Sunday, April 26, 2015

Investing in a 401k

I recently met with someone who has decided to begin investing in his work 401k but didn't know how to get started. He had all of the plan literature from when he got hired, but had ignored it because he didn't really understand it and it seemed like so much information that he didn't know where to start. Unfortunately, I've found this response to be common. In an effort to remove some of the roadblocks to getting started, Congress now allows employers to automatically enroll new employees into their company 401k into default investments (usually 'target date funds'). While this is a good start, it certainly isn't enough. Below I will walk through the decisions you need to make when investing in your 401k.

How much should I put in to my 401k?
  • Your 401k through your employer can be a great place to invest. My rule of thumb is to invest whatever you need to in order to get the full employer match. Every 401k is different so you'll need to look up your plan specifics. My employer matches up to 5%, so I make sure that I always contribute at least 5%. The person I helped the other day was eligible for a 50% match up to 6% contributions (so if he put in 6%, the employer matched with 3%). If you are able to save more than what your employer will match, you should set up a Roth IRA on your own. Why not just max out your 401k? Generally speaking, your 401k is going to have limited investment options. If you wanted to invest in something that wasn't in the lineup, you wouldn't be able to do so. Maybe the fund choices are great, maybe they're not. I would only recommend adding non-matched money to your 401k after you have already maxed out your Roth IRA for the year (current maximum is $5,500 for IRAs).
Pre-tax or after tax?

  • Whenever possible, and with few exceptions, I recommend making your 401k contributions AFTER-TAX. This means that the money you are adding to your retirement is invested after you have already paid income taxes on it, but also means that when you withdraw it, you can do so TAX FREE. Money that your employer contributes to your 401k, or that you put in PRE-TAX, is considered taxable income when you withdraw it in retirement.
  • To illustrate the true power of TAX FREE growth, consider this example. If you invested $5,000 per year over the course of a 30 year career and earned an average return of 10%, you would have over $800,000 at the end of 30 years. How much is actually yours (as opposed to the tax man) depends on whether you put the money in before or after taxes.
  • Make sense now? I've talked about the power of compound interest, but here again you can see that of the if you invest for a long period of time the majority of your account ends up being earnings. The first column shows how much you'd have if you simply put $5k/year under a mattress and the second column is if you put it into a savings account (assuming a 3% return, which is currently very high but average over a long period of time).
  • The advantage of a 401k is shown in the last three columns. Under each of the three scenarios, I am assuming that you earn an average return of 10%, the only difference is how and when you pay taxes. If you invest $5k/year outside of a 401k, you'll have to pay taxes on earnings as they happen and end up with the middle column, or about $500k. Not bad. However, if you invest in a 401k, you don't have to worry about taxes each year, so you're able to keep the entire amount invested and growing. You actually end up with the same amount in your account whether you are contributing PRE-TAX or AFTER-TAX, but the difference is if your account is PRE-TAX, then only about 75% of that money is actually yours, the rest you'll have to pay to the IRS as you withdraw. If you withdrew the entire amount all at once, your tax rate goes up and you get to keep even less than that.
  • The takeaway here is that if you make annual contributions of $5k PRE-TAX, you end up getting an annual tax benefit of ~$1,250, but end up paying about $200,000 in taxes down the road, whereas if your contributions are made AFTER-TAX, you don't get the tax benefit now, but end up paying a lot less in taxes over time.
How to invest the money once it is in the 401k
  • The most important part of saving for retirement is to actually put money in your account. The second most important thing is to minimize taxes. Once you've done this, the next most important part about saving for retirement is how you actually invest. This topic is often the part that is considered the most confusing or intimidating part of investing, but it doesn't have to be. Unless your 401k plan has hundreds of investments to choose from, I generally recommend one of two different options, and it is dependent upon how much time and effort YOU want to put into managing your account.
    • Age Based Strategy: The aged based strategy is what I would recommend for someone who prefers to be hands off, doesn't want to pay additional fees for customized professional management, and who has not yet done significant research into the various investment options that exist. Nearly all 401k plans will offer this type of strategy and you can often identify it by the funds including the target year (2020, 2030, 2040, etc). These tend to be very diversified and are invested with the assumption that you plan to retire in or near the 'target year' mentioned in the name of the fund. While I do NOT have any of my own money invested in these types of funds, I don't lose sleep knowing that I have friends and family invested in them when they are bought for the right reasons.
      • A thought about Age Based Funds: I have frequently seen investors buy multiple different age based funds in their 401ks. I met someone recently who was wanting to retire in 20 years and had invested his 401k across several different age based funds (He had 2020, 2030, and 2040 funds). These funds are generally structured so that you only should be buying one, and investing the majority of your assets in that one fund. If you were to look at what the funds are invested in, you'll see that you don't get any additional diversification by having a different target year fund (they will generally invest in the same things, just in different percentage allocations). If, for example, you were to invest half in a 2040 fund and half in a 2030 fund, you've essentially just created a 2035 fund, which is probably a separate fund you can choose. If you feel that you need something more customized than this and want to do the leg work, you should build your own portfolio using other funds.
    • DIY Asset Allocation: This is the method that I invest in my personal 401k, and the method I recommend for anyone looking to manage their own 401k. Because the majority of 401k's only have limited investment options, I almost always recommend looking for the index fund options. Index funds are invested to match the performance of an index, like the S&P 500, whereas other funds are invested to try and beat the market. There is a lot of debate out there as to whether mutual funds even can beat the market, but the data clearly shows that many funds do not do as well as the index they are trying to beat. Because you generally only have a few choices for funds in your 401k of the thousands of funds that exist, the odds of your employer selecting the best of the best actively managed funds in all categories in all times, is virtually zero. Once you eliminate the actively managed funds from your selection, you will probably be left with only 3-6 funds to choose from.
    • The next question you need to ask yourself is: How much risk can you handle? For these purposes, risk can be measured by the portion of your account invested in stocks vs bonds.
      It has been said that the younger you are the more aggressive an investor you should be. While I agree with this in theory, it isn't a perfect one-size fits all approach. I would add two additional considerations. 1) If you are invested so aggressively that you lose sleep worrying about losing money, or if you find yourself frequently wanting to sell everything, you may want to invest with slightly lower exposure to stocks than your age would dictate. If you do this, you should understand that you'll need to be saving and investing more to compensate for the lower returns you should expect. 2) If you are reasonably confident that you will NOT need to use a portion of your assets in your lifetime, and plan to leave an inheritance to your heirs, you should invest that portion with THEIR timeline in mind and not yours. This means you may have a more aggressive portfolio than your age alone would indicate.
    • The way I have invested my 401k is to put 50% in the S&P 500, 10% in International stocks, 10% in Small/Midcap stocks, and 30% in bonds. Roughly once per quarter, I will look at my account balances and see how this has shifted and rebalance back to the same mix. Over time, one would expect stocks to outperform bonds, so naturally the 30% in bonds may shrink. Gone unchecked for long-enough, the bond allocation could shrink so much that my whole account is more aggressive than I intended. Periodically rebalancing is a process to naturally 'take earnings off the table', by reducing exposure to whatever has had the best relative performance.

TAKEAWAY: The most important part about investing in a 401k is ACTUALLY PUTTING MONEY IN YOUR ACCOUNT. The next step is to make sure you're doing so in the most tax efficient manner. Lastly, you'll want to make sure that whatever you're investing in is right for you.
Do you have any questions about your 401k?

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