A Young Man’s Guide to Understanding Retirement Accounts: The 401(k)

by Brett & Kate McKay on July 19, 2011 · 63 comments

in Money & Career

Chicks dig a man with an awesome retirement account.

If you’re a young man, you’re probably not giving much thought to retirement right now. It’s understandable. It’s hard to plan and think about something that’s 40 years away (maybe many more–the traditional idea of retirement will likely undergo a lot of changes in the next several decades). Moreover, many young men put off saving for retirement because they’re intimidated by the entire process. They feel like they don’t have the requisite knowledge to get started.

Over the next few months we’re going to take a look at some of the different retirement accounts out there, see how they work, and explore their advantages and disadvantages. My goal is that by the end of this series, you’ll have a basic understanding of these accounts and feel confident enough to get started with saving for your retirement.

Why You Need to Start Saving For Retirement Today

Because time is your biggest ally when investing. The longer your money has to grow, the more money you’ll have when you retire. To show you the power of time on your investments, let’s look at an example from the book Get a Financial Life:

Suppose you set aside $1,000 a year from age 25 to age 64 in a retirement account that earns 5% a year (historically, stocks return about 8%, but we’ll be conservative). That’s $39,000 total you invest. By the time you turn 65, you’ll have have $126,840. If you don’t get started with saving until you’re 35, you’ll only have $69,760. Starting just ten years earlier would have doubled your total. Yes, doubled.

Pretty dang cool, huh?

Here’s another reason you should start saving today. If you’ve been paying attention to the news lately, you’ve probably heard a lot about our country’s budget woes. Social programs that many people currently rely on during retirement might not be around or will be severely diminished by the time a person in their 20s retires. Saving for retirement today will ensure you won’t have to worry about about whether Social Security will be around when you’re old and decrepit. So you can show up to town halls someday and yell about something else that bothers you.

Finally, saving for retirement is a great way to activate that Provider Switch that we have deeply imbedded in our male psyche. A man has a vision for his family and their future.

What Is a Retirement Account?

With fewer and fewer companies offering pensions to retiring employees, the U.S. government saw a need to encourage Americans to save for their golden years. Starting in the 1980s, Congress passed laws that created a variety of  tax-advantaged retirement accounts such as the 401(k), the 403(b), IRAs, and Roth IRAs. There are more, but those are the big ones.  Fast fact: Why are 401(k)s called 401(k)s? It takes its name from subsection 401(k) in the IRS code that creates this retirement account.

If you’re a young man just starting out in life, this alphabet soup of letters and numbers can be sort of intimidating. I know when I was in college, I really didn’t have a grasp of what a retirement account was and how it worked.

One thing I see many young men get confused about is the difference between a retirement account and investments. Many mistakenly think that a retirement account is an investment. It’s an easy mistake to make. The way people talk about retirement sometimes makes it sound like retirement accounts and investments are synonymous.  They’re not, though.

Investments are things like stocks, mutual funds, bonds, and index funds. A retirement account is more like an empty box for holding your investments. You open a retirement account and fund it with whatever investments you want–stocks, bonds, index funds. Because of special tax codes, you won’t get taxed every year on the earnings your investments make while sitting in that retirement account.

I read a great analogy that beautifully explains the difference between retirement accounts and investments in The Bogleheads’ Guide to Retirement. The author likens retirement accounts to luggage and investments to stuff like clothes and socks. Just as certain luggage and clothing have advantages and disadvantages depending on where you’re going, certain retirement accounts and investments have advantages and disadvantages depending on your financial goals.

The most important thing to remember is that retirement accounts allow your investments to grow tax-free. The less money you have to pony up to Uncle Sam, the more money you’ll have to go on cruises and spoil your grandkids. Depending on the type of retirement account, the tax savings can happen when you put the money into the account or when you withdraw the money from the account. More on that later.

401(k)s, 403(b)s, TSPs

401(k)s, 403(b)s and TSPs are retirement accounts that you typically open with your employer. 401(k)s are offered by private businesses, 403(b) plans are offered to public education and non-profit employees, and Thrift Savings Plans (TSPs) are offered to federal government employees.

All three plans work essentially the same way, so for the purpose of this post, we’ll just be talking about 401(k)s.

Tax Benefits of Traditional 401(k)s

Remember, the biggest advantage of retirement accounts are the tax savings. Here’s how traditional 401(k)s save you money. Every payday, your company will automatically deduct a pre-determined amount from your paycheck to buy investments in your 401(k) retirement account. The money you invest in that account won’t be taxed until you actually withdraw the money when you retire. This is called a pretax contribution.

To see how this works, let’s look at an example. Let’s say you make $50,000 a year at your job and you decide to set aside $5,000 a year for retirement in your 401(k). That $5,000 will go into your account, but at tax time, you’ll only be taxed for $45,000. For the next 40 years that $5,000 you put in your account will grow tax free. When you retire and start making withdrawals from your account, the $5,000 will finally be taxed.  Because your money grows untaxed for so many years, paying taxes later rather than sooner can put more money in your pocket when you’re old and lounging around in running suits.

Picking Your Investments

When you opt into the 401(k), you’ll have to pick which investments you want to fund your retirement account with. Your employer typically works with some sort of investment broker to create a menu of different investments for you to choose from.They’re usually mutual funds. Unfortunately, you’re stuck with the menu your employer creates, and oftentimes the menu is pretty crappy. But I wouldn’t let not so good investment options discourage you from investing in your company’s 401(k). Investing in less than ideal funds is better than not investing at all.

As far as which funds from the menu you actually pick? That’s entirely up to you. Take a look at the prospectus, do some research, and pick the fund that has a risk level you’re comfortable with. We’ll come back in a later post to go into more detail on how to pick an investment.

Deciding How Much to Set Aside

You tell your company how much of your paycheck you want set aside for your 401(k). You have complete control over how much or how little you contribute to your 401(k). Most financial experts agree that you should save at least 10% of your paycheck for retirement. The more the better, but 10% is a good number. It can be tough to put money aside because every dollar you put towards your 401(k) is one less dollar you can spend and enjoy now. My suggestion would be to set up an automatic contribution with each paycheck and then just forget about it. After awhile, you won’t even notice the extra money being socked away.

Employer Matching

This is one of the big advantages of 401(k)s. Many employers will match a portion of the amount you contribute with a contribution of their own, up to a fixed amount. For example, a company might match you $.50 to a $1 for every $1 you contribute to your 401(k) on the first 5% of your salary you invest.

Let’s see that in action. Let’s say you make $50,000 a year and your employer says he will match you $1 for every dollar you contribute to your 401(k) on the first 5% of your salary you invest. You decide to save 10% of your salary in your 401(k). That’s $5,000 that YOU contribute out of your pocket to your 401(k).

Now here comes your employer’s contribution. He’ll match your contribution dollar for dollar up to 5% of your salary. That means your employer will contribute $2,500 to your account. That’s $2,500 of FREE money and a 50% return on your initial investment of $5,000.

If your employer offers 401(k) matching, contribute at least the minimum amount for which you’re eligible to receive matching funds. But the more, the better.

Contribution Limits

The government has set limits on what we can contribute to our 401(k). I guess they wanted to give people a tax break, but not too big of one.

  • For employees ages 49 and below, the maximum amount they can contribute out of pocket is $16,500 a year. The maximum combined employee and employer contribution is $49,000 a year.
  • For employees who are older than 50, the government allows you to contribute a bit more so you can catch up on your savings as you prepare to stop working. The maximum employee contribution is $22,000 a year. The maximum combined employee and employer contribution is $54,000 a year.

Withdrawing from Your 401(k)

You can start withdrawing money from your 401(k) without any kind of penalty when you’re 59 and 1/2 or if you’re 55 and you have left your employer. When you withdraw money, you finally pay income tax on the money you’ve invested (and the interest it has made).

If you withdraw before you’re 59 and 1/2, you will incur a 10% penalty in addition to any normal income taxes you’d have to pay. So let’s say you’re only 40 and you decide to withdraw $10,000 from your 401(k)–you’ll have to pay $1,000 in a penalty plus pay income taxes on that $10,000. Basically, if you withdraw early, you’re losing the tax savings you’d normally get with a 401(k). Bottom line: don’t withdraw early.

Borrowing from Your 401(k)

There is a way to get early access to the money in your 401(k) that doesn’t incur a penalty. You can actually take out a loan from your 401(k). How much you can borrow from your fund will depend on your company. Typically, you can borrow up to half of the money YOU have contributed (many companies don’t allow you to borrow from employer matched funds). You usually have five years to pay the loan back. If you don’t repay the loan on schedule, the loan converts to a withdrawal, and you’ll have to pay the 10% penalty, plus any income taxes.

Do everything you can to prevent borrowing from your 401(k). While it’s tempting to tap into it as an emergency fund or to help pay for a down payment on a home, your 401(k) should be your last ditch resource for such things. You don’t want to risk not being able to pay back your loan on time and incurring the taxes and penalty of early withdrawal.

Rolling Over Your 401(k)

Whenever you leave a company, you have a few options with what you can do with your 401(k). You can just leave the money there and let it keep growing within that company’s 401(k). When you get another job, you can open up a new 401(k) with them. However, if you leave and start several jobs, the number of different 401(k)s you’ll have to manage will multiply quickly.

To simplify managing your retirement, financial experts recommend rolling over your 401(k). When you leave a company, you can take the money in your 401(k) with you by rolling it over tax free into a rollover IRA. We’ll be talking about IRA’s next time, but the important thing to know today is that an IRA is another type of tax free retirement account. You can keep your money in that rollover IRA where it will continue to grow tax free until you retire, or you can take the money in your IRA and apply it to your investments in your new 401(k).

The big takeaway on rollovers is that it’s a method for you to transfer your retirement money to different accounts without losing the tax savings benefits of your 401(k).

Roth 401(k)s

Some employers are starting to offer Roth 401(k)s. Instead of offering pre-tax money to your account, with a Roth 401(k) you invest after-tax money. You don’t get the upfront tax break that you’d get with a traditional 401(k), but when you withdraw money from your Roth 401(k) at retirement, you don’t have to pay any income tax. There are some other benefits to Roth-type retirement accounts, but I’ll be talking more about that in our article on IRAs. Stay tuned for that.

Read Part II: IRAs

Did I miss anything? What’s been your experience with 401(k)s? Any advice to the young men out there who are just getting started with their retirement accounts? Share your insights with us in the comments.

{ 63 comments… read them below or add one }

1 Hackswell July 19, 2011 at 5:22 pm

Be careful… there is no guarantee of success, even in retirement accounts… just ask the Boomers:

The Common Man ™ has only been an industrial investor for a short period of time… a time of great growth and stability in the stock and bond markets. Until 2007, we hadn’t seen a huge down cycle… for over 50-60 years… but markets DO work in large cycles, and the buy-n-hold paradigm only works in a major uptrend… not periods of down-cycles.

-Hackswell

From Di-Worsification: http://dailyreckoning.com/di-worsification

“Imagine you make 10% a year for 10 years after all taxes, dealing costs and other fees. If you reinvested the profits every year, it works out at a total profit of over 159%. $100,000 becomes $259,374, in other words.

Now imagine you make 20% every four years out of five. But you lose 30% every fifth year. Over 10 years you have eight years with 20% gains and two years with 30% losses. This time you make a total profit of only 7.5% – or an average of 0.7% a year. Your original $100,000 has become just $107,495.”

“All his [Bob the investment adviser] 20 years of experience tells him that this kind of balanced portfolio has worked out well in the past.

But there’s the rub. Even if Bob has been in the investment game for 20 years, he’s only seen a snapshot of the bigger picture. Investment returns move in long cycles. Bob has only seen about half of an up cycle. Even if he’s been around 30 years, he still hasn’t seen a time when bonds and stocks have both gone down at the same time over many years or decades.”

2 Josh July 19, 2011 at 5:25 pm

401k, rip-off, your company makes a fortune off everyone’s money through compound interest, which is why they’ll give you some percentage of your investment. The “free money” the company gives you is not free, they deduct it from their revenues, eschewing taxes, and let you pay the taxes on the money for them. If you want to actually retire, then you need to own your house without a mortgage, with its own well, and power supplied by wind, solar, or geothermal. If you want to retire, don’t start with a 401k. You cannot choose your investments properly.

3 jimmm July 19, 2011 at 5:27 pm

Don’t forget 457(b) plans for some gov’t. employees.

4 Alex July 19, 2011 at 5:29 pm

I think you missed stressing how good a deal Roth plans are for those of us early in our careers. Tax rates are low now for those of us early in our careers with low paying jobs. Paying taxes in the 15% braket now is going to be a lot better than paying in the 25% braket life style I’ll be used to after years of raises.

But you said you’d get into that next time right ;)

5 reinkefj July 19, 2011 at 5:30 pm

In general, I will agree with you. BUT, (and there is always a BIG butt), there are some caveats that should mitigate everyone’s wild enthusiasm over that “free money”.

(1) There are a lot of dirty hands in the markets and the processes around those markets. Think “front running”.

(2) There are some interesting ways that a company can “put their thumb on the scale”. Underhanded deals between the company, the provider, and the people involved have happened. Think “commissions” aka kickbacks.

(3) Funds in these 401Ks have interesting fees and commissions taken out of them. Think 12-1b fees and high load funds.

(4) Sometimes, like ENRON, there are “odd requirements” that can be fatal to someone’s financial health. Remember that fellow who was required to roll over his old PGE 401k into his new employer ENRON’s in order to participate.

Retirement savings are important. 401Ks can be “free money”. But, you have have one financial “eyes” wide open.

imho!

6 Emanuel July 19, 2011 at 5:30 pm

And let’s not forget that inflation will kill off any money you’d have made with the interest.
You’d better invest in precious metals such as gold & silver if you’re looking for life-lasting savings.

7 1916home.net July 19, 2011 at 5:43 pm

Personally, I would stay away from 401Ks right now, especially with a tanking economy (both at home and internationally).

Since this is primarily about long term retirement style investing, I would stick with industry dominators that pay back good dividends. Coke, Proctor & Gamble, Intel, etc.

First, you get dividends from them. Second, they arent likely to tank (and even if they did, they’d bounce back pretty fast). Third, these companies that dominate their sectors have revenue streams from overseas, not just at home. Coke sells Chinas #1 drink… Sprite (its #2 drink in India). In fact Coke has 60% of its sales coming from overseas now. So not only are you investing in an American company, you are also investing globally (in a round about way).

Im a self made investor (honey, are we millionaires yet?). So thats what I do with about 20% of my portfolio. Long term sector dominators that pay dividends and then I reinvest it back into those stocks. If you are lazy you could set up a DRIP portfolio so it auto re-invests your dividends. If my other investing doesnt pan out at least this option Ive mentioned (dominators that pay dividends, then reinvest) will give me a nice retirement nest egg.

8 Cale Smith July 19, 2011 at 5:46 pm

Yep, to reiterate Alex’s point: Roth IRAs are unequivocally worth a closer look. Hard to envision many scenarios where marginal tax rates aren’t higher when today’s young bucks eventually retire. Look forward to your thoughts there.

9 Matt E July 19, 2011 at 5:59 pm

“My teacher told me to save for 401k. I’d rather be young counting 401k”

10 David William July 19, 2011 at 6:53 pm

Of course it is important to save (and invest) but one of my biggest gripes is watching everyone work awful jobs they hate to save up for the old years of their live. They claim it is to enjoy their golden years, but I say enjoy these current years. No sense in waiting til I’m 65 to enjoy life.

11 Josh July 19, 2011 at 7:18 pm

@David William
You are definitely correct on enjoying life now. I go tell everyone that hates their job to figure out what they’d rather do, and just go do it. The people in your life that are close to you should support you.

12 Greg K., PA July 19, 2011 at 7:24 pm

Ah – I just turned in my paperwork yesterday morning! I’m a fairly recent college grad and have over 40 years until retirement, so I went with a riskier portfolio of growth opportunities and overseas investments. Here’s hoping there’s growth aplenty.

13 Andrew July 19, 2011 at 7:35 pm

From what I understand about investing in anything financially is that there is always going to be a risk. Some investments have more risk than other investments. Is that fair to say? We live in a world that isn’t perfect, full of people that aren’t perfect, with an economy that isn’t perfect, “regulated” by a system that isn’t perfect, and a government that isn’t perfect. To be fair, I don’t think that there is going to be that perfect, risk free investment that is for everyone of all types of ages and incomes. However, risks have payoffs. People who open businesses are taking the risk of taking things into their own hands usually investing money to start off with the hope of gaining money in the future.

To summarize, yes I do believe that one should be informed about all of the (to use the word yet again) risks to opening up any time of IRA or 401k BUT! there is still plenty of potential that you can be successful in them.

Let’s realize, I’m 22 years of age and I may not have any funds coming in from social security years from now. Meaning, I will very likely want to invest in something instead of sitting on my money.

14 Jeremy July 19, 2011 at 7:40 pm

All companies don’t allow their employees to take 401(k) loans, so keep that in mind before you contribute. Also, in most cases interest you pay yourself on a 401(k) loan will be double taxed. Many plans that don’t permit loans offer a safe harbor hardship that can be taken in certain circumstances (purchase of primary residence, medical expenses, funeral or burial, college tuition etc). While some of the newer plans offer roth contributions, there are two older forms of after tax contributions called pre-1987 and post-1986. Each of these grow tax deferred but not tax free.

15 Brian Delaney July 19, 2011 at 9:51 pm

Thank you for this article Brett.There are some really great resources to help us understand what is best for our retirement planning.
Here are a few:
- Tax Free Retirement and The Retirement Miracle both by Patrick Kelly. Easy to read and understand
- The 401K fallout by 60 minutes: http://youtu.be/nAHgr9dY9BU
- Our own resources and common sense.
– Ask the people who have invested in a 401k how it has performed for them
and listen.
– Deferred tax and employer matched contributions are usually swallowed up
by taxes on distribution within the first 3-5 years of retirement. (to get $50,000 you will pay $12,500 in taxes using the current tax rate. Typically in a 30 year career 50-60K in taxes is deferred.) Do you know what the tax rate will be when you retire?
– Does an investing strategy which includes losing money in a down market while the broker still makes money make any sense; especially when those “fees” are undisclosed and innumerable.

A modern discussion of retirement planning must include:
- A discussion of what retirement means and a discussion of values and goals
- Financial Education for the now – Don’t spend more than you make and don’t borrow money on depreciating assets
- An updated view of investment strategies for the common person (not professional investors)
– Equity Indexed Universal Life
– Roth IRA
– Annuities

16 David July 20, 2011 at 1:21 am

In congruence with other posters, I’d also urge people to look into Roths. Its kind of the classic quote about money- “A bird in the bush is worth two in the hand”. Paying taxes on investments later isnt the best idea, if there are other options. You dont know what the tax rate will be, which can make it much more difficult to plan. By paying taxes on it now, you have a 100% accurate idea of how much money you can fully count on being there.

17 STRONGside July 20, 2011 at 5:24 am

I think it is great to see some money advice on AoM. Being smart with your money, and investing wisely are two things that ever man should practice. Whether you are single or married with children, your investments will play a pivotal role in your financial future.

Also, as mentioned earlier, Roth IRA’s are another excellent retirement vehicle for those of us with a long time horizon for investing. Also a traditional IRA allows you to sock away money for retirement tax free, so it could easily be lumped into the retirement account category along with the 401(K).

18 Mike Reith July 20, 2011 at 5:32 am

You carefully covered all the angles, but the real man understands that IRA’s are fools gold. I just cashed in two IRA’s started in 1985. Even in dollars (not adjusted for inflation) I lost money. And these were top notched funds Mr. & Mrs John Q Public have entered a world in which up is down and right is wrong. Austrian School economics are for real me, they depend on hard work and savings. I divested my self of IRA’s as soon as possible or I don’t want my plan rolled over into federal needs.

Real men do not use government tax schemes.

19 Brad Alexander July 20, 2011 at 5:37 am

Nothing wrong with investing for retirement. But you make more money from business than you ever will from investments. Start a business, make money and sell it. That’s how people getting properly rich. Working for someone else all your life and coming away with a few hundred thousand or even a million + is peanuts by comparison.

Even if your business is only part time and only makes you $10k pa. You need a lot of money invested to be getting $10k pa.

20 Gino July 20, 2011 at 5:59 am

You are right. Many realize its importance only when they reach their retirement. people i their 30′s don’t use 401k properly.

21 David Swinehart July 20, 2011 at 6:54 am

To clarify one of your points: “For the next 40 years that $5,000 you put in your account will grow tax free. When you retire and start making withdrawals from your account, the $5,000 will finally be taxed.”

Is not exactly correct. In a traditional 401(k) scenario, the $5,000 principal + the interest / dividends / gain it earned are both taxable. Assuming an investment that has grown over 20-30 years, the returns will likely be several times the initial investment. It’s still a good deal, especially if your company is matching contributions and/or your find yourself in a high tax bracket early on.

I echo Alex’s comment above: if your company offers a Roth 401(k) option, this can be the most tax-effective strategy in the long term. In our younger years, many of us have other methods of reducing tax burden, such as deductions for home mortgage interest, child care, etc. Reducing my tax burden now is less of a concern to me than I imagine it will be when I hit my 60′s. Also, reiterating that the return on investment will likely be several times the principal amount, I would rather pay tax on my $5,000 contribution now than on the $20,000 it makes over the next 30 years when it’s time to make a withdrawal. That’s essentially wat the Roth does – forego today’s tax deduction for enjoying a larger tax-free benefit down the road.

22 David Swinehart July 20, 2011 at 6:57 am

I intended to say, “In a traditional 401(k) scenario, the $5,000 principal + the interest / dividends / gain it earned are both taxable AT THE TIME THEY ARE EVENTUALLY WITHDRAWN.”

23 Barrett July 20, 2011 at 8:38 am

Thanks for posting, Brett. As with any retirement articles, you’re going to get comments from detractors, and all assumptions are going to be challenged. But I learned, as a clueless 18 year old who had just enlisted in the Marines, that it is better to do something than nothing, even in ignorance. At that time, I signed up for every option I was given (TSP, savings bonds, savings allotments, etc), though knew what none of them meant. Now, I’m nearing 30, am a CPA and a financial planner, and have been through two market downturns (02 and 09), but have kept steady in the market. If I’d waited till now to start – now that I have the understanding to back up the actions – I’d have lost the past 10 years, instead of investing the majority of my money while the market was down (read “on sale”).

So, yes, the most important thing about saving, whether retirement or otherwise, is to start early and save often. Don’t let ignorance keep you from acting. No one else is responsible for your well-being.

24 Westicles July 20, 2011 at 9:07 am

I disagree that now is a bad time for a 401 (k) for young careerists. I work for a non-profit that matches up to 4.5% of my annual salary into funds managed by TIAA-Cref. If the market does tank again, as some are predicting a second dip in the recession, the value of my portfolio will decrease (as it did 6% in June). However, I find this to be a great opportunity at my age as the share price will go down, making me able to purchse more shares of funds. When the market rebounds, I will see incredible growth.

25 John Teasley July 20, 2011 at 9:58 am

Westicles is right. I’m a 26 year old and I put into my 401k what I need to get my companies match. (6%) and then 9% into a roth.

I see the down market , and prices right now as thought they are on sale. Buying when the market is up, as well as prices makes sense.

26 Alex Gay July 20, 2011 at 10:52 am

Maybe you’ll get into this in a latter article, but what about those of us who work non-traditional jobs. I, for example, am a freelance stage electrician and carpenter. I don’t work at the same place for more than a couple months, tops. Any suggestions on how to prepare for retirement under those circumstances?

27 Rob July 20, 2011 at 11:57 am

Fun seeing both ends of the spectrum on these kinds of articles…. lots of experts on here…

Markets fluctuating in price is what can give the most value to a retirement account. Especially now. in 2008 when Bear went under, it blew my mind to hear coworkers talking about getting out of their 410(k) and not contributing until the market was more stable.

If you just took a look at our stock price, it was down to $6 in 2008 (from $30/40 earlier). This sucks if you’re at the end of your career and didnt diversify, but what a huge deal to take advantage of buying shares at such a sale!

Warren Buffet made a great point at some B-School commencement. He pointed out that, if you’re in your mid-20s today, you have a huge advantage in a depressed market, as you’ll be a net buyer for the next 30-40 years.

Incredible how the reverse logic has spread around…. commercials that state “now’s the time to buy gold, it’s at an all-time high!”

28 Will July 20, 2011 at 1:03 pm

I’m married, 24, and a graduate student for the next three years. What do I do (besides stay poor for the rest of my life)?

29 Dustin July 20, 2011 at 2:22 pm

Please don’t post recommendations on investing unless you’re a professional. Any posts that scare people away from investing because the “economy is bad” and 401ks are “not good right now” are doing lots of harm. It’s a shame that most people that heed this advice won’t find this out until it’s way too late.

30 Joe July 20, 2011 at 4:05 pm

First, find yourself a local financial advisor. Second, forego the 401k unless they match your contributions. Open a Roth IRA and fund it as much as possible. Open a EIUL for yourself that is minimum death benefit/max cash accumulation. Start an individual account for shorter term purchases using c-shares. When it comes time for to take money out, your tax burden will be minimal. 401k’s and other employer retirement accounts have 1-marginal returns 2-no guidance or expertise from a professional 3-not enough options. Ask your buddy about his / her 401k. They will most likely not know how it works, how it performs, and the tax consequences. Get an advisor.

31 1916home.net July 20, 2011 at 5:17 pm

Maybe its me, but I dont trust the “professional” financial advisers. They make money off of you whether you make money or not.

Long term retirement style plans are not about getting rich, they are about securing your future into retirement. As many of us are employees, we are trained in the employee mindset and its easy to moan and groan about the economy or whatever. Hey we are human, I get it (I like to complain too). Buty have you ever noticed that successful people make money no matter what the economy does? Up or down they continue to make money.

I agree with one of the posts above about starting a business. That is where real wealth comes from. Come up with a plan where people work for you. Im not talking about being self employed, Im talking about a system to make money. Whatever it is.

One example. I called up an architect for a project im working on. He gave me some ridiculous price and in talking with him more, it sounds like he farms out all of his work. Blueprints get done by one person, 3D and watercolor drawings get done by someone else, etc. Essentially, this architect is just a middle man and gets a nice chunk of change for directing the whole deal. Im not mad at him, its business. He made a business that works for him and pays his bills. I applaud real men who have the guts and courage to use their minds successfully!

32 10 Day Fantasy HR Contest - Investment July 20, 2011 at 7:17 pm

I really don’t believe investing in 401k’s will work for the younger generation. The market is too voliate, and as one reader (hackswell, 1st post) said, a bad year or two out of 10 can cripple you. I think it’s too risky to let your money sit in a fund over the long haul. The only way I like building for retirement, and I know about 99% of people will disagree with this because it’s not mainstream thought, is to trade in and out of stocks, which minimizes my risk. I set a stop loss for each trade, and I never lose more than 6% in a month. If I do, I stop for the month. Also, sports betting and daily fantasy sports have been a consistent moneymaker for me with little downside. The main thing with my strategy is that you will have to put a decent amount of time into it.

If you park and sit in a fund, you will lose over the next 20 years. Once the first big country defaults, there will be a domino effect across the world and all your gains over the last 2.5 years will be wiped out, AGAIN.

33 All American Home Run Derby July 20, 2011 at 7:25 pm

I really don’t believe investing in 401k’s will work for the younger generation. The market is too voliate, and as one reader (hackswell, 1st post) said, a bad year or two out of 10 can cripple you. I think it’s too risky to let your money sit in a fund over the long haul. The only way I like building for retirement, and I know about 99% of people will disagree with this because it’s not mainstream thought, is to trade in and out of stocks, which minimizes my risk. I set a stop loss for each trade, and I never lose more than 6% in a month. If I do, I stop for the month. Also, sports betting and daily fantasy sports have been a consistent moneymaker for me with little downside. The main thing with my strategy is that you will have to put a decent amount of time into it.

If you park and sit in a fund, you will lose over the next 20 years. Once the first big country defaults, there will be a domino effect across the world and all your gains over the last 2.5 years will be wiped out, AGAIN.

Jon

34 Jeff July 20, 2011 at 7:27 pm

Great article Brett!

35 Mitch July 20, 2011 at 10:03 pm

Strange to see the hate for the 401k. I still think it’s one of the best things to put money in, simply because of the match. I get $0.50 on the dollar up to 10%. Say I contribute that 10%…I’m immediately starting off 50% in the black because of that match. So what if the principal only grows 0.7% over 10 years…a full third of that principal was free money! I don’t get a match for an IRA, so to perform as well, I’d need to allocate more of my money from my pocket.

36 Nate July 21, 2011 at 12:02 am

Wow, there’s a lot of terrible advice in these comments.

The stock market as a whole gains 8% on average in the long run. This has been consistent through depressions and recessions. Every big downturn has an associated upturn after it. The only people who get screwed are those who get scared and pull out during a downturn.

The way to win at the stock market is not to try to beat it. Put your money in an index fund and leave it alone. Don’t mess with it. Index funds have low maintenance fees, which in other funds can cut into your profits significantly. Index funds are also insulated from any one company or one segment having problems. Enron goes under? Your index fund will barely notice. The vast majority of heavily managed funds do not outperform the market. Index funds match the market, and do not try to beat it… and by doing so, they also never are worse than the market.

Set it. Leave it. Reap the rewards in retirement. Everything else is crazy talk. Go to the Motley Fool’s website, fool.com and do you own research.

Invest early and often. Invest in something, anything is better than nothing.

37 Seth July 21, 2011 at 8:31 am

I actually am a 401k plan manager for a major institutional provider. Great article, and one that most people are sorely in need of reading. Couple of things I would add after having spent 5 years in the customer service side of the business and a further 5 in the administrative side of the business :

1) Know what you’re getting into. It’s not a savings account that you can access just like a checking or a bank account. Money contributed to these plans will NOT be able to be withdrawn (save certain extenuating circumstances) until you have left employment or retired from your employer. No amount of calling and complaining or asking for supervisors at your service provider will allow them to override Federal regulation and give you your money.

2) Many employers choose to offer their employees free investment advice and education. If you have these features available and aren’t sure of what you’re doing, then call and use it!

3) Investments go up and down all the time. Especially if you’re younger, avoid kneejerk reactions to market events. It’s when you move your money and an investment is at it’s lowest point that you’re locking in your losses, if you let it ride and give it an opportunity to come back it’s just a paper loss.

4) RTFM, seriously. Read the enrollment booklet and materials provided. If I had a penny for every time I’ve literally been told “You seriously expect people to read that booklet”? Man I’d have a ton of pennies. Ignorance doesn’t excuse you from the rules, plan fees, transfer fees, or any other plan provision, and per my point #1 above, the Federal government doesn’t care if you’re ignorant either.

Sorry if this is a bit harsh, it’s not meant to be. I just really think people need to put a little more time and thought into something that will constitute the majority of their savings in their twilight years.

38 Will July 21, 2011 at 9:39 am

I would disagree with the statement, “Investing in less than ideal funds is better than not investing at all.”

Investing is about being right at the right time, and if you’re starting out with a list of crappy investments you’re not comfortable with, don’t give the broker your money! If you really want the matching funds, pick the most conservative option available (or leave it all in cash) and then roll over the account when you leave that employer.

The average actively managed stock mutual fund returns approximately 2% less per year to its shareholders than the stock market returns in general. Coincidentally this is the approximate sum of the fees, commissions, and loads involved in the average mutual fund.

I will echo Seth’s call to RTFM. Read the prospectus., Read the fine print. Keep doing research on the investments you pick. Nobody is going to take more interest in the success of your retirement accounts than you are, and if you’re young, you have a truly huge advantage you need to utilize.

39 Jason July 21, 2011 at 11:36 am

I started maxing out my 401k in 2001 and my company matches 30% of what I invest. It is currently worth over 300K and I am 36. I started at age 26 and it seems like it was a good move. I say maximize your employers matching funds and never look back.

40 All American Home Run Derby July 21, 2011 at 11:40 am

Nate, I agree with you that the stock market has returned 8% historically over the long haul, but I disagree it will do so in the future. Take a look at the market from 1960 to the early 1980′s, and you will see there was very little growth. I think that’s what’s in store for the next 20 years.

Hear me out here. The main reason I believe so is because of a simple theory of ‘money in – money out’. Stocks go up because there are more buyers ‘money in’ than sellers ‘money out’. Think of it like a balloon with 2 holes, as long as the ‘in hole’ is greater than the ‘out hole’ than the balloon will inflate, and vica versa. In the late 1970′s – early 1980′s the 401(k) legislation was passed. This resulted in a huge influx of money going into the stock market, which caused it to rise. Now all the baby boomers are pulling their ‘money out’ while their kids are putting ‘money in’. The rate of ‘money in’ to ‘money out’ will be less than it was the last 20 years, and therefore the market in general won’t rise by the mainstream, standard though of 8% a year.

How many people have actually averaged 8% a year over the last 10 years (without company match). I bet it’s pretty low and it will be like that for the next 20 years. Stick with trading in and out of stocks, stay away from mutual funds. The key is limiting the downside, and the market is about to crash again.

41 Sean M July 21, 2011 at 12:23 pm

If your 401k offers them, just buy index funds. You’ll save the 1-1.5% fees that the “professionals” will extract from you in good times and bad. The fact that the major US indexes haven’t done anything since 2000 is a good thing if you’re buying today. The S&P 500 has worked off its sky-high multiple and now appears to be fairly priced. I think an investor today can expect pretty good returns in the next 30-or-so years.

42 Kyle July 21, 2011 at 12:56 pm

This was really helpful. I recently graduated from college and have a job now and my dad has been saying hes going to go over this stuff with me and hasnt yet. I have actually recieved more financial advice from my girlfriends dad (gee I wonder why). but this is definetly going to help me with me budgeting for retirement savings.

43 Ian Urriola July 21, 2011 at 1:00 pm

So I just turned 19 and will be a college sophomore in the fall. Since I don’t work full-time (yet) I don’t have access to a 401k. What suggestions do you all have for someone like me, who wants to plan his retirement before he starts working?

44 Gary Zane July 21, 2011 at 8:06 pm

Wow! What an eye opener to all the doom and gloom not to mention missinformation about investing 101. I am 57 and have taken advantage of each companies 401k’s and extremely glad I did. The matching is a return on your investment even before you put the money to work. No risk there except to go to work. By the comments here it is evident your not comfortable with investing. So do what your customers or clients are doing now, which is why you even have a job. Get advice and education from a professional. My suggestion is what I have my children doing now:

1-maximize your contributions to the extent your company matches in the 401k plan
2-next, open a Roth account and max it out
4-when you leave an employer I would roll it out into your own IRA; reason for this is you are will not be limited to the investments with your employer….the whole investment world opens up to you
3- work with a financial professional your comfortable with, Just like your dentist, mechanic, doctor, pediatrician……you get the picture. If you don’t like their advise find another….isn’t that what you would do with the other professionals you use?
4-only invest in what your risk tolerances indicate otherwise your going to become frustrated and start chasing rates which is going to be the worst thing you can do. I have seen the most frustration with people not knowing their goals or their tolerance for risk. That is when their emotions take over and the big mistakes are made.
4- ( this is an extra…but does deal with financial planning) if your married and especailly with children please….and I can’t stress enough… please get sufficient life insurance outside of your employers. If you loose your job the insurance you have with them does’nt go with you.

One last thing, buy and hold for the long term still makes sense as long as the investment continiues to help you achieve your goals. If not then replace it with another. As you approach retirement your tolerance for risk may deminish and you may seek less volitile investments during your retirement years.

Best to all – Gary

45 Andrew July 22, 2011 at 12:41 am

I am shocked at how many people making comments apparently didn’t actually READ the article. “I cashed in my IRA and lost money”. “401(k)s won’t work for young people because the market is too volatile”. “I would stay away from 401(k)s in a tanking economy”.

IRAs and 401(k)s are ACCOUNTS not investments! You lost money on IRA because made POOR investment choices not because you put it into a tax deferred account! And if you invested in 2007, invested in stocks, and cashed out now, of COURSE you lost money! A 401(k) is NOT a “bad investment”. Investing in a 401(k) just means you have chosen to invest tax-deferred versus opting to pay taxes on the gains as you go. AFTER you make that decision, you can decide to invest in bonds, or stocks, or gold, or whatever the heck you want. If you think the market is too volatile, put the money into a 401(k) and leave it in a money market fund, which is FDIC insured. Or put it into bonds! But if you buy stocks and they go down, it won’t matter that you bought them in an IRA, you will STILL LOSE MONEY!

A comment directly for “1916home.net: You are right to question the motives of a financial adviser. You should always understand how people are compensated so you can understand their motivation. Speaking as a financial adviser though, a GOOD financial adviser will not take an upfront commission and will charge a fixed percentage rate (typically 1% or less) each year. So the more money YOU make, the more money WE make! It is critical to link your adviser’s motivation to yours…

Brett – Again, as a person who makes a living explaining this stuff, overall you did a GREAT job with this post. Every AOM reader is getting some FANTASTIC, unbiased, simple, solid and straightforward advice that would cost them hundreds (if not thousands) of dollars if they had to pay someone to get it.

46 Derrick July 22, 2011 at 9:22 am

Great Article! At 25 I just began contributing to my 401k. Many times you do what your told still by your parents and one doesn’t ask any questions. Its nice to begin to comprehend what is going on with my money. I am looking forward to the rest of the article, and the discussion is great too! Lots of different opinions.

47 Gigantor July 22, 2011 at 11:36 pm

Great article and here’s food for thought…literally

Imagine you are 65 and married. Let’s say You and the missus spend $5 each on breakfast, lunch and dinner. Both of you live to 85 (the average lifespan). Compound that with 3% inflation over a 20 year timespan and that’s $360,000+ JUST TO FEED YOURSELF.

Roth IRAs and 401k’s are great as well as individual trading accounts. If you don’t know anything about investing there are tons of resources on the web as well as advisors located in your bank or credit union.

And if you’re a Gen X or Gen Y don’t think there will be anything left from Social Security after the baby boomers are done with it. There are 4 times as many of them as there are of us. In fact there’s 1 baby boomer turning 65 every 8 seconds who’s starting social security.

48 Jax July 23, 2011 at 4:42 pm

Gigantor- I was suspicious of your claim that at 65 one can expect to live another 20 years. So I looked it up and it turns out, you’re right. A 65 year-old male can expect to live another 17 years and a 65 year-old female can expect to live another 20. Interesting.

The way I see it, employer match is enough of a reason to open a 401(k). Like so many of the others have said, put enough into your 401(k) to reap the full employer match, and then max out a Roth account. If you still have money left over, you can put it in the 401(k) or just an IRA or something.

As far as the investment advice from “All American Home Run Derby” (jump in and out of the market aka day trading, and also bet on sports) I would LOVE to see how your portfolio has performed historically relative to the market overall. I am also curious about how much you have paid in fees as a percentage of your total investment, and how many hours you spend per week doing all of this stuff. If it turns out that you have out-performed the market even after taking into account all the fees and time spent working with your money, you will have a convert in me, but I highly doubt that is the case.

49 Carl July 24, 2011 at 2:16 am

@ Alex Gay: As a self-employed person, there is an equivalent tax-advantaged retirement savings account called an SEP IRA. You can contribute up to 20% of your pre-tax take home pay and it’s attached to you, not whoever is writing your checks. Plus, you can invest in whatever you want, rather than a cafeteria plan set of pre-approved mutual funds &/or company stock.

Also, in addition, anyone with even a part time job or a working spouse can have either a traditional or ROTH IRA (ROTH is excellent for younger earners in their 20′s and 30′s) on top of whatever employment related plan they might have. You can contribute ALL of your pre-tax (traditional) or post-tax (ROTH) income up to $5,000 each year to it, which is ideal for students and others who work odd jobs like retail, which usually don’t offer benefits like 401(k)’s.

Try opening a ROTH IRA at a minimum and an SEP IRA if you’re actually self-employed to have the option of saving even more. Vanguard is a low cost co-op financial company with dozens of highly ranked mutual funds covering stocks, bonds, the money market, and even real estate. Starting out, a balanced fund that mixes stocks and bonds or one of their Target Retirement funds would probably be the simplest option.

If you don’t like them, you could open your IRA with an online bank, or with one of the other big brokerage firms like Fidelity. Watch out though: avoid funds with the word “load” in them, or ones with “12b1″ fees. Both of them will directly eat up part of your initial contribution or your eventual withdrawal for no benefit. Also, check out finance sites like bankrate.com, morningstar.com and investopedia, all of which have useful articles on nearly any financial subject you want to know about.

50 Elise Lowerison July 25, 2011 at 8:19 pm

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51 Allan July 27, 2011 at 3:49 pm

What a great post! Is there much of a chance of getting a Canadian version of this advice? (e.g. TFSA vs. RRSP, etc?)

52 Russell July 27, 2011 at 9:25 pm

I’ll mirror Seth’s comments and add a few more caveats as well.

For loans, you can only take up to 50% of your VESTED account balance up to $50,000. You can however extend a loan up to 30 years if it’s for the purchase of your principal residence.

However, as it’s been said, a 401k/403b is NOT a bank account. If you are putting money in, don’t expect to have easy access to it until you retire. That’s the whole point.

Someone else mentioned 457(b) plans. Those are for governmental entities. The biggest difference is that you can only put $16,500 total between what you defer and what your employer puts in. There are a few catch up provisions that extend this, but you’re much more limited in money you can stash away in a 457. Some employers can actually leverage both a 403(b) and a 457(b) and get the best of both worlds.

It will be interesting to see what this debt ceiling stuff does to retirement plans.

53 Maru July 27, 2011 at 10:21 pm

Here’s some advice I got from a friend’s father who’s made investing for retirement a personal field of study: in addition to your 401(k), also open a Roth IRA, and use it to hold a mutual fund. He recommends putting the maximum amount possible into that Roth IRA every year (currently the limit is $5,000, or your annual income if it is less than $5,000).

He recommends Roth IRAs because the money you put into a Roth IRA is taxed before you put it in; that is, deposits to a Roth IRA account are not income tax deductible. This is a pain in the short run, but it means that when you retire you will not have to pay taxes on the money you draw out of your Roth IRA. This is useful because most of us will have a higher standard of living when we are older than when we are young. Youth is the time to be poor, because you can stand being poor; you can live in a small apartment because you don’t have a wife or children, and you can economize much more easily while living by yourself. You don’t typically have many health problems when you are young, and consequently won’t need the extra money for your medical bills (although you should be taking care of your health anyway; that’s an investment too).

Also, right now tax rates are down in the basement (granted this matters more to the people in the upper 10%, and most to the people in the upper 1%, but that’s another story). They probably won’t always be down in the basement, however; we’re likely to have to deal with the national debt eventually, and we’ll probably still be dealing with it in thirty or forty years, when we’re nearing retirement. So while the IRS might take a slice from our 401(k)’s and our retirement jobs (and rightly so; even old geezers have to pay their share), the money from the Roth IRA is all yours, because you already paid taxes on it thirty years ago.

Another piece of advice this fellow gave me was, when choosing a mutual fund to put in the Roth IRA, pick what’s called a “life cycle fund.” These are a special class of mutual fund that is becoming increasingly more common. They all have a defined end date — say 2040, for example. Shares in such a fund would best be purchased by someone who will be at or near retirement by 2040, and is set up in such a way that right now, when the fund isn’t due to end for another thirty years, the investment style is very aggressive with high risk but a correspondingly high rate of return. However, as the years go by, the investment style of the fund becomes progressively more conservative, so that by 2038 or so most of the fund has been converted to money or very stable investments. These qualities make it, in his opinion and mine, a very sensible choice.

Bottom line, invest and save as often as you can. You don’t have to live like a pauper all the time, but by the same token there’s no sense in putting up money for ephemeral extravagances when it could be put towards something genuinely useful, either in the here and now or down the road. Even before Social Security became fraught with uncertainty, it was never a good idea to have that be your only support in retirement. Social Security is not by any measure a “government pension,” never was, and was never intended to be. It is, however, a very hefty and pleasant supplement to retirement that has gone a long way towards keeping many otherwise impoverished elderly people out of poverty. In addition to Social Security, get a 401(k) and put as much money into it as your employer will match. Then get a Roth IRA, put a mutual fund in it, and invest $5,000 a year in it. At this point you’re only out $8,000 to $10,000 or so. Granted, that is a hell of a lot of money for someone who doesn’t make much. If you can’t save all that, save what you can afford, and meanwhile look for ways to economize. Invest in a Costco membership and buy your food in bulk. Better yet, split one with a friend. Don’t turn on the heat or air conditioner unless it’s either 20 below or 100/100; put on a sweater and do some push ups, or open the window and turn on a fan instead.

There are always ways to save money. I am not always the best at it, and I will admit I am far better at dishing out advice than I am at taking it, even my own. This is not something I’m proud of, but I think I should still try and help people even if I am still working out my own problems, with the understanding that I might have gotten a few things wrong.

54 Maru July 27, 2011 at 10:25 pm

Oh, and one last piece of advice from my own point of view: if you get hired for a civil service job or a private sector job that still offers a defined benefits pension plan, and the job is something you like (or even, I think, something you are indifferent to and don’t actively hate), then take it. Take it like a shot. Defined benefits plans are, in my opinion, the holy grail of retirement, and I like them a lot better than 401(k)’s. You should still get a Roth IRA with a mutual fund and invest the $5,000 maximum in that, but defined benefits plans are the best, in my opinion. Of course, your mileage may vary.

55 Maru July 27, 2011 at 10:47 pm

On second thought, take everything I said (if anyone reads it, lol) with a hefty shaking of salt. It’s my own opinions, and as such prone to occasionally wobble upon emotion and irrationality. In complete contradiction of all I just said, one potential solution for saving for the future is to just take your paycheck, cash it, put all the money in a drawer or a strongbox in your house, and do nothing at all with whatever you don’t need. It seems to work dandy for people in Moldova, who both enjoy a low rate of debt and a good standard of living (at least, good for Eastern Europe).

Above all though, the thing I think people should take to heart is, whatever you do, stick to your guns. As cliche as it sounds, a quote attributed to Japanese warlord Takeda Shingen is instructive: “the mountain does not move.” Particularly if you are taking part in the stock market, you have to play the game smart, and not run like a frightened rabbit whenever something seems to go wrong. So all your stocks are tanking today? Ignore it. The minute the money is out of your hands, you should never touch it except for the purpose for which you invested it, in this case, retirement. Frantically cashing your stocks out when they’ve suffered a loss, especially if they are worth less now than when you bought them, will only widen the wound.

I would, however, echo some of the skepticism towards the stock market expressed in the earlier comments. Granted I have no idea what the alternative is. I don’t go in for the survivalist stuff (though I do think that a man could do a lot worse than to invest in land and take up farming), and I definitely don’t go in for buying gold and silver. Seriously, how much will those metals be worth if civilization actually does collapse? We’re likely to be on the barter system for at least a decade, and in that case it’s better to have either tangible goods, like a gallon of milk or a dozen eggs or a bushel of wheat, or to have a marketable skill, like blacksmithing or carpentry or brewing.

Anyway, that’s enough from me. I’m out.

56 Rob August 2, 2011 at 9:07 pm

I disagree with the 401k. There is no telling what taxes will be in 40 years. A Roth IRA is a better option in my opinion.

The best option is a free society where there is no theft(a.k.a taxes) by a government.

57 Living with Balls August 3, 2011 at 2:00 pm

Thanks for the advice. As a young person, retirement accounts can indeed get confusing. I look forward to future posts.

58 Innovative Insurance August 6, 2011 at 4:41 am

That,s an interesting post on finance

59 Ogden August 15, 2011 at 11:06 pm

Rob: I understand the uncertainty of tax law in the future, but one of the benefits of the 401k is the potential for a company match.

Personally, I max my 401k every year to the extent that I can, but at the very least, if your company offers a match, you should contribute enough to get the match.

I was lucky enough to have a mentor of sots in the early years of my career that really pushed me to get into the habit of contributing to my 401K. It’s worked out well for me.

60 Amber July 20, 2013 at 1:38 pm

I came here to hopefully learn more about retirement and saving and what not. I’m a college student and am trying my best to educate myself on finances BEFORE I reach that point where I’ll be saving for retirement. The article made me feel better, definitely helped me understand, but now the comments are driving me crazy. My question to all the people against the 401k is this; what is my best option in your opinion? I truly want to know because I can see why some disagree with using a 401k. I’m still largely undecided.

61 Dennis October 4, 2013 at 7:12 pm

Can I be refused from taking any money from my 401?

62 Natilya James January 23, 2014 at 10:03 pm

It is always better to set your retirement planning target. Before you choose your pension plan, you should estimate that how much money you would need to maintain your lifestyle once you are retired from your job. Also, you must try to convert at least seventy per cent of your pension funds to income.

63 Eric S Benard February 1, 2014 at 3:47 am

The blog about retirement plan is nice because it included many interesting points in it . Pension is such the thing that can be a strong financial source in your future life .

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