What is a 401(k) or 403(b)?
A 401(k) plan is an easy way to save for retirement and offered as a benefit through your employer. It’s called a 401(k) because it’s named after the section of the tax code that governs it. 403(b) plans are similar except they’re offered by nonprofits, educational institutions, governmental or other tax-exempt organizations. These plans originated in the 1980’s after pension plans became too costly for employers to maintain. Your employer uses a third-party administrator to oversee the plan such as Vanguard, Charles Schwab, Fidelity, etc…
Two great benefits of 401(k) or 403(b) plans:
1) They allow you to save and invest a portion of your paycheck before taxes are taken out thus reducing your taxable income.?? Taxes are not paid until the money is withdrawn.
2) They allow you to decide how you want to invest your money allowing for higher returns, compound interest, etc…
How much of your paycheck should you invest in the plan?
The financial rule of thumb is 15% of your income.
Some people have told me they can’t afford 15%. My answer to this is two-fold:
1) Take a look at your spending behavior. Are you house poor or car poor (too much of your disposable income is used towards your house or car)? Are you spending too much money eating out or entertainment? Only YOU can decide how you want to spend your money but make sure you have a budget and financial plan in place to make a good decision. You should invest in yourself first (future retirement/savings).
You also need to know that Social Security will not be enough to live on comfortably once you retire. Social Security’s cash flow has been negative since 2010 and will likely be cut by 2035. You need to put money into your 401(k) as your main source of income when you retire.
2) If you decide you can’t afford 15% and/or don’t want to change your budget and financial plan, make sure to invest at least the amount of your employer’s match since this is FREE money! FIND A WAY TO MAKE IT HAPPEN! Many employers will match up to the amount you’re investing and typically range from 2% to 7% (average is around 3.5%). For example, if your employer’s plan offers a match of 7% and you invest at least 7% of your paycheck, they will match the same amount of money for a total of 14% going into your account. If you invest 5%, they will only match 5%. Why not take advantage of 100% of the free money? Remember all the compound interest you’ll be earning on this free money!
By the way, if your employer only matches 2%, this doesn’t make them a bad employer. Regardless, it’s free money. Some employers offer a profit-sharing plan meaning there’s no match but they’ll contribute to your account on a yearly basis depending on the profitability of the company. I want you aware of any matches available and make sure you’re taking advantage of ALL free money.
Another tip is to squeeze as much as possible out of your budget and then increase your contribution every year by the amount of your pay raise until you reach 15%.
How much will you need for retirement?
Obviously this varies by person. Chris Hogan offers a great tool called the retirement IQ. Click on this link to learn more.Chris Hogan’s R:IQ
How should your money be invested?
The good news is that these plans typically give you a variety of mutual funds comprised of stocks, bonds and money market investments. Only you can decide how much risk you want in your portfolio. However, I wouldn’t worry about the market ups and downs. Keep in mind that the market will almost always feel like a roller coaster and you wouldn’t jump off a roller coaster, right? You only realize the market losses if you move your money out. Leave your money be and don’t let your peers or media put you in a panic. My preference is to invest in nearly 100% stock mutual funds. Over time your money can grow to three to four times the amount than if you were to leave it in a bond fund or money market fund.
Here are my recommendations:
1) Stay away from “target-date funds” also called lifecycle or age-based funds. Here lately there’s been an influx of target based funds being offered in an employer’s retirement plan. These types of funds are designed to provide an investment mix whose asset allocation becomes more conservative as the target date approaches (typically your retirement date). I do NOT invest in target date funds because it’s an extremely conservative approach to investing. You typically make about half of what you could in a regular mutual fund (although largely dependent on the fund).
2) Invest in index funds. What’s an index fund? It’s a type of mutual fund that mimics the market index such as the S & P 500. It’s broadly diversified capturing the returns of a large segment of the market in one fund. There are typically hundreds or thousands of holdings and is a form of passive investing so the manager of the fund is not trying to “beat the market” and thus risk a loss. The expenses of a passively-managed fund are much lower because there’s not a lot of time put into researching the stocks to buy and sell for the portfolio. The cost savings of the passively managed index fund is passed onto you, the investor.
Chris Hogan’s book Retire Inspired: It’s Not an Age – It’s a Financial Number will give you more information on the above as well as other retirement options:
What happens to your money if you leave your employer?
The money you invest is yours to keep along with the vested amount of any employer or profit-sharing contributions. Don’t cash it out. If you do, you’ll have to pay taxes on the entire amount and you’ll owe a 10% penalty if you’re under the age of 59 1/2. In addition, you don’t want to throw away your savings just because you’re changing jobs (or have lost your job). Don’t panic and cash it out!
Here are better options:
1) You can leave it in the plan though you won’t be able to contribute more money. However, this money should continue to grow until you decide what to do with it. Some employer plans won’t allow you to leave it there if you have under a certain dollar amount (such as $5000). Otherwise, if you like how it’s invested, just leave it be.
2) If you don’t like the investment options, you can choose to move it to an IRA which would open up many more investment options.
3) You can roll it over into your new employer’s 401(k) plan. This keeps all your money in one place and makes it easier to manage.
What if your employer doesn’t offer a 401k or 403b?
This is another blog post I’ll be writing about soon.?
Sign up for my Money Saving Tips newsletter if you want to learn more.