Let’s Talk Retirement Accounts: 401(k) Plans!

*Disclaimer: This is not financial advice. This is simply my opinion on how to structure contributing to your retirement. The goal is to think, educate and for you to analyze your own comfortability for your investments.

Retirement accounts are another important part of achieving financial independence and overall savings in general. For me, while real estate can help accelerate the process, it cannot be my only source of income to sustain financial independence. This is where retirement accounts come in, especially if you have a job that offers access to a retirement savings plan. We will dig into one of the commonly known retirement accounts that you may be aware of, how these retirement accounts can help you in the future, things to watch out for when choosing funds for your retirement plan and how much I think you should be putting in especially when starting out.

You just landed a job at a new company and they give you a huge benefits package filled with all this information that you have to fill out. Health insurance, dental insurance, commuter benefits, short/long term disability and the good ol’ 401(k) plan that your new employer offers. If you are a public employee or a teacher, your employer may offer you a 403(b) plan instead. Both plans are practically the same so no need to get worried about knowing both, we will stick to using 401(k) plans for this post. Companies that offer 401(k) plans give employees the opportunity to invest the income they receive before they are taxed by the government (pre-tax dollars). The advantage of investing with pre-tax dollars is you get to invest the full amount you make. However, you will be taxed in the future (BOOOOO!!). However, 401(k) contributions are also great tax benefits come tax season. For example:

White Tee Jay makes $100,00/year (I wish) and contributed $15,000 to his 401(k) plan at work for 2019. When White Tee Jay does his taxes in April 2020, his income would be adjusted to $85,000 rather than $100,000 (before all other deductions) because he contributed to his retirement savings in 2019. This can potentially bring White Tee Jay down to a lower tax bracket, which means he can pay less in taxes and/or potentially earn a bigger tax refund!

The money you invest with your company’s 401(k) plan allocated between fund financial products that is offered in your company’s 401(k) plan provider. Most commonly there are bonds and index funds available. We will dig into index funds in this post since those are the money makers, especially for young workers!

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What is an Index Fund?

Think of a percentage of all the biggest stocks that are offered by public companies jumbled into one group (fund). That is the basic definition of an index fund. You reap the benefits of public companies included in the fund without having to pay the full price for that stock.

The most difficult thing to do when setting up your 401(k) is choosing what funds to invest in! To be honest, most of these index funds will grow and give you a hefty return on investment for when you retire. The most important thing to be aware of are expense ratios/ fees.

What is an expense ratio?

Think of an annual membership to Costco. You pay once a year to be a member of Costco right? In the financial world, an expense ratio is almost equivalent to a Costco membership. Almost equivalent because you pay a percentage of your investment amount.

So for example, if you have a 1% expense ratio on an index fund and you buy $10,000 worth of the index fund, then you will be paying $100 annually in fees for investing in that fund! Doesn’t sound like a lot right? What about 1% of $1,000,000? That’s $10,000 a year!!

All index funds offered by your company’s 401(k) plan have an expense ratio associated when investing in a fund. They can be as high as 1% of your total investment and as low as 0.03%! Not to be a penny pincher, but if I’m investing in a fund and my goal is to get the best return on investment, why would I be paying 1% on a fund when there are equally as profitable funds that pay 0.03%? It adds up!! 

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So when you are filling out your 401(k) plan, look for the lowest fees! I typically stick to Vanguard Funds. They typically have the lowest fees and still give you a good return on investment.

These retirement savings plans are important for people who want to passively invest. Ever heard the term, “set it and forget it”? This is where investing with your 401(k) comes in! The maximum amount to invest in a 401(k) for 2020 is $19,500. Now that does sound like a lot, especially if you’re not making six-figures! (I wish I earned six-figures, I will get there one day..) Anyway, I currently contribute 19% of my gross annual income to my 401(k) plan at my current employer. There is also an added bonus to contributing to my 401(k) at my employer, an employer match! My employer matches 4% of my annual salary as long as I am contributing to the plan, that’s free money!! You can easily contribute as low as 1% of your income to your 401(k) plan. You don’t have to do 19% like me, that is what I’m comfortable with. Invest what you are comfortable with and what you can afford. Which is why Get Your Money Right! An Introduction to Tracking Your Finances is important. If you know how much your expenses are every month, it affects how much you are able to invest into your 401(k) plan. The “expert” recommendation is to put in 15% of your gross income into your 401(k) savings plan, you could go the expert route into how much you put in, or you can do the quick analysis of how much you can afford! Who knows, what if you can afford to put in 20% into your 401(k)?! Who wins? You!

So how can contributing to a 401(k) plan help you?

First of all, you won’t be able to touch it! You technically can touch it, if you are willing to pay the price! A 10% penalty of how much you take out! One of the biggest reasons why people don’t succeed in investing or maximize their profits is they touch their investments too much!! Don’t follow my mistakes!! See a drop in the stock market? People sell and lose money! No!! That’s not the right mindset! When the market dips, you buy more! Anyway, since you can’t touch your 401(k) funds without penalty until you’re 59 and a half, it is easy to make your 401(k) a “set it and forget it” investment vehicle. The more you contribute to your 401(k), the more your future self will be set for retirement! But let’s be real here, we ain’t working till 59 and a half right!? If you chose the FI path, it’s still harmless to contribute to your 401(k), it’ll only help you in the future. 

As mentioned before, experts say contribute 15% of your gross income to your 401(k) plan. That is a good percentage, however, everyone has different situations and comfort levels. Here is what I can recommend for someone who is starting out with their 401(k) plan:

  • Start with the bare minimum, 1% contribution
    • If you are not comfortable yet or sure, do the minimum! Especially if your employer offers a 401(k) match if you are enrolled. Remember, it’s free money!
  • Assess your monthly expenses and see how much left over you can contribute
  • Slowly increase your contributions by 1% every 3 months, 6 months, etc. 

The goal is for you to begin investing while also being comfortable. Why contribute 10%, 15% or more if you can’t afford it? This is a long-term approach. You don’t need to do things so quickly. Now if you make a high income (100k+), you SHOULD be maxing out your 401(k).

So if you haven’t signed up for your company’s 401(k) plan yet sign up today! You’ll thank yourself in the future! If you are signed up and just randomly picked some funds, take a closer look into your statements and see how much in fees you are charged. If you have access to Vanguard Funds, I say reallocate your funds to Vanguard! It’s cheaper and may even make you more money in the future! I hope this helps you get started on investing in your employee sponsored retirement plan and/or gets you to take a look into what your retirement plan is invested in. The only person that benefits from your retirement savings is you. It’s a short term loss in income for a huge long term return on investment.

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