Plan For Retirement

On the topic of retirement, realize that you don't have to wait till you are 65 to retire. If you plan ahead, are disciplined and learn to be patient, you can retire well before then. The real goal of investing and generating wealth isn't just money for its own sake or retirement when the time comes but to have the freedom to do what you want much earlier in life.

One of the most common vehicles for a retirement plan is the venerable 401(k). It takes its awkward name from the IRS subsection that it was set up under back in 1978. While not all employers offer a 401(k), enough do and tens of millions of American workers have access to investing in them. The other most common vehicle is called an Individual Retirement Account or an IRA and we'll get to that next.

Unfortunately, few companies tell their employees what do with their 401(k) - especially their younger employees. The first and biggest benefit, by far, of a 401(k) is that you can fund it with pre-tax dollars. That means that before Uncle Sam and your home state get their paws on your hard-earned money, you can put some of it away in a 401(k) such that they can only tax the remaining pay. If your combined federal and state tax bracket is 25% then you're basically getting to keep 25% of your 401(k) contribution entirely tax-free i.e. you lower your income tax every year you contribute to your 401(k). Unlike investments in a regular brokerage account which are made with your post-tax dollars, you can sock away pre-tax dollars into your 401(k) and pay lower income taxes on the balance in the bargain.

The second benefit is that many (but not all) employers also match your contributions to some extent. Usually, it is a percentage of your salary - about 2-4%. And it is often capped at about 5% of your compensation. This match is basically free money - sort of like a phantom raise that your employer gives you every pay period you are employed without you needing to have any awkward conversations with your boss. To get the match though, you must contribute (it is a 'match' after all) so that's a great reason to enroll in your company 401(k) - unless you like to say no to free money.

A very important third benefit is that your money grows tax-deferred (though not tax-free or tax-exempt). In other words you don't need to pay any taxes at all each year as your investments grow until you withdraw it. If you remember the power of compounding, you will realize that your base of growth is never nibbled away at through taxes!

"What's the catch?", you might ask. You can 1) put away pre-tax money AND 2) get your employer to match it AND 3) have it grow tax-deferred - AND there are no strings attached? It sounds too good to be true! Actually there is some fine print but it's intended to help you rather than screw you over.

The first is that you can't withdraw the money till you are 59 1/2 years old. If you do, there is a penalty. But it is still your money and that nest-egg grows year over year. And since it is a few decades out, being patient is an advantage already built into the rules of your 401(k). The next is that the IRS limits how much pre-tax money each year you can put away in your 401(k). But the limits are fairly generous: $22,500 a year in 2023. If you're 50 or more, you can make an additional $7,500 contribution taking your limit to $30,000 for the year. These limits are adjusted up almost every year so as you progress through life and career, you will hopefully earn more and more, and you have the opportunity to contribute more and more to your 401(k) before taxes.

If you ever need to withdraw the money before you are 59 1/2, then you have to pay a penalty on top of income taxes on the withdrawal. After 59 1/2 you just need to pay ordinary income taxes on the amount you withdraw, not on the (considerable) capital gains you would have made over the 15 or 25 or 35 years you have been putting money into the 401(k). A handful of states don't tax your 401(k) withdrawals either!

Think of your 401(k) as less of a savings account where your money sits around and more of a tax-advantaged brokerage account. You can invest the money too in a wide variety of offerings. Most 401(k)s also offer what are called target-date index funds which let you pick the decade in which you will retire: from the 2020s to the 2070s and over time adjust the balance of investments between stocks and bonds. When you are younger more will be invested in stocks vs bonds (about 90%/10%) and as you get closer to reitrement, the blend will switch to more bonds and less stocks (about 50%/50%) - all without you having to think about it. "Stocks" in a target-date 401(k) fund are often other index funds rather than individual stocks. Most (well-managed) 401(k)s will try to prevent you from doing harm to yourself by eliminating most speculative choices such as individual stocks. Most (in)famously, Enron let its employees invest their 401(k) dollars into Enron's own stock. For a brief period this seemed like a great investment as Enron doubled in under a year. But then, in 2001, when Enron went bankrupt, not only did Enron employees lose their jobs, they also lost some or all of their retirement savings! A truly terrible outcome. Do not put all your retirement nest eggs in one basket no matter how good an idea it seems in the moment.

Let's see what a 401(k) can do over the long-term. Not everyone can afford to put $23K away each year. So let's be modest. Much more modest. Say $10K a year. Further let's say that you add $500 each pay period which is $12K a year each subsequent year. $12K is slightly less than half of your maximum allowed contribution. In reality you may contribute less in the first 5-10 years of your career and contribute much more once you are in your 30s, 40s, and 50s. So the above is actually conservative. But let's stay conservative because there might be periods where you are between jobs or unemployed. If you do this $10K to start and $500/month for each subsequent year at the beginning of your career, say at age 25, then at age 65, 40 years of 7% growth (inflation adjusted) will result in your 401(k) account having over $2.5 million! I am not making this up - check it out for yourself.

The other most common retirement vehicle is called an IRA - Individual Retirement Account. You fund your IRA with post-tax dollars rather than pre-tax dollars as in a 401(k). However it grows tax free and as long as you withdraw after age 59 1/2, your withdrawals are also tax free (since your initial investment is post-tax)! This is a sweet deal. As long as you don't mind 'locking up' your money, the law let's you avoid paying any taxes as long as you follow the rules. There are limits to IRA contributions too. For 2023, these limits are $6500 if you are under 50 and $7000 if you are over 50.

For IRAs there are also income limits which is something to keep in mind if you are relatively well compensated. There is a vehicle called a Backdoor Roth IRA for high-income earners who would otherwise not be able to put money away in an IRA. There is a lot of fine print so you will do well to educate yourself or speak to a professional. Other than that, do what you can to max out your IRA contributions and invest them all in a low-cost passively-managed index fund and you are on your way to a nice nest egg.

Here's the big picture summary: between the 401(k) and the IRA, you can put away tens of thousands of dollars towards retirement each year. In exchange for waiting to withdraw till you are 59 1/2, your 401(k) and IRA both grow tax free. In a regular brokerage account taxes will claim a portion of the dividends you make every single year. In these retirement accounts they will grow untouched and compound towards an even bigger nest egg.

Other than retirement, the next long-term topic is how best to save for college.