The Graduates Guide to 401k Savings

Career Finance Series 1

In college, I would hold long discussions with classmates on geopolitics, the economy, business, history and politics. Our discussions never touched on personal finance. It’s one of those taboo subjects where you have to conduct your own research to truly understand.

I remember the first few days at my government job like it was yesterday. This was my first gig out of college. The administrative process was cumbersome. It felt like it took forever. I had no idea what I was signing up for. There were healthcare questionnaires, life insurance options, long term disability benefits, direct deposit forms, retirement planning, etc. When I got to the retirement section one of the questions was “what percentage of my pay should be allocated to the 401k.”

I asked the women sitting next to me what she contributed. “I contribute 5% to receive the full match,” she said.

"Match? 401k? What are these things!"

Let me try to explain.

What is a 401k:

I’m not a financial expert. However, I do consider the subject to be an important component of my life and career. It’s something I’ve grown to be more passionate about. At Mr. Career Guide you can expect to see posts related to personal finance.

No one wants to work forever. One day, you are going to want to retire. Maybe you won’t want to quit work altogether, but you’ll get tired of corporate America. The 9-5 grind tends to wear down a person after 20 to 30 years. If you don’t save for retirement, you may never be able to escape. The 401k will give you options as your money grows.

The 401k is kind of like a glorified savings account. Essentially, it’s a bucket that holds your money. As of 2018, you can contribute up to $18,500 to the 401k annually. Don't expect to touch that money until you are 59. The account will be managed through a brokerage firm (Vanguard, Betterment, AON Hewitt, JP Morgan, etc). There will be options to invest in mutual funds, index funds, target retirement accounts, and bonds. I’ll go over what I choose to invest in later.

How Much Should I Contribute?

First, you need to review the type of 401k accounts your employer offers:

• Traditional 401k – pre-tax

• Roth 401k – post tax

I’m not going to tell you where to put your money, but I’ll tell you what I do. I’m a firm believer in the Traditional 401k for the pretax benefits. Look we all know the current state of the political climate in America. Before we pay ourselves, our paychecks are taxed by the government. Personally, I don’t want to give the government any more money than I need too. I spent nearly five years working in Washington D.C. I was even a government employee. I’ve witnessed firsthand how tax money is spent and quite honestly abused. I’m all for helping others and this great nation of ours. But the government is not doing the most effective job with the taxes we pay. Why should I give them more now?

Consider paying less in taxes now while you are grinding it out. You are already paying a fair share. Strive to max out the 401k each year. That money will grow and will be taxed when you start withdrawing. By the time you reach retirement, you will most likely be in a lower tax bracket. You’ll pay less in taxes than what you pay now.

When determining the amount to contribute take your base pay and automatically subtract $18,500. If you are paid twice a month, divide that number by 24. From there you’ll be able to determine the amount you can contribute. Here's a quick example:

I know what you are thinking, how am I going to afford contributing 26% of my salary to maxing out my 401k!? You may not even be making 70k in your first job, so the contribution may be even higher than 26%. But that’s okay. If you start getting in the habit of calculating your take home pay after the 401k max contributions, you’ll adjust your lifestyle accordingly. As you see the numbers in your retirement account grow each year, you’ll be on your way to financial freedom. Your future self will thank you.

If you have student loans and other debt, consider allocating less money to 401k contributions. There are plenty of blogs and articles written on this subject, some of favorites are the following:

• Pay Down Debt or Invest? Implement FS-DAIR – Financial Samurai Blog Post

• Should You Pay off Debt or Invest? – Mom & Dad Money Blog Post

• Should I Pay Off Student Loans or Invest My Money – Student Loan Hero

Maxing out the 401k is a no-brainer. Life gets in the way sometimes. Cost of living is going up every year. When you are just starting out, maxing out the 401k can be difficult due to a lower salary and debt. If you start training yourself to live off the money after maxing out the 401k, your money will be compounding in no time.

If you can’t do the max, try adjusting your contribution percentage to an amount that gives you the most pain without missing any payments or reducing your lifestyle.

“Free Money” with the Employer Match

Some employers offer matching funds for employees who contribute to the company’s 401k plan. According to Investopedia, the average 401k match is 3%. Consider this free money. You are receiving a 100% return on the percentage matched. This money will be placed in the traditional 401k account. Additionally, it is not considered part of the $18,500 max you put in. Whatever you contribute, putting in enough to receive the match is a great strategy to grow your money.

You also need to consider the vesting period for contributions. Some employers do not allow you to leave the organization with the match until you’ve put in a few years. Also, some organizations will not allow you to receive the match until you’ve put in time. Ask HR for the vesting schedule to learn more.

Traditional versus Roth 401k

Most companies offer a Traditional 401k for pre-tax contributions. A relatively new option is the Roth 401k. Similar to the traditional, you can contribute up to $18,500 annually. However, this money will be after tax money. You’ll be paying more taxes up front as you contribute. The idea is that the money will grow tax free. Once you retire, your nest egg will be sheltered from the government.

On paper it looks like a great plan. Personally, I don’t want to pay more in taxes right now. That’s why I choose the traditional. If the Roth 401k makes sense to you then contribute.

A few of my coworkers contribute to both accounts by spreading their money between the two options.

IRA

If your employer does not offer a 401k, consider contributing to an Individual Retirement Account (IRA). The IRA is offered in a Roth or Traditional form through brokerage accounts such as Vanguard, JP Morgan, Betterment, or just about any bank in the country. You can contribute up to $5,500 annually or $6,500 if you are 50 or older. This is a great option if your company does not have a 401k.

Mr. Career Guide recently started contributing to a Traditional 401k and a Roth IRA with Vanguard. I know I stated earlier how I’m a fan of the traditional but the Roth at $5,500 gave me another retirement option. The after-tax contributions are not a burden as opposed to maxing a Roth 401k. The accounts force me to save $24,000 annually. That doesn’t include other investments or the company match. I view this as a safety net for my future self.

It took me a long time to get in the habit of maxing out the 401k. I did not do the best job of saving during my first few years in the “real world.” I’ve come to regret that now as I feel like I’m playing catch up. Invest early and increase your savings rate with salary growth.

What Mr. Career Guide Invest In

There are scores of articles out there with investment advice for your 401k and IRA.

I will tell you that I prefer to keep things simple and aggressive. I’m only 32 and have plenty of working years left in me. Personally, I believe the financial world over-complicates investing. Maybe that is why the average 401k balance for 25 – 34 year old’s is $22,256 according to the Motely Fool.

My investment strategy is based on personal preferences. I invest in low cost index funds that are passively managed. The expenses on the funds are incredibly low and my money matches the S&P 500 index. My employer offers several Vanguard Index funds. I don’t invest in bonds or mutual funds. 100% of my money is in the index. This may be a higher level of risk, but I prefer a strategy with minimal complexity.

I also remember when I was trying to get started with personal finance, I struggled with what to do first, saving or investing. I really wanted to start building my savings but I also knew that I needed to beef up investments. Once my emergency fund was fully funded, I really started investing and leveraged many of the strategies outlined in this article from Bankrate.

The 401k can feel like a colossal cluster-F when you start working. Don’t let it stress you out and consider contributing as much as you can each year with the goal of maxing it out.