So you’ve just started your new job and the HR department hands you a stack of paperwork. One of the items is a form where you need to determine how much of your paycheck you want to contribute to your 401k plan. What should you do? Phone a friend? See what your office mates contribute? Call your mom? Here’s some helpful information.
How much should you contribute? Fifteen percent. If you contribute 15% of your gross pay for retirement, you continue to work until it is time to retire, and you don’t touch your retirement accounts until it is time to retire, you’ll be set in retirement. I’ll avoid the somewhat complicated math, but if you put 15% of your paycheck into a diversified set of stocks, earn 7% on average after inflation, you’ll end up with a portfolio value of about 45 times your annual salary after about 45 years. If you then withdraw 3% of this account per year in retirement, which is about what most studies say you can withdraw without depleting the value of the account (meaning you can do this forever), a balance of 45 times your annual salary will provide you with about 1.3 times your annual salary each year in retirement. Plenty for living and medical expenses, plus some extras.
If your company contributes, do you still need to contribute 15%? Even if your company contributes as well, it is still a good idea to contribute 15%. The trouble with contributing less is that your lifestyle will grow to match whatever money you take home. If you only contribute 10% because your company contributes 5%, you’ll have trouble making up the difference if things get tough and your company stops contributing, as they have in the past. It’s better to err on the safe side. If you end up in your late forties with way too much in your retirement fund, you can always cut back your contributions then and live life a little more. Note that the assumption of only making 7% might also prove too low, but retirement can be really painful if you’re out of money. It’s better to aim high.
Should you put all of your retirement savings into your company’s 401k? The thing that makes your 401K plan attractive are, in order of priority 1)the company match, 2) the tax advantage it provides, and 3) the large amount you can contribute. The main disadvantages are 1) that you can be limited in your investment options (sometimes extremely limited) and 2) fees on 401k’s can be high, particularly for those with a lot in their accounts since the investment management firm loses money on the small accounts. If you don’t put enough into the account to get all of the company match, you’re leaving free money on the table, so you want to contribute at least that amount. Beyond that, you are generally better off putting money into a personal IRA or Roth IRA up to the limits you can based on your income (check with an accountant for the rules). Based on this logic, the best method is:
1) Fund your company 401k up to the company match.
2) Contribute as much as you can to a personal IRA.
3) Contribute whatever else you need to reach 15% of your pay to the company 401k.
4) If you still haven’t reached 15%, contribute to a taxable account.
Should you use a traditional IRA/401k or a Roth IRA/401k if that is an option? In the traditional IRA/401k, you deduct the amount you contribute from your income and lower your taxes now. With the Roth option, you pay taxes now but the money, including all of the income you earn over the years on the money, is tax-free when you pull it out. I’m split on this one. Mathematically, you’re almost always better off with the Roth option assuming that taxes stay as they are. The trouble is that the rules could change – for example, there could be a big national sales tax or value added tax when you’re retired, meaning you would pay taxes again on the money you were pulling out of the Roth plan even though it is supposed to be tax-free. There could also be a new tax created on retirement accounts over a certain value, given the current socialist mood in the US and the fact that those who save end up with millions while those who don’t have nothing. Personally I mainly use traditional IRAs and 401ks, but I could see either side.
What should you buy in your 401k? In general you want to diversify your money as much possible while keeping fees as low as you can. When you are young, you want to be mainly in stocks. Try to invest in large caps, small caps, and international stocks. Also, look at investing in both growth and value funds. When in doubt, spread it out. There’s nothing wrong with just peanut butter spreading your investments among those categories. Try to find funds that charge less than 1% in fees, but your choices will be limited. If you have the option of index funds, concentrate there and shy away from managed funds for the most part unless they also keep fees relatively low. Also, be wary of investing in the same thing in two different funds and thereby having way too much in one sector of the market. For example, you might own a lot of the same stocks in a managed growth fund as you do in a large cap index fund. Check the largest holdings in the prospectus for each fund for duplicates.
As you approach your fifties and sixties, you’ll want to shift some of the funds to income assets like bonds or even into cash a few years from retirement. A rule-of-thumb is to have a percentage of your portfolio in income securities equal to your age minus ten, but this is just a rough figure. The lower your account balance, the more protection you need. If you have way more than you’ll need for retirement, you can stay more aggressively invested and make a better return. If you’re worried about having enough, you’ll need to buy more bonds and have more cash to reduce the risk that a market downturn could set your retirement plans back. If you did put 15% of your paychecks away your whole career, you might very well be able to just keep a few years’ worth of money in cash and keep the rest invested in equities since you’ll have plenty of money to weather downturns and wait for things to recover.
What should you buy in a personal IRA? In a personal IRA, you have the option to buy virtually anything. The best option for most people are Exchange Traded Funds, or ETFs, and specifically Index Fund ETFs. These are just like the index mutual funds you can buy through a fund company, but they trade on the stock market like a stock. The best thing about these is that they are extremely low in fees and cost. Even if you are investing in a taxable IRA, if you buy ETFs on things like the S&P500 or a total stock market fund, the distributions will be very low, meaning the taxes will be very low in most years, allowing your positions to grow and compound. Forget the exotic investments here. Buy things like SPDRs (pronounced “Spiders” on the large, mid, and small cap markets and DIAs (pronounced “Diamonds”) which track the Dow Jones Industrial Average. Spread the money out among large and small stocks, and also look at REITs and income funds for further diversification.
An option for a portion of your money is also individual stocks. These should be companies you plan to own for many years through the ups and downs in the market, so find companies that are well run and have a lot of room for growth. Invest like you’re becoming an owner of the company, not a stock trader, so buy into only companies of which you would become an owner if you were rich enough to actually buy the whole company. You’re giving up a nearly sure thing in mutual funds for a chance at picking a winner in individual stocks, so tread lightly here.
Want to add to the conversation or think I got something wrong? Please leave a comment. Your feedback is appreciated! Otherwise, you can contact me at VTSIOriginal@yahoo.com or on Twitter @SmallIvy_SI.
Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.