Wednesday, February 10, 2016

What the *** Is a 401(k): A Q&A With My Younger Self

Business business business!

When I got my first job, the HR process that mystified me the most was signing up for my 401(k). Now that I've done a bunch of reading on personal finance, I understand it. So, consider this a Q&A between me and my 22-year-old self.


What's a 401(k)?
It's an account where you can save money for retirement. Only instead of being at a normal bank, it's at a brokerage, or investment bank. Money in your bank account just sits and waits for you to spend it--maybe gaining some tiny amount of interest--but money in an investment account can be invested in the stock market.


Why should I invest in the stock market?
It's really hard to save enough money to retire without investing. Over time, the money you earn loses value to inflation. (You know, the way Ol' Pops says that hot dogs were 15 cents in the good old days. Pops was probably making about $5,000 a year back then, which wouldn't go far to cover his retirement expenses now.)


To fight inflation, you need to put your money to work. Historically, inflation is usually about 3% per year, and stock market returns--over the long term--are about 10% per year. So investing can actually grow your money at a rate of about 7% per year (returns minus inflation). Compare that to the may 1% you earn on your bank account (which, if you take into account inflation, you're actually losing 2%).


Can't you lose money in the stock market?
Yes. The stock market is volatile in the short term. But, while the stock market can go up and down at random in the short term, it tends to trend up in the long term. The 7% number I asserted above is an average over the long, long, long term (like, since the stock market began).


Can't I wait and deal with this later? Like when I'm closer to retirement?
The earlier you start investing, the better. Time is the magic ingredient that allows your money to grow. There are two reasons for this:
  1. Like I said, the stock market can be volatile in the short term; you want to have plenty of time for the bumps to even out.
  2. Compounding! As you earn returns on your investment and reinvest them, there's more and more money in your account, so it makes higher and higher returns. The younger/further from retirement you are, the more time your money has to grow, and the less you need to invest overall in order to be on track for retirement.


What's special about a 401(k)? Can't I just open a brokerage account at an investment bank on my own?
You can, but there are a couple of things that make 401(k)s special, compared to investing in a normal brokerage account:
  • They are tax advantaged. In a traditional 401(k), you don't pay taxes on the income you invest until you take it out (after you retire). Typically retirees have lower income, and therefore less tax burden, than working adults, so you will pay less taxes overall.
  • Your company may match part of your contribution to your 401(k). For example, they may say, "If you invest 3% of your income, we will match that and put 3% of your income into your 401(k) as well." In other words, they'll give you an extra 3% of your income that they otherwise wouldn't have given you, on top of your normal salary--they'll just put it directly in your 401(k). You should definitely do anything you can to get as much money as you're entitled to from your employer. (See "How do I understand my employer match?")
  • Typically you'll be able to auto-deduct your contributions to your 401(k) directly from your paycheck, which can make it a fairly painless way to save and invest. You never even see the money, so you're not tempted to spend it.


What are the downsides of investing in a 401(k)?
The biggest downside is that you can't take the money out until you are retirement age, as defined by tax law. Right now, as of this writing, that's 59 ½. The whole idea of the account is to make sure you lock in that money for retirement, not for any other reason.


Another possible downside? Your company gets to pick the investment bank that hosts the account, as well as a limited number of choices for what funds you can invest in. So you don't typically have free choice to invest in anything you want. Sometimes the company picks kind of sucky options. Still, the tax advantage of investing in your 401(k) usually means it's worth it, even if they only allow you to select from funds that have high fees (see "How do I pick funds?")


Why is it called a 401(k) anyway?
It's named after the section of the tax code that created it.


Does every workplace offer one?
No. Tax-advantaged retirement accounts are an optional benefit. Some workplaces offer them, and some don't. Non-profits offer a 403(b), which is basically the same thing only it comes from a different section of the tax code. Some government jobs offer a 457, which actually allows you to take the money out when you leave the job, so that can be a nice benefit if you want to use some of the money before retirement age.


How do I understand my employer match?
Your 401(k) documents might say something like, "50% match up to 6%, vested after three years." Let's break down these components:
  • The rate the company matches at In the example, the company matches you fifty cents on the dollar. If you put $100 into your 401(k), they put in $50.
  • The maximum amount they match This is the point where they stop matching your investments. In the example, the company stops matching after you've contributed 6% of your salary. So the maximum they would put into your account is 3% of your salary, and that's only if you contribute 6% or more yourself.
  • The vesting period This is how long you need to stay with the company to claim the match. In the example, if you leave the company before 3 years, you don't get the matching funds (but you do get your own contributions and any stock market gains on those--they can't take that away from you). Some companies will partially vest at different points; you might be 50% vested after two years, for example, meaning that if you leave the company between the 2 and 3 years mark, you'd get half of the matching funds.


To sum up this fictional example: if you make $100,000 a year, and you contribute 6% or $6,000 to your 401(k), the company will match you fifty cents on the dollar by putting in $3,000. If you contribute more than 6%, they don't match any more after that--$3,000 a year is the maximum. If you contribute less than 6%, say 5% or $5,000, the company would put in $2,500. If you stay with the company for less than three years, you don't get to keep the $3,000-a-year they put into your 401(k), but you do get to keep the $6,000-a-year you put in--whatever the value is of your contributions after stock market gains/losses.


If your 401(k) documents don't mention an employer match, be sure to ask HR about it.


How do I choose how much to contribute?
You will usually be given the option to contribute a percent of your pay, rather than a set amount of dollars. This will be calculated from your gross, pre-tax pay. So if your official salary is $60,000 a year, and you set your contribution level at 10%, you'd have $6,000 a year directed into your 401(k) ($500 a month--even if you end up seeing a lot less than $5,000 a month in your bank account due to taxes and other deductions.)

It is in your best interest to contribute at least the amount you need to get the minimum employer match. If your employer matches up to 3%, contribute at least 3%; if they match 50% up to 6%, contribute at least 6%.

There's an upper limit, too. The tax code specifies a maximum amount you can contribute to your 401(k). It changes every few years, but as of this writing, it's $18,000. So if you divide $18,000 by your salary, you'll find out the maximum percentage you can legally contribute (if you make $60,000, it's 30%).

Between the lower and upper limit, you'll just have to decide for yourself how much you can afford to contribute. You may be able to contribute more than you think. Your employer's paycheck software is most likely smart enough to know that, as you increase your 401(k) contribution, your tax withholding should be reduced. That means every extra dollar you put in your 401(k) isn't necessarily $1 off your paycheck--it might be more like 75 cents, depending on your tax bracket.

My tried and true method for deciding how much I can afford to contribute? Set it at an insanely high number, and then you can always lower it if you run into cash flow problems. (Or, if you're less of a financial daredevil, start at the minimum and work your way up, adding 1% each month, until it hurts.)

Your next decision will be to choose how your contributions will be invested.

You mean like stocks and bonds?
Yup.

Ugh.

No, it's really not too bad. It's kind of fun, actually.


Okay, let's start at the beginning. What are stocks? What are bonds? What's the difference?
Stocks are little tiny pieces of a company. If you own stock in Apple, you own a tiny little bit of the Apple company. If the company does well, you'll be able to sell the stock to another investor for more than you bought it for. Also, sometimes you get dividends, or money that the company pays out to its shareholders when it's doing well.


Bonds are more like an I.O.U. for fronting money. If you buy a bond from the state government, the state promises to pay you, say, 3% interest in 10 years. Bonds are a safer investment than stocks, because the return is guaranteed (unless you buy from a shaky government and it defaults, unlikely in the U.S.) But the return is also lower.


That's the way it goes in the market--the more risk, the more reward, but also, you know, the more risk.


So, should I invest in stocks or bonds?
Both. The balance depends on your age, or rather, your distance from retirement. Folks closer to retirement should have a higher percentage of bonds in their portfolio, because when you are retiring/retired, safety is more important than earning a high return. You don't need to make a mint, you just need your money to last and to be reliable. Meanwhile, younger/further from retirement folks should have a ton of stocks, because they need an aggressive portfolio for growth. Safety is less important because time will average out the bumps in the market.


I've heard various rules of the thumb for how much of your portfolio should be stocks versus bonds. I've heard that bonds should be "your age minus ten percent," so if you're 30, it would be 20% bonds, 80% stocks. Personally, I like an aggressive portfolio so I've never seen fit to go below 90% stocks, but maybe now that I'm 30 I should consider it.


What's a mutual fund?
A mutual fund is a bundle of a bunch of different stocks and maybe bonds. When you invest in the fund, you invest a tiny bit in each stock/bond it contains. This is a great way to get diversification. Instead of pinning your hopes on one pony, you're betting on a bunch of ponies.


Most 401(k)s only offer mutual funds, not individual stocks and bonds. This is all for the best. Mutual funds are really your best bet for retirement investing.


How do I choose which mutual funds to invest in?
For this step, you will need a list of all the funds your 401(k) allows you to invest in. Some companies give you lots of choices; others give you only a few.


Often, there will be one fund called something like "Life Cycle Fund" or "Target Retirement Fund" with a year in the future, like 2035 or 2060. Many companies will default to this, with the year being the year you're presumed to retire, given your age. This is often a pretty good fund to invest in, because it's automatically balanced: it has a mix of stocks and bonds that's roughly right for your age. The upside is that it's "set it and forget it": you don't need to rebalance or move money around, and you only need to worry about a single fund. The downside is that sometimes the expense ratio is high.


The expense ratio of a fund is basically the fee you pay to the investment bank for the right to invest in that fund. It pays for any expenses related to the management of the fund. A 1% expense ratio means that they take 1% of the money you invest each year to pay for the fund. This is basically invisible: it's not like you pay it each year, it's just skimmed off the top gradually. As you can imagine, expenses can really eat into your returns, since we're only talking about single-digit percents of returns anyway.


That's why I think expense ratio is the single most important piece of information you most need to pick a fund. You can find a lot of information online about each fund. A lot of people become obsessed with looking at past performance, but I think that's misleading: past performance doesn't indicate future returns. The stock market is highly random. But expense ratio is a fact. And picking funds with low expense ratios can drastically improve your returns over time.


Furthermore, I don't believe the adage "you get what you pay for" applies in investing. When you pay a high fee, you are usually paying the salaries of human beings who pick your stocks. This is called an "actively managed" fund. Human beings are prone to emotion, overconfidence, and just plain being wrong. I prefer to let computers pick my stocks using simple algorithms, like, "give me some of every stock." This is called a "passive" or "index" fund (because it uses an index, which is another name for an algorithm). You can't "beat the market" with an index fund, but you can't do worse. Plus, computers work cheap.


So, find out the expense ratios of the funds you're allowed to invest in. If you can find a low-fee target date fund, great. If not, choose funds with as broad an index as possible. Here are some examples:


Total Global Market Index Fund: This is would consist of every stock in the world. This would be a great one. Maybe do 90% of this and 10% of a bond index fund, or whatever mix makes sense for your age.


Total U.S. Market Index Fund: This would consist of every stock in the U.S. If possible, it's good to have foreign investments as well, for more diversification. You might pick an asset allocation of, say, 60% U.S. stocks, 30% foreign stocks, and 10% bonds. See if you can find a foreign index fund and a bond fund to round this out. If not, you can always invest in foreign markets and/or bonds outside of your 401(k).


S&P 500 Index Fund: This would consist of the top 500 companies in the U.S. by size. I don't love this as much as total U.S.--I like a broad index fund--but it's a decent enough sample. I wouldn't kick it out of bed.


Great, I think I have enough to get started... wait, you're me from 8 years in the future?
Yeah.

Did we ever get a date with that cute singer who--

Married.

What?! Nobody is MARRIED. That's for old people.

Gotta look at that ring finger, son.

Aw, man!

Don't worry; there are plenty of other cuties in your future!

Nice. Wait, before you go, what do I do if I have more questions on investing? Are there some books you can recommend?
Sure. If you want to know more, or draw your own conclusions rather than taking my word for it, here are my favorite resources regarding investing:


  • The Bogleheads Guide to Investing and The Bogleheads Guide to Retirement Planning are approachable guides to investing from fans of my favorite brokerage house, Vanguard.


  • A Random Walk Down Wall Street by Burton Malkiel offers an exhaustive explanation for the math of how the markets work, and why nobody can beat the market.
  • That Thing Rich People Do by Kaye Thomas was the first book I read about investing; it's super short and easy to understand.

Happy Investing!

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