I often get asked about our 401k at work. What is it? How do I set it up? Do I need to do anything with it? How much should I put into it? What do I invest in? Let’s break down the 401k in hopes of gaining a clear understanding as to how it works, especially for younger folks establishing their first investment vehicle toward saving for retirement.
First off, as we begin I must mention the Godfather of the 401k, Dr. Richard Thaler. His work in behavioral economics and his support of the Pension Reform Act of 2016 are huge boons for the savers of America. He’s the reason most companies will automatically “opt you in” to a 401k which forces you to “opt out” if for some reason you do not want to participate. It used to be the other way around where the impetus was on you to sign up.
He’s also the reason why many 401ks have expanded their offerings to include low-cost index funds rather than more expensive mutual funds that garnered higher fees (and continuously fed Wall St. Money managers for their underperformance). For this he won a Nobel Prize in Economics. Yes it’s that big of a deal. Thank you Dr. Thaler!
So, hopefully you are working a decent job, with a decent paycheck, and you have a 401k set up to which you are contributing. Here’s some things you should know.
How much should you be saving for retirement? I would recommend you target 15% of your gross pay. New grads are earning an average of about $48,000/year these days. That would equate to saving $7,200/year in your 401k. This is money you can’t touch until you’re 59.5 years old without paying big taxes, penalties, and fees so you are in for the long haul here. If you’re 25 and you save like this until you’re 60 you can easily end up with somewhere around $2,000,000, and that assumes your contributions stay constant. As your income rises your contributions should rise as well, meaning you could see well north of this amount in your early 60’s. Welcome to the Millionaire’s Club. Set it, forget, and let it ride…
Most employers will match your 401k contributions, in some fashion, up to 6% of your gross pay. Do not turn down this “free” money. For instance, my employer will match 50% of your first 6% as soon as you start working, so you should set your contribution at a minimum of 6%. As I stay longer with the company that match will increase to 75% and then eventually a 100% on my 6% contribution after 5 years. Incentive!
To get to my 15% savings goal I need to adjust my input and crank it up to 12% on my end. Seeing the 3% contribution from my employer gets me to 15% overall. As my employer match increases I can adjust my side of the contribution accordingly. One caveat, you may have to wait a period of time before your employer contributions “vest” or become fully owned and/or transferable. Furthermore, your employer contributions may be taxed differently than your contributions depending on how your 401k is set up. Read on…
With your 401k you will have a choice on taxes – tax me now or tax me when I’m 60 and begin withdrawals. I definitely recommend the “tax me now” option. With US debt at record highs and socialist vultures like Alexandria Orcasio-Whatshername circling around talking about 70% tax brackets I’d rather lock in a low rate now and not pay income taxes when I retire. My wager is tax rates will be higher than they are today. This means I set up my 401k as a “Roth 401k”. My contributions are taxed before they go into the 401k which means my withdrawals can be made completely tax-free when I retire. If you have a question on this you can talk to your HR Department to see if you have access to a Roth 401k.
The alternative here is a Traditional 401k. That means the money you contribute is not taxed, so you would not pay taxes on the amount you contribute per year. Yes your tax bill would be lower today; however, you will be taxed on your withdrawals when you retire. Your employer contributions will always go into a Traditional 401k no matter what.
Do you want to gamble on tax rates being higher or lower in 30 or 40 years in a country that is banging a very loud Socialist drum over the past decade? There is a good rundown on the differences between Traditional and Roth 401ks here.
What do I buy?
What is in your 401k? What are you investing in? Good question. Again, thanks to Dr. Thaler, there is a good chance you have what is called a Target Date Fund. This is a great option. The fund will have a date like “Target 2050” which attempts to target the year in which you will retire. As you start investing, the allocation of this fund will be very aggressive. A vast majority of your investment will be in stocks, and it will automatically spread you across large cap, small cap, and international stocks.
As you begin to near your target date the fund will automatically begin to shift into more conservative investments. You will move into a higher allocation of bonds and large company stocks that are more stable, and the fund will attempt to generate more income by way of dividends. This is a great “set out and forget it” plan. Otherwise, you can go through your list of available options and allocate your investments however you see fit. I always recommend a low-cost S&P500 index fund as an alternative.
So that’s brief 411 on the 401k. Hit me if you have any questions, or call your HR team as they can speak specifically to your plan. Above all, you should not only invest in your 401k but take the time to learn about it – learn what’s in it, how much are you putting away, and how to reach your retirement goals. Work with confidence and there will be no stopping you!
Cheers, and thanks for reading!