5 Lessons on 401(k)s and IRAs Nobody Tells You About
Fresh out of school or early on the career path and you think retirement is a distant worry. Nothing to deal with now, right. Not true. Retirement planning, particularly examination of early 401(k) and IRA options, should begin the moment that option is available. The earlier, the better.
Of course schools don't bother with this. (Remember they've already gotten your money.) In fact nobody teaches the risks. So we created a five-point primer for smart and early planners. Call it Retirement 101.
1. Not all 401(k) investments are created equal
Many people think putting tax-free money aside for retirement means they’re winning the game — but that’s not the whole play. Pay close attention to the costs or expense ratios for each of the funds offered in your company’s 401(k), the retirement savings program sponsored by employers.
- Fee rates below 0.10 percent are great.
- Rates below 0.25 percent are good.
- Rates around 0.50 percent are fair.
- Expensive funds charge you 0.75 percent - 1.50 percent.
High administration fees will eat into your profits long-term. If your fund produces a 6 percent rate of return in 10-years, that 1.3 percent annual “administration cost” will reduce your return-on-investment to only 4.7 percent each year.
Let’s compare to illustrate: A $10,000 principle investment in a fund that returns 5 percent per year and charges only 0.10 fees will be worth $27,014.85 in 20 years time; that same $10,000 investment in a fund that also returns 5 per cent per year but charges a hefty 1 percent in fees will return only $22,167.15 in 20 years time. You just paid $4,847 in administration fees.
Thus, it greatly improves your margins to elect 401(k) fund(s) with the lowest possible fees.
2. An IRA can fix your 401(k)
If your employer’s 401(k) offers limited low-fee fund options, you might consider dropping the high fee fund from your 401(k) portfolio and reallocating those funds into an IRA that offers better low-fee options (it only takes 10 minutes to open an IRA). But keep in mind that you’ll be limited by the $5,500 per year IRA contribution max. As a result, this is easiest to do with a smaller portion of your total retirement portfolio. However, do not — in an attempt to avoid high fees — contribute less money to retirement than you otherwise would. The benefits of tax-advantaged 401(k) savings will almost always trump the lower return-on-investment from a high fee account. And of course: saving more money is better overall.
Note: if you feel your employer’s 401(k) options are abysmal, consider using this resource to approach management with suggestions for improving the plan.
3. Get aggressive in your 401(k) retirement savings
But not too aggressive! All 401(k)s allow your money to grow in tax-advantaged ways, so it isn’t optimal to invest in bond funds or low-risk money market accounts, especially as a young person. Instead, invest in indexes, always prioritizing low-fee accounts. Tax-free bonds do not belong in 401(k) retirement accounts. At the same time, using your tax break to invest in high-risk, high-return funds — that also carry high fees to cover the active fund management — will usually not return over a low-fee index fund.
The best way to invest in bond funds is through an IRA. A great choice is a no-load bond fund that can be connected to your bank account for liquidity. Within 24-hours, you can get the cash you need from this fund. Again: always choose the low-fee option.
4. Target-date funds make this all easy
If the idea of electing specific investment funds from among the many options in your 401(k) and IRA gives you a headache, you should consider a Target Date fund. Generally speaking, these funds offer the best of both worlds. They invest more aggressively in the early days and relocate to secure holdings toward the end of your working life, keeping a diversified portfolio all the while. Simply pick the year you plan to enter retirement and elect that fund. But again, pay close attention to fees. A fee of 0.5% is common here because the fund mixes high and low fee investments, but the lower the better.
5. Doomsday prophets will not help your profits
Finally, ignore those predicting the imminent decline of the market. The market has good years and bad years, but over the last 50 years, the S&P 500 has risen on average 13.6 percent per year.
To put that into perspective: A $10,000 dollar investment in the S&P 50 years ago is worth roughly $5.78 million today.
Any attempt to predict climatic market shifts for personal gain is risky (unless you’re very near retirement age, in which case some caution is advisable). As a young investor, you should always put your money in the market, and put even more money in the market when the market is down. Odds are, you’ll win big in the end.
But hey, buying a couple of bitcoin wouldn’t hurt either.