401k Plan – The First Place to Save for Retirement
Saving money is hard enough. I would hate for anyone to neglect saving for retirement because he or she is unsure of the best way to do so. There are lots of savings options such as IRAs, ROTH IRAs, rental real estate, precious metals, or simply building up a big stash of safe liquid money in the bank. However, a workplace retirement plan (401k/403b) should be the first place employees save for retirement.
Top 5 reasons your 401k plan is the first place to save:
- Automatic payroll deduction makes a huge difference. Savings that are “budgeted,” but not automatically deducted from your paycheck, frequently end up getting spent on “emergencies”…like holiday presents.
- Tax Savings: An employee in the 25% tax bracket could take home $.75 after taxes or put the full $1.00 in his 401k plan. The additional 25 cents (in this example) could be earning money over the next 10-50 years.
- Company Match: All companies do not offer matching contributions, but many do. Companies may match 0-100% of the employee’s contribution. Let’s assume your company matches 50%. This is like an automatic 50% return on investment on day one! You put in $1.00 and your company gives you $.50. It’s free money. When I put it that way, it almost sounds too good to be true.
- Dollar Cost averaging: We all know that investors want to buy low and sell high. Sadly, natural human instincts lead investors to do the opposite. Investors are more apt to invest after recent investing success (at market highs) and frequently stop investing after recent losses (at market lows). The 401k plan will save you from your own worst instincts by taking the emotion out of investing decisions. The contributions are automatic, so you continue to buy more shares after market declines (buying low) and then you’re rewarded when the market inevitably rebounds. This is called dollar-cost averaging. It is one of the principles of good investing.
- Target Date Funds: All principles of investing apply to 401ks (diversification, risk tolerance, time-horizon, etc.). An easy and prudent way to invest in your 401k is to allocate your account to a target date fund. These funds hold a combination of stocks and bonds. Stocks are more aggressive, and they have higher expected returns than bonds over extended periods of time. Unfortunately, stocks also have greater potential for significant declines. Bonds are generally less volatile and provide the consistency that investors want as their time horizon gets shorter.
Make your 401k plan investing almost foolproof:
The beauty of the target date fund is it automatically adjusts your mix of stocks and bonds as you get closer to your planned retirement date. Do you see why this is almost foolproof? You can set it and forget it. The fund does the rebalancing for you.
You could also adjust your target date based on your personal risk tolerance. For example, a target date fund that is later than your planned retirement date would be more aggressive (more stocks, less bonds). An investor with a high-risk tolerance could pick a 2035 fund even though he or she plans to retire in 2030. The corollary is a conservative investor could pick a target date that is sooner than his or her actual planned retirement date (2025 instead of 2030).
Any way you slice it, target date funds reduce the need for constant monitoring of your investment allocation and help to reduce emotional investment decisions.
So, to summarize…the main reasons we love the 401k plan are:
- Automatic payroll deduction: Saving does not get crowded out by overspending.
- Tax savings: More for you, less for Uncle Sam.
- Company match: Supercharges your savings.
- Dollar Cost Averaging: Keeps you buying when markets are low.
- Target Date Funds: Makes prudent investing easy.
From my experience, most millionaires types did not make their money by speculating on real estate, starting a business, or even inheriting money. Most millionaires I meet made their money by systematically contributing the maximum to their company retirement plans.
Have a great week.
Disclosure: The opinions and forecasts expressed are those of the author, and may not actually come to pass. This information is subject to change at any time, based on market and other conditions and should not be construed as a recommendation of any specific security or investment plan. Past performance does not guarantee future results.