Debt Free Living: Saving for Retirement

First, let’s do a quick review of The Baby Steps:

  1. Save $1000 as a starter emergency fund.
  2. Pay off your debts, smallest to largest. Pay minimum payments on everything except the smallest, and absolutely freaking kill the small one.
  3. a) Put 3-6 months of expenses away into a Money Market. This is your fully funded emergency fund.
    b) Save for a 20% down payment on a house, plus all closing costs and moving expenses, including all that furniture you want to buy.
  4. Invest 15% of your gross pay into retirement accounts.
  5. Save for your children’s education.
  6. Pay off the house.
  7. Put your former house payment into mutual funds.

Saving for retirement is Step 4. You shouldn’t be doing any retirement savings before finishing you’ve paid off all your debts and have a good emergency fund. If you were a renter when you started, you’ve put down 20% on a house or bought one outright. Now it’s time to save for retirement. This is where it starts to get fun.

Note: I am not a Certified Whatever Planner. Get a professional to help you out. Use what I have here as a starting point.

You want to start wherever you have a match. After that, you want to go for after-tax retirement vehicles and then pre-tax ones. Once you get to 15% of your gross pay (not your take-home pay), you stop. For now. When we get to Step 7, you max out everything you can.

Let’s talk a bit about pre-tax and after-tax retirement. In a pre-tax account like a traditional 401(k) or a traditional IRA, your contributions go into those accounts and are not hit with an income tax. So, if you make $50,000 a year and contribute 3% to your 401(k), the entire $1500 is deposited. If you also put $1500 in a traditional IRA, then you get a $1500 tax deduction (I think. I don’t use one, so I don’t have experience with how that works). Those investments are taxed when you pull the money out.

With an after-tax account, the contributions are made with after-tax dollars, but you’re not taxed again when you pull the money out. It grows tax-free.

Now, which would you rather pay taxes on? The smaller amount that you actually invested, or the giant amount you get at the end when you factor in compound interest? Charles Schwab has a great tool that shows you the difference. I encourage you to do your own research here, but you’ll probably come to the same conclusion I did. My father didn’t, because he was sure that the government would change their minds later and decide to double-tax the after-tax investments. That’s not really a rational exercise because if you follow that far enough then you shouldn’t be investing at all because the government will eventually go full-commie and take everything anyway. Some people do have that attitude, you know.

Anyway.

When picking investments, diversity is your friend. Single stocks are not diverse. Just ask former Enron or WorldComm employees about what happened when they filled their 401(k)s with company stock. Single stocks are too dangerous to rely on, but you can certainly play with them.

Mutual Funds are where it’s at, so that’s all I’m going to talk about here. Mutual Funds are basically collections of hundreds of different stocks. They are automagically diverse, but usually they invest in companies that are somewhat similar. You want to get several Mutual Funds so that you can diversify your diversity 😀

There are several different categories of Mutual Funds, and your information packet you get from HR or your investment guy will separate  the funds you can choose from into these categories. I usually pick the top performing fund from each category, as long as it is at least 5 years old. My preference is a fund that has better that 13% return over 30+ years, but you don’t always have that option. Investing is the long game, so only look at the lifetime returns. Who cares if the fund made 30% last year if it’s had a -50% return since 1992? More realistically, you might see a 3% lifetime return, and that is still terrible.

Your matching plans will come from your employer. You don’t get much choice here, but you will should get to choose among several mutual funds. You will likely be limited to the funds offered by the company your employer chooses to administer their retirement plan. For example, my choices are limited to about 30 of the over 7,000 mutual funds in existence.

There are two types of 401(k)s: Traditional and Roth. Both allow an employer match, and in both cases the match will go into a Traditional 401(k)  as a pre-tax investment.

If you get a traditional 401(k), contribute up to the match and then start funding a Roth IRA. If you’ve fully funded the Roth IRA, go back to the 401(k) and contribute more. Let’s go through an example of what this would look like:

Lets say you make $60,000 a year and your company matches the first 2% of your contributions. Fifteen percent of $60,000 is $9,000, so need to walk through our options until we hit that number. We start where we have the match, so there’s $1200. Next, we move to the Roth IRA. For 2011, you can contribute $5,000 to the Roth IRA. You fully fund that at $416/month. Now we have $2800 left that we need to invest, so we go back to the 401(k) and add another 4.7%.

You end up with 6.7% going into your 401(k) and 8.7% going into your Roth IRA. You also get an additional 2% put in by your employer as a bonus. We don’t count that in the 15% number because employers will sometimes decide not to match that period.

If your employer offers the Roth 401(k) option, take it. If you do, and the fund choices are excellent, and you don’t already have a Roth IRA, just put the entire 15% in. Otherwise, do the same thing here that we did for the traditional 401(k).

Those are the basics. Get with your local investment guy and start cracking!

4 comments to Debt Free Living: Saving for Retirement

  • GD

    re: 401(k) tax interaction
    You don’t get a “deduction” per say, but the money is taken from your paycheck prior to computing FIT, so it doesn’t contribute to your withholding. Additionally, when you do your taxes, it is not included in your net income calculation from your W2.

  • Chad

    “I usually pick the top performing fund from each category, as long as it is at least 5 years old.”

    You probably also want to look at the expense ratio when picking a mutual fund. What you pay in expenses is going to eat up your return over time.

    For example, if you assume a market return of 7%, a fund with an expense ratio of 0.2% leaves you with a return of 6.8%. A fund with expenses of 1.2% leaves you with a return of 5.8%. With compounding over 30 years, you end up losing a significant amount of money.

    Something else to keep in mind is that, over 30 years, no fund is going to outperform the market. (John Bogle, the founder of Vanguard, has done a lot of research on this — I want to think I saw it in Common Sense on Mutual Funds.) The best you can realistically expect is to match the market. This is why the expense ratio is so important — the larger the expense ratio, the more you’ll lag the market in real returns.

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