Trying to envision what life will be like some four decades down the road is next to impossible. There are so many unknowns, including your career trajectory, family situation and even the fate of Social Security.
But there is something easier to predict: the need to look out for yourself. Social Security probably still will exist in some form, but gone are the days when companies provided a guaranteed safety net to employees in the form of pensions. These still exist, but only in select industries. This is especially important for Millennials, who in many ways have the most to gain from contributing to their 401(k) accounts because time is on their side. As you go throughout my blog on focusing on early retirement I also recommend having a long term plan too.
So What Is a 401(k)?
To put it in really general terms, a 401(k) is a retirement savings account offered through your employer. (If you’re self-employed, you can open a Solo 401k, but that’s a whole separate topic).
You set aside a certain amount of money each month from your paycheck, and use it to invest money through this account. You have the option of investing in a variety of assets (i.e. stocks, bonds, mutual funds). Over time, your money grows. Ideally, when you retire, you’ll have a big stack of money that’s been growing for years.
The money you earn from your 401(k) investments isn’t taxed until you withdraw it—ideally, after you’ve retired.
Why Do I Need One?
Saving for retirement is important and you should do it as soon as you can. If you want to retire in the short term or the long term you need to do it. Saving even $50 a month can work for you.
With a 401(k), your company might offer to match a percentage of some of your 401(k) contributions. This is basically free money. Also, since the money you invest is “pre-tax,” you could reduce your annual tax bill. It’s a win-win. Another benefit to having a 401(k) retirement plan is having taxes deferred until you withdraw the money at retirement. So, since the 401(k) actually reduces your tax rate, you won’t be paying taxes on the money until you withdraw it. Since many people tend to be in a lower tax bracket when they retire, the 401(k) actually has you paying a smaller tax rate on your savings when you take it out of the account.
Of course, you’ll eventually have to pay taxes on this money when you retire.
How Do I Pick My Investments?
When you open your 401(k), you’ll have to pick your investments. Your employer usually works with an investment broker to come up with a list of options. This means you’re stuck with the list they offer, and sometimes, the list isn’t great.
Either way, you’ll have to pick a fund from this list that’s based on a risk level you feel comfortable with. Investor Place runs down the five major types of funds you’ll likely have to pick from:
- Stock Funds: As the name suggests, this type of fund covers a variety of stocks that you can invest a percentage of your account in. According to Investor Place,
“Most 401ks only offer a handful of stock funds to choose from, so selecting funds in this category shouldn’t be hard — just look at expenses (lower is better) and long-term returns (higher is better) to find the best fit.”
- Target-Date Funds: These funds are pretty simple and basic. You pick your target date for retirement, then pick the matching fund. Because they’re so simple, there’s not much maintenance, as the fund adjusts your asset allocation over time. The fees of target-date funds might be higher.
- Blended-Fund Investments: These funds have a set ratio of stocks and bonds. You can pick one that’s appropriate for your situation. This means you’ll have to consider your tolerance for risk and how many years you have until retirement.
- Bonds/Managed Income: These are funds are meant to safeguard your money, but your money won’t grow much with these funds.
- Money Market Funds: Investor Place calls the money market fund a “glorified CD.” There’s zero growth here, and, in fact, these funds barely keep up with inflation rates. They recommend avoiding money market funds if you want your money to grow.
A Word On Moderation
Whether you envision working full time into your golden years or aspire to drop out of the 9-to-5 rat race a lot earlier, the steps you take now will help your dreams become reality. But retirement probably isn’t your only goal, and it’s important to be realistic about what else you’d like to save for, like buying a home, starting a family, traveling or going back to school.
The basic advice still stands: Contribute as much as possible to get the company match for your 401(k). But the key is to take a measured approach, striking a balance between short-term and long-term goals.
Being too aggressive can cost you. Don’t save more than you can for retirement if you’re simultaneously amassing high-interest credit card debt or haven’t established an emergency fund. Dipping early into your retirement account often incurs a 10% tax penalty if you’re under age 59½, unless you’re doing so for some very specific reasons allowed by the IRS.
The journey to retirement is a long one, and while someday sooner than later you should aspire to max out your 401(k) contributions, you should only do so when it makes sense within your overall financial picture.
I understand this is a very important topic and I want to be as detailed and helpful as possible. So if you are interested here is a how to set up a 401(k) guide.