Wednesday, March 14, 2007

Essentials for the Working Stiff: The 401(K)

Gentle reader,

In case you haven't noticed, there are many companies that no longer offer a pension.

If you work for a company and they have never, not even once, mentioned that you are a part of their pension plan, then you probably work for one of those companies.

Of the few companies that remain that do offer pensions, some are going to go bankrupt. So they really don't offer a pension either.

If you are young and naive, you probably think you are going to live forever and you aren't too worried about your retirement.

However, I am here to tell you that you won't live forever and before you die there is a good chance that you will be too tired or sick to work.

In that case, you will need a supply of cold hard ca$h.

It is likely that the government will provide *something* to you in your old age (I am talking about what is currently known as social security).

However, the amount probably won't be enough to live on.

What is a financially well-informed person to do?

Well, the simple answer is: "Save Money".

The 401(k) plan (basically, a tax-deferred savings account) is probably the best way to do that, assuming you are eligible (i.e. your employer has such a plan).

There are a few reasons why it makes sense to put money into a 401(k) plan:

1) You are not immediately taxed on the money you invest in a 401(k) plan. In other words, you save the income tax for yourself instead of paying Uncle Sam.
2) The earnings (profits) you earn from investing that money is also not taxed until you start taking the money out.
3) Employers typically deduct money from your paycheck to go into your 401(k) plan on a regular basis. So, there is no additional "work" required on your part other than to keep your job. This makes it far more likely that you will accumulate a sizeable amount of money than if you had to actively mail a check each month. You are "paying yourself first".

The investments that are available in a 401(k) plan are typically mutual funds.

A mutual fund is a collection of many stocks all bundled together. When compared to investing in individual stocks, mutual funds are typically fairly "boring", because they move slowly as opposed to individual company stocks (think McDonald's, Disney, IBM, etc) that are more volatile. The "boring" factor is actually good thing: you are more likely to forget about them, and then wake up one day and realize that you are RICH!, or are well on the way.

I will take a closer look at how to pick from the different funds in your 401(k) plan in a later article.

The one thing to keep in mind is that, on average, stocks (and therefore mutual funds) increase in value over time, and over long periods of time (say, 30 or 40 years) often increase A LOT. I mean, a very lot.

The longer the time period, the more you are likely to gain. The bottom line:


How much should you invest in your 401(k) plan?

Before you even start to invest in it, think about the following because that will (or may) affect how much you can afford:

1) Do you own your own house? If not, would you like to own one? That is a reasonably good investment itself and it's worth putting your money there first if that is one of your personal goals/dreams.
2) Do you have an emergency fund that will allow you to live for 6 months if you were to lose your job today? If not, build up that fund and put it in something safe like an interest bearing savings account.

After thinking about 1) and 2), consider putting as much money into your 401(k) plan as possible, up to the maximum allowed yearly contribution (which is $15,500 for 2007).

The government is essentially offering you "free money" so take as much as you can get.

Note that I make this suggestion whether or not your company matches part of your 401(k) contribution or not.

If your company does contribute more free money, then you should definitely take advantage of that as well.

You (or your loved ones) will thank you later.

On to today's quote:

“He is richest whose pleasures cost the least.”
-Benjamin Franklin

Until the next time, gentle reader, I remain,

your friend,

Buford twain

[ Disclaimer: Not to be taken as financial advice. Think for YOURSELF at all times. ]

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