As I think back over the past several decades of our journey, one critical key that will help in providing a more secure financial retirement or for that matter allow you the freedom of FIRE is simply…. saving.
There’s much written about having the right asset allocation; the percentage of your assets that you hold in equities, bonds, cash, etc. Selecting just the right investment in your equity or bond portfolio is another big topic. Don’t get me wrong, they are important, however, the mere act of saving, repetitively, is the critical key.
It’s really the first step. You can’t move onto investing or asset allocation until you’ve saved some money. Saving has to be, at first, a determined conscience decision. Once a rythym is established, it just becomes routine with very little thought.
Getting started can be easy. There are several ways to save and for the remainder of this post, I’ll focus on employer retirement plans. In a later post, I’ll make suggestions on how to save without an employer sponsored plan.
Many have access to an employer retirement plan (401(k), 403(b)). If one is available to you and you haven’t yet enrolled, contact your Human Resource or Benefits representative and find out how to join. The benefits of using a employer sponsored plan can be phenomenal! A pre-tax contribution allows you to save for your future as well as save on your current taxes. In fact, pre-tax can allow you to save even more than you thought.
As an example, say you can afford to save $100 every week. Since you avoid paying taxes on the $100 going into the 401(k), your take home pay only goes down by $75. One way to look at it is you are saving $75 and the government is kicking in an extra $25!* Sounds like a matching contribution to me! And speaking of matching contributions, perhaps your employer contributes 50 cents for every dollar you contribute. That’s another $50 per week. So, in this example, you’ve committed to contributing $100, but you only have $75 deducted from your net pay while the government and employer contribute $25 and $50 respectively for a total of $150 per week or $7,800 per year. That’s a fantastic deal!
Wait there’s more! Recall that I wrote that saving pre-tax can allow you to save even more than you thought? Well, it can. If you knew that you could contribute $100 each week, due to the tax savings, only $75 would be netted from your check. If you increased to $133 per week, then, after taxes, your paycheck would be reduced by $100, the amount you felt you could afford. But if you’re now contributing $133, that means that the employer is matching $66.50 (a 33% increase!). $200 per week or about $10,400 is being invested into your account! You’re well on your way to FIRE!
As an aside, if your plan does offer a matching contribution, I urge you to contribute at least the amount that captures the maximum match offered by the company. It always saddened me to learn each year that many of my fellow colleagues left thousands of match dollars on the table because they either didn’t participant in the plan or contributed less than the maximum match amount.
To see the impact of the amount retirement funds you are giving up, consider the following example of a 25 year old making $40k and the employer matching 100% up to 5% of pay in the retirement plan. The employee doesn’t want to contribute 5% of pay or $2,000 a year to the plan (Roughly $38.50 a week or $28.90 net after the tax savings using the same tax rates as my previous example). Because the employee doesn’t participate, the employer doesn’t match the $2,000 each year and the assets don’t compound for 40 years. Finally, at age 30, the employee begins to contribute, but the damage is already done. The lack of saving for that first 5 years is astounding! The employee has $264,000 less in the accumulated retirement account.**
Don’t let getting caught up in selecting your investments slow you down on joining. Most plans have a default investment selection if you don’t choose one yourself. And of those plans, many will have a target date fund as the choice. It’s a perfectly good choice for you as you begin your savings.
Target date funds typically have a year in their name (2045, 2050, 2055, etc.). The year indicates when the fund becomes most conservative with the assets of the fund as it corresponds to approximately when you would otherwise retire (around 65 years old). For instance, if you’re currently 25 years old and you default into one of these funds, it would most likely be a 2060 target date fund. As you approach 2060, the fund slowly reduces its equity investments and increases its fixed income and cash investments. The slow transition from aggressive to balanced to conservative composition is often called a glide path.
Other default funds may include balanced funds (a mix of both equity and fixed income) or target asset allocation funds. In any case, as you are just starting out, don’t let this slow you down from participating. You can always change your investments later on when you learn more about investments.
Another feature many plans now offer is an automatic increase of your contribution. When you first join, you may be contributing 5% of your pay and then each January, the contribution rate increases by 1% until you hit 10%. This feature will typically raise the your contribution percentage at the same time you receive an annual merit raise, therefore making the increase in contribution to your retirement plan painless and easy. As an example, if your merit raise is 3% and your 401(k) contribution is increased by 1%, you still feel good because your paycheck went up by 2%.
If your plan doesn’t automatically do this but does offer the option to automatically increase your contribution rate, I highly recommend you take advantage of it. It’s a great way to painlessly increase your savings over time and to my point at the beginning of this post, create a routine that doesn’t require much thought.
To start the process of accumulating wealth, you have to start somewhere. The actual act of saving is key. Employer sponsored retirement plans allow you an easy way to begin. The government and many employers entice you with lower taxes and matches along the way. If you have access to a plan at work, by all means take advantage of it and explore the features that allow you to place it on auto-pilot and automatically increase your contributions painlessly and routinely.
In my next post I’ll explore saving outside an employer retirement plan and then later on I’ll post my thoughts on investing and asset allocation. In the meantime, if you participate in your employer plan, what features are available to you to save effortlessly?
Thanks for stopping by.
*I’m using a 20% Federal tax rate and a 5% State tax rate for illustrative purposes. Your federal and state effective tax rates will vary.
**The example assumes a 7% growth rate for the 40 years and that the employee receives a 3% raise during the first five years of employment.