by Robert Rapier, Investing Daily
Investing.com Article of the Week
The source material for this column often comes from conversations I have with people about money. Someone approaching retirement may ask me a question about their strategy, and it will trigger me to write on the topic.
This week’s topic is for those who are just entering the work force. My oldest son has been working for a utility for a couple of years. I recently looked at his pay stub to make sure everything is in order. I noticed a deduction for a 401k, so I asked him about it. He had no idea where that money was going, nor could he ever remember electing such a deduction.
This led to a discussion with him about the importance of such retirement plans, especially early in a career. I explained that he may have 40 years until retirement, and the choices he makes today can have an enormous impact on how much money he ultimately accumulates. (I never cease to be amazed at how carefree people can be about money decisions that can make or break them in later years.)
So today, I want to discuss the major types of individual retirement plans, the importance of getting an early start investing in them, and how critical it is to make good investment choices.
Getting Rich With the 401k
First up is the 401k plan. These plans are offered by many employers as a way for employees to save for retirement. This year, the IRS allows individuals to contribute up to $19,500 to a 401k if you are under 50 years old, and up to $26,000 in the account if you are over 50.
Many companies make a matching contribution to a 401k. The bare minimum anyone should contribute to their account is up to the amount of the company match. For example, a common 401k match is dollar-for-dollar up to 5% of your salary. If you make $40,000 a year, your annual contribution would be $2,000 and the contribution from your employer would be $2,000. Thus, you have an instant 100% return on your contribution in the year you make it, to go along with any market returns. That is an unbeatable return.
Further, these contributions are made pretax. That means if you elect to contribute $2,000 in the example above, your annual take home pay won’t be reduced by $2,000. It will be less than that, and the money that you would have otherwise spent on state and federal income taxes can grow and compound for years. You don’t pay taxes on the money until you withdraw it.
If you make the contribution above, and your employer matches as in the example, that account over 40 years could grow to be worth more than $1.6 million (assuming the average long-term performance of the S&P 500). Your weekly out-of-pocket cost in this example would be $30 to $35. That’s all it could take to give you a nest egg worth more than a million dollars at retirement. And of course if you save more, you can accumulate a lot more.
In contrast, if you don’t pay attention to your investment choices and you allow that money to accumulate in a low-interest account, that $1.6 million could end up being less than $200,000. So pay attention to where your money is going.
Other Retirement Accounts
The other accounts aren’t quite as potentially lucrative as the 401k, but they are still worthwhile. The Individual Retirement Account (IRA) allows you to contribute earned income of up to $6,000 in 2020, or $7,000 if you are 50 or older. As with the 401k, the contributions are pretax. But in this case there is no company match.
A Simplified Employee Pension (SEP) IRA is designed for small business owners and self-employed individuals. If you are eligible, you can deduct up to either 25% of your compensation or $57,000 in 2020, whichever is less. As with the 401k and IRA, the deductions are pretax.
The Roth IRA is different in that its contributions are post-tax. However, withdrawals from the account are tax-free. The contribution limits are the same as for a traditional IRA, and only earned income can be contributed.
There can be penalties associated with taking out funds from these accounts before you reach the age of 59 1/2, which is an incentive to leave this money in and let it work its compounding magic for a long time. There are some exceptions, but I would consider tapping into these funds to be a measure of last resort.
Invest Aggressively
If you are young and have decades to invest, don’t mess around with bonds or money market funds. Put this money to work in either an S&P 500 index fund, or in some other fund devoted solely to stocks. For the passive investor, index funds are great because they have low expense fees, and there’s just really not much you need to do. Set up the investment, and let the automatic contributions grow your wealth.
A more active investor may split their investments into sectors. They may want a portion in a commodity or international fund. Personally, I devoted about 15% of my overall investments early in my career to the health care sector. That decision paid off extremely well. But you would have also done well investing in other sectors, such as technology.
However, if you break your investments into sectors, don’t get too aggressive with a particular sector. And don’t bet too much on a particular stock. In hindsight, Apple (NSDQ: AAPL) may appear to be a no-brainer, but there was a time that many thought AOL or Enron would rule the world. You can’t afford too much single stock or single sector risk, even with decades to invest.
Finally, as you do approach retirement, that’s the time to start shifting money into bonds. It’s a personal preference, but I would start shifting money into bonds if my retirement target was 10 years away. Once those years of compounding are no longer in front of you, you need to get more conservative.
But until then, invest as much as you can, and let time and compounding make you rich.
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