Let me be the first to say “Congratulations”! Despite the intimidating packet of papers you need to review and fill out as well as the dozen 401k questions you probably have, this is a great opportunity for you!
Not only will you be starting down the road to financial freedom (in other words: retirement), but you’ll also be given the opportunity to make FREE MONEY! Yes, I said free money! Why is it free?
1) The money you put away comes out of your paycheck BEFORE taxes and it grows tax free until you retire!
2) Your company will likely (as a lot of companies often do) kick in a little bit extra cash in addition to the money you plan to put away. Who wouldn’t take a little extra money for free!
Without further ado, let’s see if we can tackle some of your 401k questions with a few of the topics below:
What Exactly is a 401k?
A 401k (named after the section of IRS tax code) is an U.S. employer sponsored retirement plan where taxes are deferred until retirement. What that means in plain English is that it’s a special type of investment account intended for retirement where you automatically get to take a portion of your paycheck out before taxes and place them into that account. The money grows tax free until you retire and someday take the money out. At that point, you then pay taxes on both the money you initially put in (the principal) and all the earnings that it grew.
A 401k is sometimes regarded as the modern version of a pension. Back in the day, if you worked for a company for a long time, they would take care of you in your elderly state by sending you money every month (similar to Social Security). As you can imagine, this was a VERY costly expense for most companies, and most of them have since phased them out (replacing them with a 401k plan). The most likely place one would still find a pension would be with a government institution.
In some ways, the 401k is a major advantage for you over the traditional pension plan:
1) First of all, a 401k belongs to the individual whereas a pension is owned by the company that sponsors it. For example, if the company you work goes bankrupt, your 401k is still yours. The pension, however, will either be significantly decreased or (worse) disappear. Similarly, the 401k follows you from job to job.
2) Next, the individual has control over what investments the 401k will invest in whereas the individual usually has little to no control over the investment portfolio of a pension.
3) Finally, you control how much money you wish to contribute which will ultimately dictate how soon you may possibly be able to retire. For example, you can contribute a little bit (and retire later) or a whole lot (and retire sooner). With a pension, there is usually a set amount of money that gets contributed and a certain number of years before you are eligible to officially receive the benefits.
However, this last point is a double-edged sword. The individual also has the option to put NOTHING in their 401k at all, which will devastate them financially in old age. In short, a 401k makes you the only one responsible for you and your future. You’re the only one looking out for yourself.
First Things First, Commit to Contributing:
I know it’s hard to imagine cutting money out of your paycheck because it probably already doesn’t feel like enough. But you have to commit yourself to putting away some percentage of your income. No debates! Even if it’s just a little bit. Why is this so important:
• Because if you don’t start now, it will get harder as you get older, and you’ll regret not starting sooner.
Whatever your situation is now, you’re probably in a much better position (both health and ability wise) to survive financial ups and downs and replenish your earnings if necessary.
Also, the earlier you start, the more “time” has to work its powers of “compound interest”. More on this topic in a later post.
Okay, I’ll Commit! So How Much Do I Put In?
This question can be answered by splitting it up into 3 smaller questions:
1) How much do you need to put in to max your company’s contribution match?
2) How much can you afford to put in?
3) When do you really want to retire?
Question 1 – In order to get the most amount of free money possible from your employer contribution, you first have to find out what their maximum payout is. For example:
• If your employer matches your contribution $1 to $1 up to a 5% contribution, then 5% should be our starting target. At $1,000 per paycheck, you would put in $50 and your employer would also put in $50.
• If your employer matches your contribution $0.25 to $1 up to a 10% contribution, then 10% is our starting target. At $1,000 per paycheck, you would put in $100 and your employer would also put in $25.
The goal is to get your employer to put in the most amount of money possible. To put in less than this amount is like leaving money on the table.
Question 2 – Hitting the maximum employer contribution limit is a good starting point, but can you do better? Can you afford (or live with) putting more away, say 12 or 15%? Remember, compound interest works best when you start early with strong savings!
What about the other direction? Are times tough and you need to be more realistic by putting in less, say 8 or 5%? If you can honestly answer yes, then put food on your table first before saving for retirement. Besides, you are always free to change your contribution percentage later. But no matter what, don’t put nothing away!
Question 3 – This question is not looking for you to answer with a specific number. It puts question 2 in check:
• If you want to retire early, then you better bump up your percentage as high as possible.
• If you plan on taking your time towards retirement, then feel free to be a little more modest with your percentage.
If you’d like some advice on what percentage to pick, Charles Farrell recommends in his book “Your Money Ratios” to start by putting away 12% and then raising it up to 15% at approximately age 45. If you start at age 25, this should put you on track to retire by age 65.
The Internet is also full of a sea of free calculators that will let you play with these numbers to see how realistic your plan is.
Official Federal rules state that the maximum amount you can contribute to your 401k in one year (as of 2011) is $16,500 (or $21,500 if you are 50 or over). Good job if you contribute so much that this becomes a problem for you!
There’s a Lot of Choices to Pick From. Which Products Do I Want?
Chances are that your 401k options will consist of mostly mutual funds. Usually they will come in a few varieties:
• Government bonds
• Corporate bonds
• Large-cap stocks
• Mid-cap stocks
• Small-cap stocks
• Foreign stocks
Without getting too technical, the basic trend is this:
• From top to bottom of the above list, the possible risk goes from small to large.
• Also from top to bottom of the above list, the possible reward goes from small to large.
You should pick a combination of products that will match your preference for risk vs. reward, a concept called “asset allocation”. There are entire books written on the topic of asset allocation. However, the old rule of thumb is as follows:
• 110 – Your Age = The percentage of your portfolio that should consist of stocks (riskier investments).
• The remainder should consist of bonds (more stable investments).
The logic behind this age-old technique is to shoot for higher return when you’re younger and don’t need the money for a long time. As you get older and closer to retirement, you’ll want to move more of your money into safer investments.
Again, this is your account and you’re always free to change your mind on which products you pick.
Despite your preference for risk, you can still use some basic fundamentals to pick the better options:
• Pick ones with low expense or cost ratios.
• Pick ones with higher percentage returns over the past 10 years or so. You can basically ignore 5, 3, 1, and year-to-date (YTD) percentage returns since they are too biased towards recent market trends.
• Check your picks on Morningstar.com for a free, professional rating of the mutual fund. Top honors receive a 5-star rating.
• If your plan offers “Target Date Funds”, buyer beware. Although they logically will automatically perform a technique similar to the “110 Rule” above, there has been a lot of controversy over whether they actually perform as well as picking regular mutual funds. Again, consult Morningstar.com for the individual fund rating.
My Plan Talks About “Vesting”. What Does “Vesting” Mean?
Another thing to learn about your company’s 401k plan is what their terms for “vesting” are.
• Vesting is a process where you gradually over time own the money that your employer kicks in to your 401k.
Go back to the section where I told you that your employer kicks in money to your 401k every time you do. Is that money actually yours right away? The likely answer will be “no”. Although the money is part of your account for you to choose to do with as you please, it is not really yours until a certain amount of time (i.e. vesting) has passed. Usually, each year that passes brings you closer to becoming “fully vested”, meaning you own 100% of the money your employer put in.
• Example: Your employer’s terms are 5 years until you are fully vested. At the end of your first year, your employer contributed a total of $1,000. Since only 1 year has passed and you are 20% vested (1 divided by 5), you actually only own $200 of the $1,000. The remaining $800 is still property of the company. If you were to quit or be let go, the money would return back to the company’s general fund.
• Example: Your employer’s terms are 5 years until you are fully vested. At the end of five years into your employment, your employer contributed a total of $5,000. Since you have reached the required 5 year term, you now own the entire $5,000. It can no longer ever go back to the company.
Why do companies do this? Because they want to reward those employees who in it for the long haul and are loyal to the company. This protects them from opportunists who are looking to use the company as a spring-board to leave for the next big opportunity.
Make sure you fully understand your company’s policy on vesting since every company will have a different set of rules. Although you may not be thinking about it now, it will be particularly important if you ever have to leave the company or are let go.
Other Important 401k Questions:
What About My Money? What if I Quit or Get Fired? Is the Money Still Mine?
All the money YOU ever put in your 401k is yours, no matter what happens. Depending on when you become vested will determine how much of your employers contributions you get to keep.
Just remember that depending on which investment products you pick, your money will fluctuate up and down in value. For example:
• Suppose you put $5,000 in your 401k and leave your job. The stock market did well that year and your account is now worth $6,000. You get to leave with $6,000.
• Suppose you put $5,000 in your 401k and leave your job. The stock market did terrible that year and your account is now worth only $4,000. You get to leave with only $4,000.
In general, if you leave your job, you don’t “cash out” and keep the money. It usually just stays right in the same account (that you own) or gets rolled into an IRA (another thing that you get to own) (a whole other topic worth discussing in a post about!).
You basically cannot withdrawal either the principal or earnings until age 59 ½ for any reason. Otherwise, there is a 10% penalty. There are a few exceptions:
• If you are leaving your employer when you are at least 55 or you become disabled.
• You can also “borrow” against your 401k, but please DO NOT DO THIS! (Again, a whole other topic worth discussing in a post).
So in short, here’s what you do with your 401k packet:
• Yes, sign up!
• Max out the employer contribution
• Put in as much as you can afford
• Pick a modest combination of stocks and bonds
• Stick with it and keep on contributing!
I hope this very long post has answered all your questions about your 401k packet. Please feel free to post any other questions that may not have been covered.
Image Credit: Microsoft Clip Art