August 29, 2023

First Job, Now What?

When you get your first job with benefits, you normally are not making a lot of money. So, how can you afford to save for retirement? I say, how can you afford not to?

I remember thinking, I’m scraping by, how can I save for retirement? Since most companies offer some type of matching benefit, that is a 100% return on those funds. If you are making $30,000 and your company matches 4%, that means for the first $1,200 that you contribute, the company will double that; so, your retirement account will receive $2,400 a year. Essentially, the company gives you a 4% raise if you choose to contribute to your 401K.

Since 401K contributions are based on pretax money, the $1,200 that you are contributing — if you are in the 25% tax bracket — is $900 out of pocket that you are “missing” from your paycheck. This amounts to approximately $75 per month. Alternatively, if you are paid every two weeks, it is about $37.50 per paycheck.

Now think about your raises as an opportunity to increase those contributions. For instance, if you are given a 4% raise, consider upping your 401K by 2%. In essence, you are effectively giving yourself a 2% annual raise while simultaneously saving an extra 2% for retirement. These are funds that you never previously had or were accustomed to spending. As your career progresses, these incremental additions could accumulate significantly.

Contributing when you are young can help establish a path towards achieving a comfortable retirement status by the time you retire.

Here are a couple of illustrative examples.

  1. Individual 1 starts to invest at age 19, consistently putting $2,000 per year to their 401K until age 27 (8 years). At age 27 they stop adding money to their 401K until retirement age of 65. With a presumed 10% rate of return, this strategy could yield $1.02 million by the age of 65.
  2. On the other hand, individual 2 starts to invest at age 27 and puts $2,000 a year until they turn 65 (38 years). Despite contributing for over 30 years longer, with a presumed 10% rate of return the outcome would yield $805,185.

The disparity is driven by the power of compound interest. To delve deeper into compound interest and its impact on investments over time, I recommend exploring my article titled The Importance of Saving Young.

Choosing Your Investments 

The majority of 401Ks do not permit the direct purchase of individual stocks. Instead, they typically offer two primary options: Exchange Traded Funds (ETFs), which track a diversified group of holdings representing broad market segments or Mutual Funds, composed of individual stock holdings determined by a portfolio manager.

Historically, the average annual return of the stock market has been around 10% over the past century, that includes both upward and downward trends according to Investopedia I believe it is crucial to keep in mind that the funds in your 401K are for the future, so short-term market fluctuations shouldn’t overshadow your long-term goals.

When approaching investment decisions in your 401K, I believe it is important to examine the 5-and 10-year return numbers for each portfolio option.

Here are two approaches.

  1. The Simplest Option is to pick Target Date Funds: depending on your individual circumstances and risk tolerance, these can be a good option for initial setup. They automatically adjust their asset allocation – mix of bonds, equities, and cash- as you approach retirement. This shields you from common errors such as over concentrating in one asset class, chasing past returns, or letting emotions dictate your investment strategy. Keep in mind that not all target date funds follow the same pattern so researching each funds adjustments in equities, bonds, and cash over time is essential.
  2. Mutual Funds/ETFs: Most 401K plans provide information for the funds that they offer. Constructing a diversified portfolio based on 5-and 10- year performance records help you avoid chasing past returns. Your portfolio should contain a blend of stocks, bonds, and cash distributed across various sectors, sizes, and styles, encompassing different risk levels from conservative to aggressive. Thoroughly researching the available funds is vital since not all funds are created equal. Morningstar’s mutual fund ranking system offers a valuable tool to compare funds and access their performance relative to peers.

I believe it is important to review your 401K often so I recommended reviewing the investments at least 2 times per year. Most 401K providers provide educational resources and guidance to help you when making these decisions.

Rather than allowing uncertainties to deter you from starting to save for retirement, approach it as an opportunity to shape your desired retirement lifestyle. Time may be your greatest ally when planning for retirement.

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