Millennials & Retirement: The Traditional 401(k)

Millennials & Retirement: The Traditional 401(k)

How much do you know about the traditional 401(k)? Do you know how it works and ways you can earn FREE money?

Besides transferring money into a checking or savings account, the first investment people usually make is towards retirement, particularly their company’s 401(k).

Unfortunately, people our age have never been taught basic financial principles, and it shows. 66% of people between the ages of 21-32 have NOTHING saved for retirement.

That’s potentially a full decade without the effects of tax-free compounding in your 401(k) retirement account!

The reasons being are typically self-inflicted. There’s always costs to any decision, especially financial ones. Most millennials have:

  • High student loans.
  • Credit card debt.
  • High rent or mortgage.
  • Car loans.
  • No financial knowledge.

Simple solution: go out and educate yourself financially. And yes, it can be done. I find personal finance highly addictive!

In this week’s post I’ll go in detail on how 401(k)’s work, when to begin investing in your 401(k), and proper 401(k) investment strategies for millennials!

 

WHAT IS A 401(K)?

 

The term “401(k)” is named after the Internal Revenue code that governs it. A 401(k) plan is a cash or deferred arrangement which an employer chooses to have their pay compensated into a qualified retirement plan.

In more basic terms, your 401(k) plan allows you to move a portion of your pre-taxed pay into a retirement account backed by your employer. The key here is that this amount is removed from your pay BEFORE being taxed. Once removed, you can allocate your investments into whatever stocks, bonds, or diversified portfolios your company’s plan offers. Taxing occurs upon withdrawal, meaning the compounding effects of your investment is tax-free.

So where is this free money? Employers have the opportunity to match a certain amount of their workers contributions to their 401(k) plans. The median match is currently around 6%. Might not seem like a lot but compounded positively over 20-40 years equals a ton of FREE money. There are yearly limits as to how much you can contribute to your 401(k). In 2018, your maximum contribution can’t be more than $18,500 (or $24,500 after the age of 50).

But there’s a kicker: you can’t take your 401(k) out until your 59 ½ without paying a 10% penalty! This 10% penalty will be added on top of income taxed withdrawals! Depending on your tax bracket and adjusted gross income, you could end up being taxed around 40-50% of your withdrawal! Now, there are loopholes, but that’s another can of worms I’ll go over in another post.

 

WHEN TO START A 401(K)?

 

Pretty simple, as soon as your company offers a match in your 401(k) plan.

You always here, “pay yourself first” and this is a clear example. Student loan and credit card payments ALWAYS come after your 401(k) withdrawals from your salary, no ifs, ands, or buts about it. DO NOT MISS OUT ON FREE MONEY.

If your company doesn’t offer a match in their 401(k) plan, and you’re young, start a Roth IRA instead. For a Roth IRA, I’m assuming you a.) have created a safety net for savings, b.) NO credit card debit, and c.) manageable student loans (meaning low-interest or not much left to pay off). Our next CAREER post will dive into Roth IRAs. I’ve recently opened a Roth IRA account and have gotten familiar with how they work.

Always strive to increase your contributions to your 401(k), preferably 10-15% of your pay if you’re in your 20s! Instead of increasing your spending habits when you receive that raise or promotion, increase your 401(k) contributions. Like I said earlier, PAY YOURSELF FIRST.

For example, I used an online calculator on bankrate.com to show how time in the market, combined with compounding, equals massive profits:

 

Case 1

·       $60k per year salary

·       3% yearly salary increase

·       Current age: 25

·       Retirement age: 65

·       Return on investment (ROI): 3%

·       Employer contribution: 50 cents on the dollar of up to 6%

·       Your contribution: 6%

·       401(k) at 60: $849,622

 

Case 2

·       $60k per year salary

·       3% yearly salary increase

·       Current age: 25

·       Retirement age: 65

·       Return on investment (ROI): 3%

·       Employer contribution: 50 cents on the dollar of up to 6%

·       Your contribution: 15%

·       401(k) at 60: $1,373,790

The difference in 401(k) accounts near retiring is a staggering $524,168!!!!

 

WHAT TO INVEST IN FOR MY 401(K)?

 

First off, a lot will depend on what your company’s plan offers. If they offer funds with high expense ratios (greater than 1%), don’t bother investing in their 401(k). You’re getting screwed if that’s the case. Start a Roth IRA instead.

The younger you are, the more risks you can take. More of your investments can be made into stocks, which are more violate, instead of bonds. As you grow older, your investment strategies should become more conservative, favoring bonds more than stocks.

This is why Target Date Funds are so popular in retirement accounts. They automatically transfer investments to less risky options as you approach your retiring date. I, however, am not a fan, mainly because I find it not risky enough for young people and your ROI (Return On Investment) is barely above yearly inflation. Also, if you’re not careful, Target Date Funds can be more expensive (higher expense ratios), than more profitable investment options.

For newbies in your 20s, 80-90% of your 401(k) investments should be towards equities (a.k.a stocks) and the rest in bonds. Most people have 70-80% of their equity investments in domestic (U.S.) stocks, and the remaining in international equities. I find investing in international stocks is a BAD investment. International stocks rarely outperform U.S. markets, and when U.S. markets suffer, international markets suffer just as bad, if not, worse.

So, what do I do?

I like a diversified account (meaning covering many sectors) but simple. More diversification through more index funds CAN lead to more fees if you aren’t careful. My go to is any S&P 500 index fund, which mimics the market, with a low expense ratio (less than 0.1%). Again, and again it has been proven that pretty much NOTHING out performs the market over time. I’ll also have a small percentage allocated towards secure, low expense ratio bond funds just in case.

 

Hope you like this week’s post! This is all just advice. I AM NOT A CERTIFIED FINANCIAL PLANNER!!!! Look more into traditional 401(k)’s ins and outs before making any decisions based on my personal opinion. I’m just trying to provide somewhat of a wake-up call for the people who need it! If anyone needs some beginner guidance on 401(k)’s, don’t hesitate to reach out.

If you’ve missed last week’s Q & A on Marriage in America, click here! As always, don’t forget to like, comment, share, and subscribe!!

 

“The question isn’t at what age I want to retire, it’s at what income.” 

 

Book of the Month:                          “Discrimination and Disparities” by Thomas Sowell

 

 

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