401ks Are Your Friend: Demystifying Personal Finance Part 3
Welcome to Part 3 of our Demystifying Personal Finance Series! This series is all about how to assemble a sound financial life as a young professional, though many of the topics covered are useful to folks of all ages. The series also serves as a reflection of the steps Mrs. Frugalwoods and I have taken to stay debt-free (other than our mortgage), save 71% of our incomes, max out our 401ks, avoid the lifestyle inflation trap, and map a plan for reaching financial independence in 2.5 years at age 33. A quick disclaimer: I am not a financial professional in any sense and am just some guy on the internet. Contrary to popular belief, Frugal Hound is also not a financial professional.
Saving for Retirement (And Why You Should Start ASAP)
Once you have your high interest debt under control, as we discussed in Part 2 of the series, it’s time to start thinking about the future. When you’re 24 (or even 34), retirement seems like a ridiculously long time away. And, unless you’re retiring early thanks to some extreme frugal weirdo actions, it is! But even if you’re not planning to retire until a more traditional age than Mrs. FW and I, you’ll still want to get started as soon as possible in order to retire comfortably.
There’s a famous parable (well, it’s famous in my mind) that addresses the importance of starting to save early. I call it the tale of Anna and Mauricio.
Anna and Mauricio are both 23 years old when they land their first “real” jobs. Anna starts saving into her 401k immediately at the rate of $300/month. Conversely, Mauricio waits 8 years (until he’s 31) to start saving into his 401k and then contributes the same monthly amount as Anna.
Anna stops contributing to her 401k at age 33 (which represents 10 years of saving) and Mauricio continues to contribute until he’s 65 (which equals 34 years of saving).
Assuming an 8% annual growth rate (which is considered a conservative and standard rate of return), who has more in their retirement account when they hit 65? Anna.
Did I blow your mind? Put another way, Mauricio NEVER catches up. How crazy is that? Anna’s 10 years of saving beats Mauricio’s 34 years of saving. Now THIS is why compound interest is a magical unicorn of awesomeness.
For more awe-inducing math, take a look at this sweet graph of their earnings:
This graph is both inspiring and terrifying!
It’s one thing to intellectually internalize the power of compounding interest, but it’s quite another to look at a graph like that and meditate on your own preparations thus far.
As Frugal Hound is fond of saying… the best time to start saving for retirement was 10 years ago. The second best time is today! No matter where you are in the journey of saving for old age, it’s always a good idea to re-asses and determine if you should be putting more towards your future.
How Much Should I Save For Retirement?
If you google that phrase, you’ll find myriad benchmarks and theories. And in reality, the question you want to ask is “how much money will I need in order to safely retire?” Once you know that dollar amount, you can work backwards to ascertain how much you should be saving at present.
So how much do you need to retire comfortably? There are several different ways to address this, but the standard answers fall into just two categories
1) 8 times your final salary:
- This is traditional retirement advice, which assumes that in retirement you’ll spend about 80% of what you spent while you were working.
- However, I don’t find this particularly useful. Why? Our salaries have no bearing whatsoever on how much money Mrs. Frugalwoods and I spend every month. Since we live well below our means (to the tune of saving 71% of our incomes), this metric is essentially meaningless for us and anyone else on a similarly frugal path.
- Obviously, how much you’re going to spend in retirement has a huge effect on how much you need to save.
2) Enough to live on 4% per year of your savings:
- This is much more modern advice, which is modeled off of academic work demonstrating that a well-diversified portfolio will last throughout retirement if you begin by taking just 4% out per year and adjust for inflation.
- The magic of this retirement savings approach is that the amount you need is directly controlled by how much you spend. If you’re currently behind on saving for retirement, my advice is to start living more frugally AND start saving more. That way, you’re working at the problem from both ends. And by permanently reducing the amount of money you need every year (as Mrs. FW and I have done), you’ll permanently reduce the amount of money you need to save for retirement.
OK, Mr. Frugalwoods, we get it, clearly we need to save for retirement. But how much per paycheck should we save?
This is highly dependent on your personal situation. That answer’s not a cop out, I swear! Here are the two elements that should determine this dollar amount for you:
1) The amount you’ve already saved.
2) How much money you plan to spend in retirement.
Since I realize #2 might seem nearly impossible to determine at this stage of life, here’s the Frugalwoods rule of thumb: Aim to save 10% of your salary for retirement your first year out of college. Each subsequent year, add another 1%, with the goal of reaching the maximum tax deferred amount per year ($18,000 in 2015) by the time you hit 30. This is precisely what Mrs. FW and I did and we hit the $18k per person per year level at age 29.
Is this an aggressive savings rate? Heck yes. But did you expect anything different coming from us notorious frugal weirdos? Further, it’s been my experience that as people stroll into their mid-thirties and have kids, a mortgage, and a stay-at-home spouse… retirement savings suddenly become much harder to come by and a much lower priority. So, you might as well get a solid foundation nice and early.
But How Do I Actually Save For Retirement?
Now that I’ve hopefully
scared you into motivated you to save for retirement and given a guideline for how much to save, where should you actually put your money?
This is the part that seems to intimidate my friends and coworkers the most. They know they should be saving, but the actual mechanics baffle them. Well friends, be baffled no more! It’s actually pretty straightforward once we break it down. So don’t be deterred!
If your employer offers a 401k (or a 403b* if you work at a nonprofit), you should use your employer’s program. Hopefully they match a certain amount of your contributions. But even if they don’t, the ease of automated savings is worth using your 401k first.
*The rules governing 401ks and 403bs are identical, so I’ll just use the term 401k from here on out, but if you have a 403b, all of these guidelines apply to you as well.
So what’s a 401k anyway?
- It’s a tax-deferred savings account. This means you don’t pay income taxes on the money you put into your 401k, but you will pay income taxes when you withdraw your money in retirement.
- You’re allowed to put a maximum of $18,000 per year into your 401k (in 2015).
- Employers can choose to match your contributions with money of their own:
- These matching funds do not count against that $18k limit.
- My employer is very generous and matches up to 8% of an employee’s salary in 401k contributions. That means I put in my $18k every year and my employer kicks in an additional 8% of my salary.
- Matching funds are free money. I can’t stress this enough, people. If your employer offers matching funds and you’re not taking advantage of it, you are literally leaving free money on the table. For this reason, matching funds are a major consideration for Mrs. FW and I when we evaluate potential employers.
- You can begin to withdraw money from your 401k when you’re 59.5 years old. Prior to that age, you’ll pay a penalty to withdraw the money. For this reason, you shouldn’t ever liquidate a 401k prematurely except in the case of a life-shattering emergency. A 401k is not your emergency fund and it’s certainly not your “I’d like to buy a boat” fund.
How does money get into my 401k?
- Money is automatically taken out of your paycheck and direct deposited into your 401k at the rate you specify. You don’t have to move money into a 401k manually, it’s a “set it and forget it” automatic deduction every month.
- You can take your money with you when you change jobs:
- You have a choice of either transferring the funds into your new employer’s 401k program or “rolling over” your 401k funds into an IRA. Usually, rolling into an IRA makes the most sense.
- What is vesting?:
When greyhounds wear trendy vests.
- Some employers have a “vesting schedule” for their employer matched 401k contributions. This means that you need to stay with that employer for a certain number of years in order to take the employer match portion of your 401k with you. Your contributions are always yours regardless of a vesting schedule.
- My employer has a three-year vesting schedule. So if an employee at my company left after two years, they’d take all of their 401k contributions and 66% of the employer match with them when they left. Obviously, it’s best if you can remain at a job until you’re fully vested so that you can take 100% of your employer’s matched funds.
- Not all employers have a vesting schedule, however. Mrs. FW’s doesn’t and so she’s eligible to take her contributions and her employer’s matching funds at any time.
If your employer doesn’t offer a 401k program, you can use an IRA. The limits are lower, and the contributions aren’t quite as automatic, but any brokerage (such as Vanguard or Fidelity) can help you set one up.
To start saving into your 401k, just talk to your friendly HR department. Most companies have a form for you to fill out specifying how much you’d like to save per paycheck (remember, start with at least 10%!). Then, you can set up an online log-in (very similar to online banking) so that you can observe your 401k funds.
Once you’ve set up your 401k, there are two more important decisions to make: Roth or Regular, and what to actually invest in. Not to leave you in suspense, but, this post is already super long so I’ll tackle those considerations in Part 4 of the series.
As with all aspects of personal finance, the first step in saving for retirement is to take a proactive role and educate yourself. The very fact that you’re reading this means you’re well ahead of the majority of Americans. Don’t stress over past financial transgressions and don’t beat yourself up if you haven’t started saving for retirement yet. Start now and commit yourself to an aggressive savings rate that your future self will thank you for!
Want to make sure you’re among the first to receive Part 4 delivered hot and fresh to your email machine? Sign-up in the Frugal Hound email box below and she’ll send you a message.
Are you saving for retirement? What advice, or questions, do you have about the process?
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