For most of us in the middle class, our one main tool for building wealth is our 401k or self directed Individual Retirement Account. This is the basket of index funds that we are consistently contributing to in order to build wealth one lego brick at a time. The fact that this goes on a kind of autopilot for most folks is part of its power because we tend to forget about it and let it ride through the years.
Hopefully one day we look at that account and are pleased to see a considerable basket of assets that will support us in the future. But, that said, I have seen so many people shoot themselves in the foot when it comes to harnessing the power of this awesome tool. The device or machine needs to be left alone to build the power, harness compounding and be resistant to our human failures when it comes to long term strategic thinking. Along these lines, here are several ways to make the most of this tool and most importantly not screw it up.
What is 401k and how does it work?
A 401K is a workplace savings account that allows you to contribute a specific amount of pretax income each tax year to a savings account usually invested in stocks, bonds, or ETFs. The income you sock away each year is deducted from your total income reported to the IRS, thus enabling you to pay less taxes and grow your nest egg. It’s not completely tax free, when you are older and retire, it is mandated that you take out specific amounts each year and pay taxes on that income at a much later date. If you are in a lower tax bracket in your retirement, you will pay less taxes that you would have paid now. If you are in a higher tax bracket, you will pay higher taxes. For more on this topic, check out investopedia.
Please check the fees. The fees can be a huge psychological trick. The 401K plan administrator can say “the fees are only 2%”. 2% over 30 years of compound growth on your hard earned money can equal hundreds of thousands of dollars. That is your money, not theirs, you must be prepared to fight back on this. It is your future, take charge of it. If the fees are too high there are so many easy options to reduce the fees. Vanguard, Fidelity, Americas Best 401k all offer low fees!
Look, But Do Not Touch
Try your best to avoid taking loans from the 401K account. The only exception I made once is removing a reasonable amount for the purchase of a home. I justified it because the payback was low interest and I was putting the money into another appreciating asset. I would always avoid removing the money for depreciating actions, like a car, vacation, new TV, home remodel, etc. Many folks tap the 401(k) for unexpected expenses, this is why an emergency fund is critical. Avoiding loans gets someone more compound growth! This will keep you happy.
Save More Than 7%, Try To Save At Least 15%-20%
Owning a 401(k) allows you to magically harness compound growth tax free. You contribute pre-tax money, lowering your income taxes. Your savings then grow tax free. A little more saving now makes your nest egg a lot bigger later via compound interest. According to Vanguard, half of retirement plan participants saved over 6 percent of income last year. Half saved less. Be better than average. Much better. Hence much better off! Here’s a simple 401K calculator.
Seek Advice, Knowledge Or Support
26 percent of Americans get retirement advice from an investment professional. Almost as many tap family and friends. Others use online calculators or commentary from articles and blogs. But, 46 percent didn’t seek any advice. If unsure, you should seek the advice of fiduciary professionals, who need to legally put your interests out front. Always ask if the person is a fiduciary.
Max Out the 401K If Possible, Or Up The Contribution Each Year
Only about 13 percent of Vanguard’s retirement plan participants max out their 401(k) contributions. Maxing is tougher for lower-income folks, with only 3 percent of workers earning between $50,000 and $75,000 doing it. Yet even among folks making six figures, less than half contributed the maximum.
If you’re maxing out at $18,500/year for folks younger than 50 and $24,500 for those older, then you are truly building wealth quickly! Every year the max changes. Currently it is $22,500 for 2023, and those 50 and older can add an additional $7,500.
What Is Your Number?
What is your magic number in order to reach a comfortable retirement. Most people never think about this, but it makes the journey more tangible. If you can live off $40k with a paid off house, then your number may be lower than you imagine.
How much income will you need down the road? What must you save now to get that retirement you dream of? Online calculators aren’t flawless but they are a start. Use them as a rough guide. Perhaps your number is $600k with a paid off house? Conservative estimates allow a 4%/year withdrawal rate, therefore a $1 Million 401K can produce $40k/year comfortably and be part of a broader strategy.
Get The Match For Crying Out Loud!
I see so many people not up their contributions up to get the employer match. This is free money, why are we leaving it on the table. Think of your family, think of your kids, think about your future needs. Many employers partially match their employees’ retirement contributions, juicing folks’ savings. But not everyone takes full advantage.
A recent report showed that one-fourth of workers don’t contribute enough to their 401(k) to get their employer’s full match. Vanguard reports the average potential employer match is about 4.2 percent of total pay.
Retirement planning is a long and winding road and life happens. But if one can at least get the 401k machine right, they are probably well on their way to process with a delayed benefit. It is important to enjoy the incremental milestones and wins along the path to FI!
The main concept is to automate investing into a basket of powerful companies that represent the overall US economy and future growth. And do not worry when the market drops or “corrects” at times. During these times we are buying more shares on sale. Doesn’t everyone like a good bargain. The bottom-line is that an automated 401k or self directed IRA can be a powerful wealth building tool.
This is not investment or planning advice to any on individual. The views and opinions expressed are solely the authors.