As part of my ongoing advice and guidance, I'll be hosting a 401k seminar later this month. This is the first time I've done something like this, and I'm honestly pretty excited. I've solicited questions from the group and a couple of themes have emerged. As part of my preparation, I wanted to share some of my thoughts on these topics.
To provide some context, the audience is all 20-something recent college graduates working at their first job. We pay them pretty well (mid 50's), are in a lower cost-of-living area, and provide some amazing benefits. Our company offers an excellent 401k match and relatively short vesting period.
401k Match - this is 'FREE MONEY' and there are almost no good excuses for passing this up. As an incentive to get you to contribute to the account, employers will often provide matching contributions. Make sure you're at least getting your full match.
Vesting Period: The money your employer puts in your 401k might require you stay working there for a period of time. I've seen as short as 2 years and as long as 7. If you leave the company before you are fully vested, you may forfeit some of the employer contributions. The money you put into a 401k from your paycheck is always yours and you'll never have to give it back.
Q: What is the difference between After/pre-tax contributions and which should be a priority?
A: We have the choice between traditional and Roth 4o1k's. My general advice to anyone is to focus on Roth contributions. This is especially true for those who are young. The difference between the two is that you end up with lower take-home pay by doing Roth, but you end up with much more in retirement. Here's a simple example:
Either way, a 6% contribution puts $3k into your 401k. The difference today is that if your contribution is in a Roth, you end up paying slightly more taxes now, but won't ever have to pay taxes on that money again.
If you invest $3k per year for 30 years and it grows at 8% per year, you end up with $339,000. Not bad for only investing $90,000, right? But you will pay taxes when you withdraw if your contributions are made pre-tax (traditional). All of a sudden that $339,000 is more like $288,000 (15% taxes). It's even less if you want to take out so much that you get pushed into a higher tax bracket.
On the other hand, if you had been making Roth contributions, that $339k is ALL YOURS. This is why I sometimes say that Traditional 401k/IRA's include 'Phantom Money'. Even though you see the balance, it's not all yours unless it's Roth.
My preference is to have all of my contributions go into Roth. Since employer contributions can't go into Roth, I'd prefer to have as much as possible actually be MINE. For those currently doing pre-tax contributions, I'd consider transitioning your contributions over.
Q: Can you talk about 401k early withdrawal penalties and payback options?
A: Honestly, I'd rather not. Long term you'll always be better off finding ways to avoid taking money out of your 401k before retirement. While you are actively employed, the only way to get money out of your 401k is to take a loan. Loans are paid back via increased payroll deduction. Although it is true that you pay yourself back with interest, the interest rate you pay yourself is generally much lower than the returns you'd be missing out on if the funds had stayed invested.
The big risk of a 401k loan is that if you leave the company, the balance of the loan is due in full within 60-days. Any amount left unpaid is considered an early withdrawal, taxed, and penalized (if you're younger than 59 1/2).
Several in my audience may be considering going back to school for an MBA in the next few years. To them, I would recommend avoiding student loans but definitely plan ahead and do not rely on 401k funds to pay for the degree. Although there are provisions where Roth contributions can be withdrawn without penalty, I still believe that it should be avoided before retirement.
Q: What's the right mix of stocks and bonds?
A: This is perhaps the hardest question to answer because there really is no one-size-fits-all answer. The right mix for each person depends on your goals and risk tolerance. You may have heard that in the early stages of your career you should be as aggressive as you can tolerate, but without having gone through a bear market it's hard to really know your risk tolerance.
There are rules of thumb out there like "120 minus your age is the percentage you should have in stocks and the rest in bonds". Rather than give that blanket statement, allow me to share how my asset allocation has shifted over the years.
My Asset Allocation History
When I started my first 401k, I loaded up on stocks and maybe only 5% in bonds. This was back in 2006 and the market was hitting new record highs, sound familiar? A few short years later, I had built up around $25k with more of a 70/30 stock bond split. And then the financial crisis hit. My portfolio was basically cut in half in what seemed like a matter of days. This was a huge gut check for me and caused me to rethink my asset allocation. Thankfully, I didn't get out of the market like many clients I was advising at the time wanted to.
I kept a 70/30 mix for years and was a believer of the age-based asset allocation model. When friends or family members were just starting out, I would recommend using Fidelity Freedom Funds or Vanguard Target Retirement Funds that automatically rebalance as you get closer to your target retirement date, eventually landing in a 20/80 stock/bond mix. There is nothing wrong with this approach, and for many people, it may still be a great one.
My Current Allocation Strategy
Where I differ now from the mainstream age-based strategy is that I am planning on retiring much earlier than traditional retirement age. Also, I believe that we in the DIY$ household have proven to not act irrationally during bear markets. During down markets, we don't sell and continue to dollar-cost-average into our investments. This tells me that we can handle having a larger allocation to stocks. Our current asset allocation is over 90% stocks, and we plan to keep it that way until and during retirement.
I am subscribed to the strategy outlined in Simple Wealth, Inevitable Wealth. Simply stated, this strategy is to only invest in stock mutual funds, and during retirement to keep a cash reserve equivalent to 2 years expenses. During retirement, we will replenish cash from investments except during significant down markets. During those times, we'll draw down cash to allow the market to recover and build the cash account back up after the investments recover.
This strategy may not work for everyone, but this is why personal finance is so personal. You need to find what works for you, develop a plan, and stick to it. That's the important part though, having a plan vs. not having a plan. I'm sure we'll have plenty more to talk about, but these are the thoughts I've collected thus far.