Death and Taxes
One of the best ways to keep the taxman from totally destroying your nest egg is to prevent the dramatic effect that taxes have on compounding by putting your money into a tax-sheltered account where it can grow unmolested by the government.
Back in the day, all good companies and state jobs had a pension plan. You worked, you paid into the pension plan, and when you retired, you got a check until you died. The best companies had “widow’s benefits” where a surviving spouse would continue to get a check for life. Most companies realized that running these guaranteed pension plans was a huge expense and a huge risk. They got out of the business and started participating in what has come to be known as a 401(k) plan.
A 401(k) is an employer-sponsored retirement plan. If you work for a nonprofit institution (like a university), you may have a 403(b) plan; they are the same thing, just a different paragraph in the tax code. The idea is that the employer takes money out of your check, saves it for you in the plan, and when you retire you start taking your money out. Different plans work different ways, but the idea of all plans is to invest your money, so it takes advantage of the magic of compounding. Most plans have several different options as to how to invest your money. Most all of them are bad. Some of them are downright terrible! You have to know what you are doing with your money before you start one of these if you don’t want to eat Alpo when you retire.
I don’t like most 401(k) plans because the investment options available in most of them are simply not very good. With many plans, your best bet is to invest all of your 401(k) money into a low-cost fund that mimics the behavior of the S&P 500 stock market index. Other options are not very good, and fees eat up all of your profits. Companies and public agencies don’t manage the 401(k) plans, they “sponsor” them. They bring in outside firms to actually run the plans.
Your employer gets to pick that company for you; if you work for a large business or a big public agency, you may have a couple of options. The “Representatives” of the 401(k) plan managers will try to tell you all about risk aversion and age and capital preservation. These people are just reading off a card they got from the corporate office. Do not listen to them. Safety means poverty when you listen to these folks. Within the limits of what your employer’s plan will allow, choose the options that give you the most control over what happens to your money.
So far, I make it sound like the 401(k) system is a bad idea. It has some awesome points that make up for the annoying lack of control that you have over your money. The first big advantage is that you don’t pay taxes on money that goes into your 401(k). That means a lower tax bill at the end of the year. It also means more dollars are actually invested because your 401(k) contributions are made before taxes are taken out. This is a very strong incentive to invest in your 401(k).
The second big advantage is that many companies and agencies have what is known as a match. When your company does a “match” it means for every dollar you put in, they will put in a dollar. There is always a limit, expressed as a percentage of your salary. My retirement plan, for example, allows for a 10% match. That means if I am willing to contribute 10% of what I make to my retirement plan, then the university will match that 10%. It doesn’t take a genius to appreciate how awesome this is. Free money is always good (assuming that it’s legal and ethical—this is both!). Looking at it another way, your investment made 100% interest instantly! It would take from 5 to 20 years to do that through actual investing.
You cannot afford NOT to contribute to your 401(k) up to your company’s match.
I don’t care if you are eating beans and rice six night a week; stuff every free dollar you can get into your 401(k)! Moreover, it gets even better; you don’t have to pay taxes on the free money either. You do have to pay taxes on 401(k) withdrawals when you retire, but that will usually be at a lower rate because you will likely be in a higher tax bracket during your working years (assuming that tax rates don’t change, which may not be a very good assumption at all). Also, consider the fact that if you follow my advice, you will be a millionaire and taxes will not be such a big deal. If you are a very wealthy individual and/or think taxes will rise in the future, there are other instruments (well mention these later) that let you pay taxes now but none later.
Therefore, the biggest benefit of the 401(k) is the match. If your company does a match, get the max amount of free money that you can. If your company does not do a match, then do not participate in the 401(k) if they give you the option to opt-out. There is a much better option for saving your retirement money if you don’t get the match. If you are like me, your psychology may be an issue. If you know that you will procrastinate and not contribute to a retirement account, then it is better to put your money into a not-so-good company-sponsored account than it is to save nothing. There is a powerful psychological benefit to never seeing the money (as take-home pay) that goes into your retirement account.