Harnessing the Most Powerful Force in the Universe and Your Road to Financial Independence through a 401(k)
Welcome back guys to another installment of “First Principles” series. In our previous post, we looked at compound interest or as Albert Einstein said “the most powerful force in the universe” and ran through some quick examples of how it works.
For today we are going to take a look at how to harness this power and use it to fuel our futures! We will be doing this by looking at a 401(k) or equivalent retirement account.
If you are working for a large company or in the public sector, chances are that your employer will offer you retirement benefits in the form of a 401(k)/403(b)/457 plan. This is awesome because it allows you a chance to save money for your future!
For those just entering the work force, setting up your 401(k) plan is a MUST DO once you get hired on. As we saw in our last article, the earlier you start, the more time your money has to grow into that big nest egg you will need later in your life.
While retirement may seem like an eternity away for some, many employers are willing to help you out by giving you free money!
How do companies do this? They do this through an employer match. This is where your company puts in money into your 401(k) for your contributions into the account. Many companies out there will do a 50% match up to 6% of your salary.
So what does this look like in real life? Let’s say you make $100,000 and your company has the employee match benefit as noted above. The company will give you $3,000 if you contribute $6,000 to your retirement account! That right there is an automatic 50% return on your investment!
*Note: I am aware everyone doesn’t make $100,000, but I’m using it to make the math easy.
Everyone loves free money, but the benefits just don’t stop there! Any contribution made to your 401(k) account is tax deferred. This essentially means that you don’t pay any taxes on this money and the money made until you withdraw it.
As of 2018, the 401(k) contribution limit is $18,500. Again let’s assume you make $100,000 and contribute the maximum amount to your 401(k) ($18,500). Because you did so, your taxable income now becomes $81,500 ($100,000-$18,500). In this particular case not only do you pay less in taxes, but you also drop into a different tax bracket (24% to 22% Federal Income Tax)! Double bonus!
For those savers out there who are older than 50, there is another wonderful benefit. You wonderful engineers get to contribute an extra $6,000 to your 401(k) in what is called a catch up contribution. This in essence makes your contribution limit now $24,500 which is now also tax deferred!
Finally while I don’t wish this upon anyone and hopefully because I got awesome followers, but should you get in trouble with creditors, your 401(k) account is for the most part off limits.
Word of caution
So you might be wondering this must be too good to be true, and that there has to be a catch. Ah yes, indeed there is unfortunately. Since this is a retirement account, Uncle Sam (the IRS) only wants you to use this money for your retirement. As a result, you can only start withdrawing at the age of 59 ½.
This shouldn’t be a problem because we want to use the most powerful force in the universe (compound interest) to continue to allow our money to grow until that age or sometime after.
Should you want to withdraw that money, you not only have to pay the income tax that is owed on that money, but there is also a 10% penalty on top of that L. Double ouch. While there are some exceptions to this penalty it’s probably not best to touch this money unless absolutely necessary. Again this is because we want to harness the most powerful force in the universe (compound interest).
Another drawback to be aware of is that many companies have vesting schedules on the contributions they made to your 401(k). A vesting schedule is set up so that you stay with an employer for a minimum number of years. So should you choose to leave early, you only get some or none of the company match. Don’t worry though, your contributions you get to keep of course!
If the current job you are in right now is not a healthy work environment or a better opportunity has come up, you should definitely move on and not worry too much about missing out on the employer match.
One thing you need to know is that while 401(k)’s are set up to help you save for retirement. The company managing your retirement portfolio has set up a gold mine to make money off of you in the form of fees, fees, and more fees.
These fees can be administrative fees, investment fees, service charges, account maintenance fees, fees for fees, you get it.
Generally when you log into your 401(k) plan, you will notice a long list of funds from which you can choose from. These funds are split between low fee index funds, which are set up to match the return of the stock market and high fee actively managed funds that have professionals who “try” to beat the market and get you “higher” returns.
But with that said, actively managed funds with professionals are not that much better at producing higher returns for you. Even John Oliver points out how a cat beat out 11 financial professionals!
So the point is that if all things are equal in terms of results, why would you want to pay more to someone who gets you the same or worse results? Here at Independence Engineered, I’m here to optimize your savings and using an actively managed fund is no way to do it.
Therefore we need to select funds that have low expense ratios (less fees) so that we can make more bang for our buck. Fees and expense ratios are expressed as an annual percentage of your total investments. So let’s say that in your 401(k) you have invested $10,000 dollars in a fund with an expense ratio of 0.5%. You in essence are paying the company managing your 401(k) $50 a year!
Not only is this a yearly fee, but here is where compound interest can come back to bite us, just like with credit card debt. So as a rule of thumb, good expense ratios to look out for are anything below 0.1%.
Typically you can find all this information by selecting the fund and they will have this all spelled out on the landing page or a fee’s page.
Below is an example from Vanguard:
Finally while we want our money to grow for as long as possible, Uncle Sam still wants his take. He does this through what is called a required minimum distribution (RMD). Basically Uncle Sam requires you to start taking money out after you turn 70 ½. If you don’t start your RMD the penalty is pretty steep (50% of the RMD amount….ouch).
Putting it all together
Again I am aware that everyone has their own personal financial situation and as such you should do what is comfortable and/or possible for you.
So I know that there is a ton of information there, but let’s just wrap it all up for everyone.
1. Set up a 401(k) or equivalent plan if you are offered it. Investing in a retirement plan is better than saving money in your mattress through the power of compound interest.
2. If you get a company match, take advantage of it! It’s free money after all. Make sure to contribute at least up to the limit. By doing so you automatically get a return on investment!
3. If you are able to, contribute the maximum amount of money ($18,500 for 2018) into your 401(k) or retirement plan. Doing so will help you save on taxes!
4. Invest in low cost index funds. Look for index funds with an expense ratio of less than 0.1%. We want the most powerful force in the universe to work for you not against you!
I really hope that you fellow engineers found this article to be super helpful and that it can super charge your savings for your future!
Let me know what you have done below and how you are planning for your future!