out your company match. If they will match the first 5% of your income you invest in your 401K then at least try and contribute that much in the beginning. Otherwise you are throwing away free money. A person making $40,000 per year is throwing away $$2,000 per year if they don’t use the company match.
If you can afford more try to invest at least 10% of your income. Between your 10% and the company 5% match, you will have achieved your 15% contribution while only reducing your take-home pay by about 7%-8%.
If you cannot afford the full 5% yet, don’t worry. Start with whatever you can afford and then each time you get a pay raise, try to put half of your pay raise towards your 401K and enjoy the other half in your paycheck. A $100 per month pay raise would mean $50 more towards your paycheck and $100 (with the company match) towards your retirement. Because of the company match it’s like all of your pay raise is going to retirement but you somehow still get more spending money! Once you reach the company match, it is still a good idea to continue adding each time you get a pay raise until you reach the full 10% from you or 15% overall.
Keep in mind, the most expensive purchase you will ever make is not college or a house. It’s your freedom from having to work – called retirement. And since you can’t make payments on retirement after you stop working then you need to start paying yourself now. That way when you are 70 years old and you go to the store, it will be to spend your money, not to apply for a job.