You may have already heard of the “oh so” famous 401k.
In a nutshell, a 401k investment account is used to save for your retirement. If you are how I used to be, then you probably view this account as a waste of time. I mean Uncle Sam already takes a good portion of your paycheck with taxes, why deduct more money from your paycheck right?
This past year I’ve come to change my perspective about my 401k account. I still don’t view it as the ultimate solution for retirement, but if your company offers you the option to invest in a 401k account, then you should gladly take on their offer.
Regardless of how long you plan to stay with your current employer, you should try to maximize your contribution amount.
The 401K isn’t perfect, but it does come with some benefits.
Right off the bat, it’s worth noting that some employers will match a percentage of your contribution amount. Companies do this to keep current employees happy, and to attract new ones. Regardless of why this is FREE money that no one should leave out!
If you have bills, and a personal situation I totally get that you won’t be able to contribute a large portion from your paycheck. However, at the bare minimum, you should contribute what your employer is willing to match. Let’s say that your employer matches up to 5% of your bi-weekly paycheck, then this should be the minimum percentage you should aim for.
You shouldn’t notice too much of a difference with a 3-5% contribution, so take advantage of this. Once you get accustomed to this amount you can enable your contribution amount to increase automatically each year.
This is the best way to start spending your annual raise in my opinion.
Your 401K is pre-taxed, meaning that it is deducted from your paycheck even before Uncle Sam tries to grab your piece of the pie.
This is very beneficial because it can make all the difference of which tax bracket you’ll fall into, and how much you’ll end up paying in tax season. Let’s say that you make $55,000 annually, and you ended up contributing 10% ($5,500). This will mean that at tax season you’ll only be taxed for $49,500 vs $55,00.
If you break it down even further it goes as follows:
$55,000 X 25% (amount you’ll pay in taxes) = $13,750
$49,500 X 25% (amount you’ll pay in taxes) = $12,375
This is assuming that you’re single, but you can find your exact tax bracket here.
Apply the same formula to a lower salary amount, or with a higher contribution and this can put you in a lower tax bracket. The max you can contribute into a 401k is $18,000 annually, and you can probably begin to see why.
In the previous scenario, you would be paying $1,000 less if you’d contributed more money in your 401k. You’re killing 2 birds with one stone if you ask me.
Think again if you think you can’t afford to contribute more because it can actually cost you money down the road!
Ok, so all the benefits are nice, but what if you have no clue how to invest?
For starters, what you don’t want to do is go by the default contributions that your company assigns you.
Well because it’s not customized to fit your needs. All of your money may be allocated in bonds when it should be the other way around. For example, your company’s default distributions may be as follows: 40% bonds and 60% stocks. If you’re a millennial, then chances are you should be contributing more in stocks vs bonds.
Bonds are considered to be more conservative investments, meaning they are more secure with fewer gains. A 60-year old person will be better off having a higher ratio of bonds since they are nearing retirement, and more security is required to retain their investments.
You can determine your risk tolerance here.
After you’ve determined your risk tolerance you’ll next start selecting your investment options. Each company will have different stock and bond options available for their employees. A good rule of thumb is to select an index fund.
Index funds invest by tracking an index such as the S&P 500, making them less expensive since they are maintained “passively” vs “actively”. For example, if you opt for an “actively” managed fund then it will be more expensive. People invest in such funds because they believe that professionals can outpace the market.
I completely disagree with this choice, and I’m sure you will also if you don’t already do so. There’s no way to beat the market consistently. Yes, analysts have outpaced the market, but not on a consistent basis.
If you receive a 13% increase in your annual investment and you end up paying 2-5% in fees, what’s your real gain? Probably anywhere from 9%-11%, and this is assuming such a large gain. The market average is anywhere from 7%-10%, so depending on your fees your actual gains could be lower than the market average.
Hey if you don’t take my word for it, there’s no hard feelings.
However, make sure you check this book out since it explains why index funds are a powerful investment vehicle.
What if you’re looking for an alternative solution to index funds?
Target funds are your answer. These funds will have an end year in their names. For example, Rowe Price Retirement 2050 Fund displays the maturity year as 2050. This fund is ideal for a millennials age 25-30.
You would invest 100% of your money in a target fund, and your money will be diversified with large company stocks, small-company stocks, bonds, emerging-markets stocks, real estate stocks, etc. All of your money will be automatically distributed to each type of investment vehicle.
As you get closer to your retirement date, the fund starts adjusting itself to become more conservative. This is to reduce your risk of losing money as you’re getting ready to cash out.
401ks are actually an important mix to have for your wealth portfolio.
My lack of knowledge in the past led me to believe that it was just another account to put money into. However, as I learned some of the benefits that the 401k had, I quickly realized that I needed to contribute more money. If your employer doesn’t offer one, then you can look into opening your own IRA or Roth IRA account.
I and thousands of other millennials are in the prime time to start building wealth because time is in our favor. Regardless of one’s age, it’s never a bad idea to start investing in a 401k or an IRA account to plan for retirement.
Don’t let fear stop you from managing your own 401k account.
Remember to start investing by determining your risk level. Next, you’ll either dump most of your money in an index fund mixed with bonds or into a target fund where your money will be diversified automatically.
Finally, get help when needed!
Hey, I’m not saying that you need to go protest in the streets that you’re against hiring a financial advisor. They are all the experts. However, no one and I mean no one will care about your finances the way you do.
So, it’s best that you become well rounded in understanding the different types of investment vehicles available to you. When you feel that your portfolio is getting complicated, or just want a second opinion to make sure that you hire the right financial advisor.
Here are some key traits to look at when hiring your financial advisor:
1.They clearly state being fiduciary (will work for your benefit, not theirs)
2.They make the investments they sell you
3.They are priced at the average cost (do your homework)
You get what you pay for, so make sure that you spend just the right amount of money in hiring your financial advisor. If you overspend your money hiring a quality advisor, then you didn’t lose as much as hiring a bad advisor.
I hope this article has been helpful and inspired you to start investing in your 401k as aggressively as possible.
You’ve got this in the bag!
Questions for you
What investment vehicles are you using to plan your retirement?