The transition from being a student and moving into the work force can be an intimidating phase of your life. Not only do you have to learn new skills and apply problem-solving habits honed through your course work, but you must also make important decisions that will affect your life for decades to come. Much of that has to do with how you handle your money and what you value as an individual.
My first words of financial advice for younger investors is to always focus on paying down high interest rate credit cards and have a “rainy day” fund for emergencies. This is critical to keeping your credit intact and establishing a safety net in case you lose your job.
Once you have those objectives in place, it’s time to think about saving for the long-term. That’s when you need to get involved in your company’s 401k.
What Is a 401k?
This retirement savings vehicle is a critical component of financial security that you should be maximizing to its fullest.
A 401k is an investment account where you can set aside a portion of your paycheck each month before the money is taxed. Most employers offer these types of plans or equivalent savings vehicles so that you can easily invest for the long-term.
401k plans have several advantages and drawbacks. Foremost, they allow you to contribute money on a tax-deferred basis. That means you don’t pay any taxes on the money you are investing until you decide to pull it out much later. This also allows you to reduce your net taxable income to the IRS so that you can potentially pay a lower tax rate.
Many employers also offer a matching contribution up to a certain percentage of the amount that you contribute. You can earn this additional free money simply by participating in the plan.
The primary drawbacks of a 401k are limited investment options and potentially higher embedded expenses than individual retirement accounts (IRAs). Most 401k plans have anywhere between 15-30 fund choices that are selected by the employer or an advisor. You don’t get to choose the menu of funds, but you do get to decide, which funds to own and how you want your money invested. There are also penalties that can apply if you need to take the money out prior to retirement for an unplanned expense or other need.
The greatest advantage that you have as a young employee isn’t the amount of money you are able to save each month — it’s the time that you have to compound it over many decades. Time is the most valuable commodity an investor can possess. It creates a much greater cushion for mistakes and allows you to build on your wealth year-over-year with ever-increasing efficiency.
Think about it like this — all things being equal, the earlier you start, the more money you are able to accumulate for retirement. Putting off contributing to your 401k by even 5 or 10 years can mean hundreds of thousands of dollars in lost wealth over the course of your lifetime. Make it a priority now!
How Do I Use My 401k?
Once you have the account established and money is being contributed each month, it’s time to decide how to invest it. Some would have you put all the money in company stock or try to time every little gyration in the market. You can potentially consider those things down the line. Right now, your job is not to try and be Warren Buffett or George Soros, it’s to learn the ropes of a new career and be a good saver.
To that end, the simplest course of action is to try and pinpoint the lowest cost and most diversified investment funds in your plan. Anything with Vanguard in the name should automatically be a strong candidate. Also look for key words like “index fund” or “core fund”. Those types of strategies are generally going to be designed for correlation with a big basket of stocks and bonds with minimal expenses.
There may also be the option to select a “target date” retirement fund that automatically adjusts itself from more aggressive when you are younger to less aggressive as you get older. These can be easy ways to own a comprehensive and diversified portfolio in one single fund so that you don’t have to select multiple options.
Another thing to keep in mind when looking over your retirement/401k plan: Don’t try to time the market. Don’t try to shift money around each month or quarter (you may incur penalties for over-trading).
Just put as much money to work as possible and watch how it performs for a year or two. As you begin to accumulate more experience and learn about the markets, then you can make small adjustments that may benefit your efforts over time. Remember that even if the market takes a sharp dive, that you are buying more shares at lower prices with your monthly contributions. That is a good thing for the long-term.
The Bottom Line
Start your 401k as early as possible. This is especially true if your company matches up to a pre-determined level — that’s free money that you get simply for being involved.
Keep your investment responsibilities as simple as possible. Select a couple of funds that you know are low-cost and provide correlation to the markets. Even diverting to a target date fund or the 401k sponsor’s model portfolio can be a worthy option to consider if you are overwhelmed by the choices.
Let the miracle of compounding work to your advantage. Time is your greatest ally and getting involved sooner rather than later will provide you with a tremendous leg up over the course of your lifetime.
David Fabian is Managing Partner and Chief Operations Officer of FMD Capital Management.
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