401(k) for Dummies

401(k) for DummiesNearly half of those surveyed in a recent Charles Schwab Corp. survey said they don’t know if they’re making wise investment decisions within their 401(k). Can you blame them? When you begin working at a company, Human Resources will explain the 401(k) plan they have available for you. But the 401(k) plan is brokered through a third party: Vanguard, Fidelity, Charles Schwab, etc. Even if you do ask HR the right questions, they likely won’t be able to supply you with complete answers. They will tell you to contact the brokerage firm they use. It may feel like they are just passing the buck. If your brokerage firm doesn’t have great customer service, you may be even more confused than when you left HR. But let’s slow down for a second. All is not lost. A 401(k) really isn’t that complicated.

What is a 401(k)?

A 401(k) is a retirement plan provided to employees by a private company. Nonprofits and public companies typically offer the 403(b) as an alternative. There are many similarities.

You can either take advantage of a 401(k) or (sometimes) a Roth 401(k). The biggest differentiating factor is when your money gets taxed. With a 401(k) you get taxed when you withdraw money from your plan. With a Roth 401(k), your contribution is after-tax money and your money grows tax-free.

Many private companies offer a ‘company match.’ This means they will match up to a certain percentage of whatever you contribute. The average company match is 4.1% according to Vanguard. If you allocate 5% of your salary to your 401(k) and your employer does a 5% match, you are essentially getting a 5% boost to your retirement money – for free. A good rule of thumb is to always contribute up to your employers match. Before you contribute to an IRA or any of form of retirement investment, go for the 401(k) with a match. Beyond the match, you can keep contributing. The 2015 max contribution limit has risen for 2015. You can now contribute $18,000 per year. If you get started early enough and choose the proper investments, the 401(k) will likely be enough for you to retire on.

How much should I really care about a 401(k)?

Short answer: a whole lot. If you want to travel when you retire, treat it as your travel fund. Consider scrapping the name altogether and giving it a more personal name. ‘Destination: Europe’ could be its new name.

It’s so important you should always be employed by a company that offers a good 401(k) plan. According to a Market Watch article, a bigger 401(k) match trumps a bigger salary.

Can I use the money before I retire?

The short answer is ‘yes.’ But nearly every financial advisor will discourage this action.

If your employer allows, you can take loans from your plan. You can take up to 50% of your vested balance if it doesn’t exceed $50,000. It must usually be repaid within 5 years. To deter you from doing so, here are 8 Reasons to Never Borrow from Your 401(K). This really shouldn’t even be considered unless you are in a very desperate financial situation.

What should I be investing in?

This is a tricky question. The general advice is to invest aggressively while young and more conservatively as you age. An aggressive portfolio is more volatile. If the stock market crashes at age 30, the market will have time to recover before you retire in your 60s. If you are aggressive with your investments in your 60s, the stock market may crash and it not recover by the time you need to begin taking money out. This is a terrible position to be in but it’s one that’s avoidable. An easy way to measure how much risk you should take is to invest part in equities (stocks) and part in bonds. Jack Bogle (founder of Vanguard) recommends you ‘buy your age in bonds.’ Bonds are safe. As I mentioned earlier, the older you get, the less risk you want. When you’re 25, you should only have 25% of your portfolio in bonds. When you’re 65, 65% should be safely tucked away in bonds. Let the rest be invested in volatile (but profitable) equities.

Most brokerage firms offer a simple solution for how you can invest. They give you a ‘target fund’ option. This means that this fund will adjust based on your target retirement age. As you get older, the fund will automatically become more conservative. If you really don’t want to mess with your plan, this is your easiest option. However, they typically aren’t very tax efficient since your 401(k) target plan will act as your be-all and end-all retirement plan. In reality, your life is probably not that simple. When thinking about your 401(k), think about it in the proper context: how does it fit into your overall financial plan? Do you have any other assets? Does your significant other? Think about all your assets when arranging your 401(k).

Final Thoughts

Once you get your 401(k) on a steady path, it’s pretty hands off. Get it setup while you’re young so you can retire wealthy. There will be more posts about retirement plans in the future. Stay tuned.

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