The traditional 3 legs of the retirement income stool are Social Security, Pension Plan, and Personal Saving. By 2040, Social Security and Pension Plan won’t be sending us much money. The only control I have over this rickety retirement stool is the personal saving leg. The 401k plan is the foundation of a salaryman’s saving plan and every working stiff needs to take advantage of it.
The main advantages of the 401k plan are:
1. Auto deduction from pay check
2. Employer contribution/match
3. It is pretax (let’s assume we are going with the traditional plan for now)
Let’s go through the numbers and assume I contributed the maximum amount when I started working on Jan 1st, 1997 for simplicity’s sake.
Here are the 401k contribution limits since 1997:
OK, $16,500 seems like a dauntingly huge amount to put away, but it comes straight out of my paycheck and I never see it in my bank account, so I don’t really miss it. If I have money burning a hole in my checking account, I’d probably use it to buy new TV, DLSR lens, nicer cars, all the iApple products, new couch, more clothes, eat out at expensive restaurants, and a lot of other things. This is the best advantage of 401k auto deduction – it’s physiological, but it’s real. I do want all this stuff, but I want a big 401k a lot more. If you just graduated from college, you are used to living a cheapo lifestyle and it won’t be that difficult to auto deduct right away. The lifestyle is still a lot better than when you were an undergrad.
To start with – Contribute the maximum amount to a no-brainer, low fee index stock.
For example, let’s say I contributed the max amount every month and bought VTSMX, the Vanguard total stock market index. VTSMX tracks the performance of the overall stock market. On Jan 1st 1997, I invested $791 (9,500/12) and continue to do this again at the beginning of every month until 2010. By October 2010, I would have invested $176,750 and my account would be worth $211,370. This is a 19.6% return. The return is not great because the stock market is still in the recovery process, but at least the VTSMX portfolio didn’t lose money.
The market went through 2 big corrections in this 14-year period, the Dot Com Bubble and the current Great Recession. These are actually good for our 401k portfolios. I have faith that the stock market will recover at some point and VTSMX will gain at least 10-20% in the next few years. The reason the dips are tolerable is because I keep adding to the 401k every month. During the dip, I get more shares of VTSMX and when the market recovered I made money from the cheaper shares. This is the hidden advantage of auto deduction and 401k – dollar cost averaging.
This is just an example and you can do better with a balanced portfolio. If you are just starting out, I would put 100% in a low fee large index fund similar to VTSMX. This is easy and it will get you started saving. When you are starting out, it is more important to save as much as you can. It is much less crucial what fund you pick. Once you learn more about investing, you can adjust your portfolio and rebalance it as you see fit. For example, you can go with something like 40% large index, 20% small index, 15% developed international, 15% emerging market, 10% bond. This will give you a more stable 401k portfolio and better total return.
So what does retirebyforty’s 401k portfolio looks like you ask? OK, I made some crucial missteps along the way and my 401k is not quite $211k. I will go over the number and the mistakes I made in part 3 of this series.
Another huge benefit of 401k is employer matching. This is free money, if you don’t take it you are leaving money on the table. Every time you get a raise, the employer match raises too, so don’t pass this up. There are many good article about this, Google it. Or better yet, just listen to me and contribute at least enough to get the whole employer match. The employer-contributed part of my 401k is around $100k. This $100k would go to my boss if I didn’t contribute enough to match! Can you live with that?
The last benefit is tax write off. Your 401k contribution is pre-tax and you can write it off in April to get some cash money back from uncle Sam. Would you rather have the money or let uncle Sam spend it? That $16,500 pretax would looks more like $12,000 in my saving account. That’s a huge chunk of change to the government.
retirebyforty’s 401k strategy
> set up auto deduction when you start a job
> sacrifice and contribute enough to at least get the whole employer matching, typically 5-8% of salary.
> increase contribution to the max limit as soon as you can and maximize the tax benefit. The early money in the 401k makes the biggest difference down the road.
There are other benefits of 401k such as the ease of rebalancing and portability, but I am out of room and I already covered the main points.
I know this one was a little long, hopefully you made it to the end. Let me know what you think.