“Would you like to participate in the company 401(k) plan?”
Short answer – Yes!
You maybe sitting down on your first day of work, or just answering the annual HR survey, but this question raises a few more questions of your own:
1) Why Would I Use the 401(k) Vehicle?
Sure, this account is intended to be a “Retirement” account, but ask yourself why you should begin to contribute to this account? Because NO ONE else is going to prioritize your future, let alone your financial freedom!
If you don’t begin the habit of planning for the future by ‘Paying your future self first’ then who is going to worry about future you?
We all must become investors and begin to USE the 8th wonder of the world compound interest. When we choose to become investors, we stop just working for money and instead we turn money into our employee to have it work for us!
Employ Your Money!
When we discuss investment options, we will address the advantage of having a long-term time horizon. But beyond daydreaming about ‘what if’ scenarios that seem way too far off to give any type of purpose, perhaps you change your lens to a closer view of WHY you are contributing:
- Because I want to have $50,000 in 5 years
- Because I want to have 5,000 this year
- Because I want to have wealthy habits
A 401(k) can provide an automated system to prioritize your future, we will discuss the tax advantage and the ‘free’ money from your employer, but possibly the best advantage of a 401(k) is it builds a Habit. In the end, it is your habits that will determine your success!
2) How Much Should I Be Contributing?
There are endless theories on what the ‘right’ amount is. Where you should start is not the right question, where can you start is more personal planning.
One of my favorite financial sayings is:
“I Made a Dollar, I Saved a Dime!”
That means starting with 10% of every dollar you make going to ‘Future You’. If on the other hand you are looking for an ‘ideal’ amount – try to aim for 15%.
Remember, it is not where you start that matters, it is when you start!!
You should also inquire about your employer’s 401(k) match. No matter who you are, you should confirm with your plan administrator that you are contributing the correct amount and in the correct months to capture the entire match. This is ‘FREE’ money no one should pass up!
Regardless of what you choose today, the next time you get a raise, or a bonus ask yourself if you can increase your contribution by 1%. You won’t feel it in your monthly paycheck, but you will see it far down the road when it has compounded into a beautiful sum of money.
3) When Should You Be Taxed?
The 401(k) plan is called a ‘tax advantaged’ vehicle because it gives you a choice around when you want to be taxed.
People often confuse their contribution dollars as being ‘taken’ because they don’t see those dollars in their monthly paycheck, but those dollars are just being placed into a new account. This action has a tax advantage because when your dollars go into the 401(k) account, they are shielded from income tax today. This means in a ‘pre-tax’ or traditional 401(k) contribution you will receive a tax deduction today and are choosing to pay taxes down the road.
Not all plans have an option of pre-tax (Tax Deferred) or after-tax (Tax Free) accounts, but this is where you decide WHEN you want to be taxed.
Pre-tax or the traditional 401k says:
‘Don’t tax me today, tax me down the road in retirement when I will use the dollars.’
This means that the money you contribute to the 401(k) will be deposited before even taxes are taken out. They will be allowed to grow in your account without incurring any taxes. In retirement when you take the money out to use, then the investment will be taxed as ordinary income, in what you hope is a lower tax bracket.
After-Tax or Roth 401k says:
‘Tax me today, but never tax these dollars again!’
This means that the money you contribute to the 401(k) will be deposited after taxes have been taken out. But these dollars that are taxed today are then considered ‘after tax’, going into your 401(k) account. The dollars will grow tax free and down the road in retirement when you choose to use the money you will NOT be taxed.
What can help make your decision?
Here are some high-level thoughts on Tax Defer (traditional 401k) vs Tax Free (Roth):
- I believe my future taxes will be lower than today –Traditional 401(k)
- I believe my future taxes will be higher than today – Roth 401(k)
- I do not trust where the tax system is going – Roth 401(k)
- I want to maximize my cash flow today – Traditional 401(k)
- I want to pass this money to the next generation – Roth 401(k)
4) What Type of Investor Will You Be?
This is an area where you will have to discover your investment personality and investment style.
How do you feel about risk?
A) Want to avoid it at all cost
B) Understand there is a relationship with return
C) Doesn’t scare me, bring it on
If you chose ‘A’ then you should build a solid foundation in your allocation. Not concentrating on one group but diversifying across a wide range of investment options.
If you chose ‘C’ then you are accepting the rollercoaster that comes with equities or concentration and expect over a long-term time horizon the return will justify the ride.
How confident are you in investing?
A) I want someone else to do it and not to think about it
B) I want someone else to do it and not to think about it, but would also like some personal attention
C) I want to read articles and financial statements to find what investments would work best for me
If you chose ‘A’ then I would like to introduce you to ‘Target Date Funds’ which will base an allocation on your age and grow more conservatively as you near that retirement date.
If you chose ‘B’ then I would encourage you to reach out to the investment advisor on your 401(k) plan and inquire if they have any model portfolios that they will manage? Then ask if they will do it, for no additional charge?
If you chose ‘C’ then I would applaud your confidence. You must make sure you have the time, energy, and expertise to handle this all-important question, as you will be placing your family future into your own hands.
Based on your selections above, you will be able to better understand what to invest in and how you should go about choosing your investments.
5) Who Do You Want to Benefit?
Did you know there are millions of dollars sitting in old 401(k) accounts? Is some of this from people forgetting to roll them over and then just forgetting, yes. But a lot is also from accounts that did not have a beneficiary selected and are left in the wind.
A ‘Beneficiary’ is the person you elect to inherit your assets, in this case the funds in your 401(k) account.
This is never an easy question to answer because no one wants to think of worst-case scenario, but if you don’t answer it, then who will?
Take just a moment and think through who you would want to impact if worst case scenario came to fruition? If no one comes to mind, you can always choose a philanthropic endeavor.
This decision should be made as you are setting up your account and updated as life events occur – example Divorce.
You are prepared to work hard for your money, after answering these questions you should feel more confident that your money will also work hard for you!