One of the DIY investing methods to achieve your financial goals is through an employer sponsored 401(k). In today’s world, your retirement investing and planning is essentially in your own hands. This sense of obligation to save and invest on your own can seem daunting, but the sooner Millennials internalize this sense of responsibility the better off they’ll be to provide financially for themselves and their families. My goal is to help empower you to take financial ownership over your personal finances. One of those ways is to understand the mechanics of the 401(k) so you can DIY. Not every Millennial will have access to a 401(k), but in the event that you do one day find yourself with one, you’ll want to be best prepared to open, fund and manage it to the best of your DIY investing ability. Here’s a 401(k) overview.
A 401(k) is … an employer sponsored retirement plan
A 401(k) is sponsored by your employer for the purpose of saving and investing for retirement. With the demise of pensions and the future of Social Security uncertain, the 401(k) has become the mainstream retirement plan for the private sector. Your employer will partner with a plan administrator to offer the plan. This partner could be one of many financial institutions, such as Fidelity, Morgan Stanley just to name a few. With a 401(k) the onus is on you to save for your retirement needs. Any employee can participate. Your employer may make you wait at least one year or some sort of timeframe before you can start to make contributions, or they may may let you start contributing on Day 1. You will want to understand from your employer when you can start making contributions.
A 401(k) is … a tax-advantaged retirement account
My dad used to lightly tease that there’s only two things you have to do in this life, “Die and pay taxes.” Perhaps many of your parents have said the same. You’ll pay taxes on a 401(k), but one of the benefits of a 401(k) are on when taxes are due. There are two flavors of 401(k)s: the Traditional and the Roth. In the Traditional, your contributions are pre-tax, but you pay ordinary income tax on the withdrawals. The opposite is true for the Roth. In the Roth your contributions are post-tax, but your withdrawals are tax free. You pay no taxes on dividends or capital gains, allowing your investment returns to grow tax free. When you take advantage of a 401(k) you get tax benefits that help your money grow.
A 401(k) is … a long-term investing commitment
A 401(k) is an investment account, but it is also a commitment to your future financial self and retirement security. Think of it as a container for you to invest and grow your money. When you invest you give up money today so that you can earn a profit in the future. Your plan administrator will have a pre-selected menu of investments, such as mutual funds, that you can select in order for you to invest in. A 401(k) account is not a checking account or a savings account, which you can easily take money out of with no penalty. Instead, a 401(k) restricts your ability to withdraw funds. You can start to withdraw funds from your 401(k) at age 59 1/2 without any tax penalty. If you do so before you will be subject to a 10% tax penalty (unless under extenuating circumstances known as hardship withdrawals). When you start to invest in a 401(k) you are in it to win it and for the long-haul.
A 401(k) is … a great wealth building vehicle
You can build significant wealth through a 401(k), if done smartly. First, your employer may provide a matching contribution, which is free money to you. (Not all employers do, and if they do, how much they match is at their discretion.) Second, if you start to invest early in your 401(k), you can take advantage of the power of compounding over long periods of time. Compounding is when money makes money on itself. For example, if you invested $1000 today at age 22, and let it sit for 45 years earning 8%, you’d end up with $31,920 at age 67. Third, your 401(k) will most likely provide an option for you to invest each pay period through automatic deposits so that you can invest consistently. The benefit here is you get the benefit of dollar cost averaging, lowering the average cost over time you pay for your investments. You may also be able to sign up for automatic contribution increases, which automates increasing your contribution rate each year. Use the 401(k) to save for retirement and build your net worth.
Stay tuned! To get this blog started, I’ll be taking inspiration from my upcoming book, From Millennial to Millionaire: DIY 401(k) – 5 Do-It-Yourself Steps for the Digital Generation to Design and Manage their 401(k), to write blog posts. My new book should be available in eBook and paperback on Amazon by summer 2017.