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The 401(k) is a piece of law enacted in the late 70’s-early 80’s and named after the 26 U.S. Code § 401- Qualified pension, profit-sharing, and stock bonus plan. Most American employers allow their employees to participate in the program by contributing a percentage of their earnings. The reward for your contribution is an additional matched percentage by your employer.
Popular 401(k) programs will match 3% of your contributions if you contribute up to 6% of your annual income. So if you take full advantage, your company will add an additional 3% on top of your 6%, making your annual contribution 9%, all of which goes towards retirement. There are variations in these 401(k) programs, but most follow similar guidelines.
There are two types of Individual Retirement Arrangement or Account (IRA). Roth IRA and Traditional IRA, here are some of the basic differences.
Roth IRA vs. Traditional IRA
With a Roth IRA, you are paying taxes now at your current tax rate. Therefore, when you take the money out, the government will no longer tax the amount you withdraw because you already pay them when you began contributing to your account. The additional benefit is that all your money grows tax-free.
With a Traditional IRA, you pay the taxes later when you withdraw the money. This account is tax deductible, but you will pay taxes in retirement when you withdraw it. You must consider which tax bracket you’ll be in 20, 30, 40 years from now and decided which route to take.
Most millennials like myself like Roth IRAs because there is a greater chance that taxes will go up in the future and we assume we’ll be earning more as we get older, thus we rather pay taxes now at our current tax rate, then later when our income increases.
Both Roth and Traditional IRA limit your annual contributions to $5,500, $6,500 if you are 50 or older. That would be a monthly contribution of $458.33. Most company matching plans match up to 6%, so anything above that amount can be better spent in your personal investments outside of your employer 401k plan.
Pay off your debt
Before you consider contributing or investing in retirement get rid of all your debt. Your debt is keeping you from building wealth. Take into account how much debt you have and how quickly you can pay it off if you are thinking about pausing contributions. We decided not to pause our contributions because we paid off over $34,000 in less than two years.
If you know you can use the extra thousands to pay debt quickly, then pause your contributions. Do not, however, use what you have already invested in your retirement account to pay your debt. You will be taxed 10% on top of your regular tax. Your goal is to build the largest nest egg possible to enter your years of retirement securely and wealthy.
Get Free Money
I don’t really mean free money because there is no such thing as free lunch. What is true, is that if your employer participates in a 401(k) matching program then don’t leave that money on the table. Take full advantage of your employer’s match. This past May we decided to take full advantage of the match. The difference is worth noting.
Before we began contributing the full 6%, the employer’s match was only 1%. The first month of contributing the full amount went up to the full additional 3% match. The difference in three months was a total $382.62 that came out of the pocket of the employer. That equals to 50% of the money that came out of our pockets, $750.44.
So every month that you don’t take advantage of the full match, you are actively leaving money on the table, money that you can be earning interest on!
How to grow your money
Since we started investing in retirement, June 2014, our account has grown to $9,633.38. Out of that amount, only $4,498.02 have come out of our pockets. The rest is the magical work of compound interest. In the past 7 months, our investments have grown at a rate of 7.89%. And in the past two years, it has averaged a whopping 21.28%. What can you compare that to? Well, a regular savings account averages 1-3% return on investment (ROI) annually, and a Certificate of Deposit (CD), or bond might be able to reach 4-5% (ROI).
So yes, you will come out winning by investing in your employer’s 401(k), even more so, if they match your contributions. How can you invest this money? The number one thing I can recommend is to speak to someone who has done it, educate yourself and maybe even find a millionaire or someone who has successfully retired. We talked to family members who have been retired for a while, so before making any decisions, we made sure to ask as many questions as possible. This is how those investments are spread out:
As you can see, we are huge fans of Vanguard. They have some of the best and cheapest fees for investment options. Not only have I read two books by their founder John C. Bogle, but I have also spoken to someone who has invested with Vanguard for a long time. That’s the best thing you can do for yourself, speak to someone who has done it and educate yourself as much as possible before investing in anything. And do not do anything that you are unfamiliar with.
Create a plan
One of my favorite quotes from French poet and writer Antoine de Saint-Exupéry is “A goal without a plan is just a wish.” You need to stop wishing and hoping that someone takes care of you. You must think long term about your future! Ask yourself questions like:
- How much do you need to live on when you retire?
- At what age do you want to retire?
- How much do you need to put away in a retirement account?
- Is a 401(k) the only option, or should you invest more? How?
- What about college for your kids?
- What if there are medical or other type of emergencies?
All these questions are not something to be afraid of. They are meant to prepare you for your future. Personal Capital’s retirement calculator can answer most of these questions. You can add and edit how much you want to invest and how much you will need to sustain yourself during retirement. Give them a try, it is totally Free to use!
How can you secure your retirement?
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