What is a 401K, how do I use it and why does it matter?
A 401K is an employer sponsored account that is funded directly from payroll deductions. With traditional 401Ks, this money is taken out of your pay before it is taxed. This means it also grows tax free until you take it out in retirement. Many employers will work with a brokerage firm like Charles Schwab to set these up. The employee then goes in, selects how much of their pay they want to go into this account and how it should be invested within the account. In many ways it automates your savings/investing so you are paying yourself first.
401Ks for most people are a great way to save for retirement. The automation allows you to purposefully move money into your investments before you really have control to spend it. Many employers pay packages include some matching on these dollars also. As an example, you may put in 5% of every paycheck and your employer would match that 5%. So I put in $200 and they also put in $200. I would strongly encourage anyone that has an employer match to make sure they are taking full advantage of this benefit. It’s a 100% return on your money that you could be missing out on. I’ve been very shocked at the number of people that do not do this.
I understand that many people in America live pay check to pay check. The thought of taking 5% and setting it aside feels like something they cannot afford. I believe that you cannot afford NOT to do this. There are disadvantages to 401ks and I’ll get to those in a bit. But to not take advantage of employer matching will hurt you for the rest of your life. Downgrade your car, downgrade your phone plan, downgrade your lifestyle. Do it now, take advantage of this benefit and thank yourself in 20 years.
Now 401Ks are not something everyone loves. They are often limited in what investments you can choose within the account. These are typically chosen by someone at the employer with support from someone at the broker. They are mostly mutual funds that to offer some diversification options but also can have hefty management fees. The limitations on these accounts make them not as appealing for many that like to be more active in managing their investments or who like choices. And one of the biggest selling features to them is that the money is put in before tax and grows tax deferred. The benefit of this is fueled by the idea that you will have a lower tax rate in retirement than you do in working years. So it’s better to pay tax then vs. now. A flaw to that could be that our government is growing and society is evolving in many ways and many believe it’s naïve to think that taxes will not be much higher in the future.
Some employers also offer a Roth 401K. Much like a Roth IRA this is funded with after tax $ and therefor you pay your taxes up front and not when you withdraw in the future. Many see these as a better alternative based on future tax assumptions. I believe that everyone has to make the right call for themselves. There are benefits to both. I actually have some of my 401K in traditional and some in Roth.
Another thing I have seen that I would like to caution people on is not speaking to a professional at the brokerage or someone else to help you learn about diversification within your 401K. Many people follow the set it and forget strategy. This means that when you first set up your account, you pick your investments (which mutual funds) and you go on never to really look at it again. This can be a problem based on how your matching goes, are there targeted stock funds included (like a fund that solely investments in your company’s stock), are some of the mutual funds performing way better than others, etc. etc. This can lead to your account becoming very “unbalanced” and not match what you originally set out as your strategy. Also, as you age, as your income increases, as your lifestyle and or goals change, you will want to review your allocation and account to ensure it’s still on the right track. This is another place a professional investment adviser can really add value for you. I would recommend at least an annual checkup to ensure all is still on track.
At the end of the day, if your employer offers a 401K and especially provides a matching contribution a 401K is a great way to automate your savings/investing plan for the future. It’s really easy to say that you will do it on your own, but it’s even easier for life to get in the way. Those funds get spent, used up and never saved. Then you get to retirement and you have nothing put away to support the life you want in your later years. Social Security is often NOT enough to support your lifestyle desires. You can’t even access SS dollars until you are least 62 and with how long people are living and how few people are being born and paying into the system. Something is gonna have to change in a big way for SS to be able to support your retirement at all. Do yourself a favor and automate your saving/investing. Do what you have to do to make it work and maximize any benefit your employer is offering. Your future you is dependent on it and YOU ARE WORTH IT.