Monday, July 30, 2012

The Value of Index Funds: Part 1

I have friends who frequently ask me what's the best option for their 401k's. I've divided this post into two just because I want to take some time and explain everything fully. For those of you who don't know what this program is, let me elaborate. Up until about 30 years ago, company pensions were the chief mode of saving for retirement. In this scenario, companies would automatically deduct a certain amount of money from their employees' pay, and invest it for them (usually adding some additional money too). What was nice about this whole setup was that the employee was guaranteed to have some sort of income in the future when they retired. They were not tempted to spend their savings, because they never saw it. What was kind of annoying about these programs was that the employee really had no choice as to what their retirement money was being invested in. Often times, companies would mitigate risk by purchasing US Treasury bonds, etc... This allowed for only the bare minimum of interest to accrue in these plans. If the employ had been given this money and invested it wisely, they would have probably earned much more than what the pension was offering.

Along came 401k's and companies' desire to cut costs.  The basic 401k program involves the employee voluntarily selecting how much they want to remove from their pay (usually pre-tax) and putting towards a number of investments selected by the controlling company.  Usually, the company will match your investment up to a certain amount thereby providing some free cash for those who contribute.  401k's became preferable to companies, because they offered a much cheaper way to pay for retirement.  No longer would a company have to pay all the administrative fees and expenses in keeping a pension plan.  Furthermore, a company was "off the hook" for your retirement once they gave you the matching contribution.  It was up to you to determine how much was enough.  There lies the beauty of these plans; it offers each of us the freedom to control our own retirement destiny.

I mentioned earlier that your 401k contributions are tax free, however, you will have to pay tax once you draw funds in retirement.  This unfortunately, is the stink in the whole mess.  Imagine if you were a farmer and had to give up some of your seeds for taxes or some of your harvest.  Obviously, giving up your harvest is the more burdensome scenario.  Well, their is an alternative for those of you who happen to have a benevolent company; it's called a Roth 401k.  In this situation, your contributions are taxed and you get to withdraw your earnings when you retire tax free.  This is definitely the preferred situation!

If your company does not provide a 401k program (maybe it's too small), then you should open up an Individual Retirement Account (IRA).  It mimics the tax benefits of the 401k, but does not include a company match.  Additionally, you have a much wider choice of investments for an IRA.  Their is also a Roth version of the IRA for your financial amusement.

So, how much should I put into my 401k?

The most beneficial scenario is for you to put in at least as much as your company is willing to match (usually somewhere between 1 and 4%).  This will allow you to maximize the amount of company money going into your account.

Should I put in more?

This is a little trickier.  I think for most people out there, this is a good idea because it allows you to efficiently save for the future without having to do much work.  I however feel that if you are financially savvy and disciplined enough, you should instead use that additional money for your own investments and not be limited to the select provided by your company.

That leads us to the next question and the point of this mini-series: What investment should I put my money in?  Stay tuned....

Wonderful Moment of the Day: I'm actually knee deep in writing my first book which will be in the "e-book" format.  I just received my cover art today and am really motivated to finish up the second half.  The book is a conglomeration of much of the good advise that has gotten me through this world very successfully.  I'll let you know more once it gets closer to finish.

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