ELI5: How does a 401k work?
In plain English, a 401k is an account you put money into that receives favorable tax treatment. Each year you can elect to contribute money to your 401k plan through payroll deductions. Elective deductions are usually specified as a percentage of your income, although some plans allow you to specify a dollar amount as well. The annual contribution limit is $17,500 in 2013. Do not go over this limit (some plans will not let you, and will simply stop accepting contributions once you reach $17,500).
401k plans come in two flavors:
- Traditional 401k plan contributions reduce your taxable income. This is known as tax deferral – you are not taxed on the money you contribute now, but will pay income tax on your contributions and your earnings at your marginal tax rate when you take distributions from your 401k in the future.
- If you contribute to a Roth 401k, contributions have already been taxed at your current marginal income tax rate. In exchange, all earnings may be distributed tax free if the distribution meets certain age and eligibility requirements. Note that not all 401k plans have a Roth option.
Which one do you choose? It depends on a lot of factors, but the big ones are:
- Income – High earners are usually better off contributing to a traditional 401k, as this allows them to avoid paying their current high marginal tax rate. Conversely, those with lower incomes usually favor the Roth option, as they can pay a low marginal tax rate now in exchange for never being taxed on that money again.
- Your guess about your future income tax rates – Those that believe they will be in a lower income tax bracket when they retire usually favor the traditional 401k. Those that believe they will be in a higher income tax bracket when they retire usually favor the Roth option. Those that believe income tax rates will rise across the board in the future usually favor the Roth option.
Money you contribute to your 401k must then be invested in the funds your 401k provider offers you.
ELI5: How should I invest within my 401k?
Once you have contributed to your 401k, you are still left with the somewhat daunting decision of how to invest within your plan. For better or for worse, 401k providers typically “help” by limiting your choices to a small number of mutual funds (after all, the only true freedom is freedom from choice, right?).
A good strategy that will serve anyone well is the 3-fund portfolio. In the 3-fund portfolio you aim to hold broadly diversified index funds in the three major asset classes: US stocks, International stocks, and Bonds. By investing in this manner you are instantly diversified across thousands of different securities, will never significantly underperform the market, and are mathematically certain to outperform most investors doing differently.
Identifying what asset class a fund belongs to can be challenging, especially if your 401k provider doesn’t break them out for you. Googling the fund name or looking up the ticker symbol on a website like Morningstar will usually make it obvious. If you’re not sure, ask /r/personalfinance (Reddit). Identifying which funds are index funds can be even more difficult, but in general index funds will have expense ratios that are much lower than the other available funds. The expense ratio is the annual fee you pay for the privilege of investing in the fund. A low expense ratio is the single best indicator of superior long-term performance. An expense ratio of 1.5% may not seem like a lot, but when compared with an index fund charging an expense ratio of 0.3%, that 1.2% difference compounded over 30 years will add up to tens of thousands of dollars in lost returns. Vanguard offers various tools to compare the costs of investing in high or low expense ratio funds (1,2).
Unfortunately not all 401k plans are created equal, and some fund selections are truly horrendous containing funds with expense ratios in excess of 1.5%. If this is the case for your 401k plan, consider campaigning for improvements. While you’re doing that, make the best of a bad situation and choose the lowest-cost funds in your plan. You could also consider funding an IRA before contributing to your 401k, however, if you are saving for retirement you should contribute to your tax-advantaged accounts to their limits before putting money in a taxable account with no tax advantages.
ELI5: Asset Allocation
Your asset allocation is how you divide your money amongst the various asset classes and the various funds you’ve elected to invest in. The literature on asset allocation is extensive – use Google if you want the nitty gritty details. Here are some basic rules of thumb:
- The core of your portfolio should be the three major asset classes – US stock index funds, International Stock index funds, and Bond index funds.
- A good starting point for determining your bond holding percentage is [your age]%.
- At least 20% of your stock holdings is recommended to be in an international stock index fund [Source].
- The younger you are, the more risk you can afford to take on in the form of higher allocations to stocks.
- Your asset allocation can and should change over time. A 25-year old’s investments will be very different than a 55-year old’s.
- Target date funds take the work out of asset allocation for you. Target date funds will automatically get more conservative as you age, reducing your exposure to major market movements as your ability to wait them out declines.
Some other frequently asked questions
1. My employer does not match my contributions. Should I still contribute to my 401k?
If your employer does not match contributions and you are looking to save money in a tax-advantaged account, most people will be better served with an IRA. However, the IRA contribution limit is $5,500 per year and has income limitations. If your income is such that you do not get the full tax advantages of an IRA, it is absolutely worth contributing to your 401k in order to save for retirement.
2. My 401k is crappy. Should I still contribute to it?
If your 401k has a poor selection of high cost funds, consider contributing to an IRA first. You can open an IRA with whoever you want, thus allowing you to choose which funds you have access to. If you have already maximized your IRA contribution for the year and still have money left over you want to put towards retirement, you should contribute to your poor 401k. The effect of high expenses really only starts to bite after long periods of time, and 401ks are quite portable in that you can roll them to your IRA if you leave your current employer, or sometimes you can roll it into a new 401k with a new employer. Bad 401k plans can turn into great IRAs in a heartbeat.
3. I want to retire early. Should I contribute to my 401k and lock up my money until age 59.5?
You should take advantage of the tax structure of the 401k for at least some of your savings, assuming you are planning to live past 59.5 years of age. Early retirement requires a lot of planning – you should project your needs before and after you’re eligible to take distributions from your 401k and plan accordingly.
From [arichi]: If you plan to retire before 59.5, but close to it – say, at 55 or so – you can use 72(t) distributions to access pre-tax money without penalty. If you do so even earlier, you can access it with a five-year delay via a Roth IRA conversion ladder, although you’ll still need the first five years’ expenses available via taxable accounts, Roth IRA contributions, and perhaps part-time work.
4. Pay off debt or contribute to my 401k?
If your employer matches any of your 401k contributions you should contribute enough to get the full match. This is free money that you should not leave on the table. After that, any high interest debt carrying interest rates beyond what you could reasonably get investing elsewhere should take priority. Remember that paying down debt offers something that only scammers can claim otherwise – guaranteed, risk free return!
5. I’m a young person and want to invest aggressively – why invest in bonds at all?
Bonds provide a source of funds to purchase potentially higher-yielding investments when they can be had at discount prices during market downturns, reduce your portfolio’s volatility, and usually offer a steady return themselves. On the technical side, there are numerous studies that show that 100% (or more) stock investors are not compensated in proportion to the extra risk they take on by doing so. While stocks have outperformed bonds over the long run to date, “past performance is not indicative of future returns.” Finally, the psychological/emotional effects of a severe bear market really cannot be appreciated until they’re felt first hand. It is one thing to say you’re OK watching half of your investment portfolio evaporate in a few weeks. It’s quite another to watch it happen for real and have the wherewithal to stay the course. Bonds offer some consolation in such a scenario.
6. What is a vesting period?
[By suggestion from dgmachine] Any contributions that come out of your paycheck are always 100% yours. However, if your employer provides any matching contributions to your 401k, occasionally they become yours according to a vesting schedule. A vesting schedule is essentially a time delay between when the money your employer contributes becomes “yours,” and is used as an incentive to keep employees with a particular company. Vesting schedules can take many forms – some schedule vesting in 20% increments (20% the first year, 40% the second year, etc.), some have a set amount of time (100% vesting after 3 years), others do not have a vesting period at all and the money is yours immediately. Your company’s HR section should be able to explain the terms of your company’s vesting schedule, if you have one.
Cite: This article has been contributed by aBoglehead — http://www.bogleheads.org/