A new job means one thing: lots of paperwork. Signing contracts, human resources papers, taking mind-numbing seminars about company policy and hidden in all those stacks of paper, often in the benefits package, is one piece of very important paper: the paper containing details of your retirement plan.
Why save for retirement now?
We often hear about young professionals entering the work place and forgoing the company retirement plan in order to pay down debt or have a little extra money to spend. In a majority of cases, this is a bad idea.
Two words sum up why you should starting saving for retirement now: compound interest.
Compound interest is the practical embodiment of the expression “money begets money.” When your money is introduced to compound interest, you will be earning interest on your interest. This is important, because the earlier you start investing, the longer you have to accumulate wealth.
Let’s say you invested $1000 in year one and earned $150 in interest. In the second year, you would be earning interest on $1150 instead of just your original $1000. It may not sound like much at first, but as you diligently contribute money to your fund and it continues to compound, it adds up quickly.
The earlier you begin saving for retirement, even in small amounts, the longer your money has to compound and grow. The difference between starting a 401(k) or similar retirement fund at age 22 and age 30 can be hundreds of thousands of dollars.
Using this calculator, you can see that if you start contributing $4,000 each year towards retirement at the age of 22, with an estimated 6% annual rate of return, you will have $750,030.31 by 65. If you wait until 30 to do the exact same thing you will only have $445,739.12 by 65.
What is a 401(k)?
There are several ways, which all depend on your employment status. One of the most common is a 401(k) – which is also known as a 403(b) for those working in the non-profit realm.
A 401(k) is often offered by employers to their employees as a way to save for retirement with the employer matching a certain percent. For example, an employer may offer to match up to four percent of the employee’s contribution. So, if an employee makes $30,000 a year and contributes six percent (or $1,800) into a 401(k) then the employer would match up to four percent (or $1,200). This means, the employee would only contribute $1,800 to her 401(k) but end up with $3,000 thanks to the match.
Some employers may vest your match immediately, while others may have a timeline over how long it takes for you to get the money your employer contributes.
A 401(k) is offered through providers like Fidelity, Charles Schwab or Vanguard. Employees then need to determine asset allocation, which is a fancy way of saying “where are you putting your money?”
How do I pick my investments?
First, see if your company offers the opportunity to speak with a financial professional. If you feel overwhelmed going through the process of starting your 401(k) he or she will be able to help.
Your 401(k) should offer a variety of investments to take you from conservative to aggressive. If you’re young, it’s best to be aggressive with your investments and modify that to moderate and conservative, as you get closer to retirement age.
Aggressive investors will focus more of their assets on stocks than bonds (the old rule of thumb is 100 – your age = the percent of your investment that should be in stocks, but feel free to take more risk if you’re young). If there is a dip in the market, there will still be ample time for young investors to see the market rise again, unlike investors closing in on retirement age.
Depending on your provider, there may be a “model portfolio” for you to follow. These portfolios are often based on risk tolerance; so younger investors are better served to follow the “aggressive” path. If you’re wary of selecting your own funds, then consider following the model portfolio.
When should I decide against investing in my employer’s 401(k)?
If you have an employer contribution, you should at least contribute enough to receive the match. But if you feel there are too many fees or not a lot of options to maximize your investments, then there are other places to put your money.
Most personal finance experts advise to save at least 10 percent of your income for retirement. So, if you only get a four percent match from your employer, what should you do with the other six percent?
One of the easiest options is to open an IRA with Vanguard, Fidelity or Charles Schwab, among others. However, if six percent of your income is more than $5,500, you’ll have to invest the rest elsewhere. In 2014, you can only contribute $5,500 of your income to a traditional or Roth IRA.
401(k) Quick Tips:
- Starting contributing to your retirement account as soon as you’re eligible
- Understand if your employer-match vests immediately, or if you have to work a set number of years before you see the match
- Contribute at least enough to get your full employer match!
- Compound interest is your best friend when it works for you
- Diversify your portfolio – never invest all (or even a majority) into your company stock.
- If you’re young, be aggressive
- Understand the fees associated with your 401(k), and if they’re too high then search for other ways to invest for retirement (likely an IRA)
- Check in with your 401(k) – see how your funds are doing and if your portfolio is still appropriate for your retirement goals