Investing 101 – The 401K

In the post Investing 101 – Before You Invest, I gave my thoughts on how I approach post-tax investing. Now I want to cover the other side, which is pre-tax investing in a 401K or similar plan.

Many workers are down big time in their 401K this year. Although it sucks to take a big hit on any investment, losing money in a retirement account isn’t quite the sting as losing the same amount of money in a post-tax account. I’ll explain.

Before you make or lose a dime in a 401K account, here is what you have going for you:

  1. Delay federal income tax on your contribution until retirement.
  2. Delay or eliminate state and local income tax on your contribution until retirement.
  3. Employer matching. Not every employee gets this, but it is a sweet deal. Your fund may be down, but because your company matched generously, your 401k may be still higher than your contributions.
  4. Money you don’t spend. It is far more difficult to spend 401k money early than anything you put in your checking account. Without this forced discipline approach many workers would just spend their entire paycheck.
  5. Protected in bankruptcy. If you file for bankruptcy, your 401K earnings are protected. If you are in financial trouble, resist the urge to dip into your 401K unless it really makes sense.

Post-tax investing is quite different.

  1. Already paid federal income tax on it.
  2. Already paid state and local income tax on it.
  3. No employer matching.
  4. Requires more discipline to not spend it.
  5. Not in protected in bankruptcy.
  6. As you make profits, you pay capital gains tax.

This is why although the dollar loss maybe the same, I feel far worse when it happens to my post-tax account. The money I lose in a post-tax investment is money I’ve already paid taxes on and delayed purchases with. So if your 401K is down this year, I hope this makes you feel a little better.

How do I approach 401K contributions? I max it out and max it out early. Because I always have at least 6 months salary in savings, I can direct the maximum amount into a retirement account. And if I decided to quit my job in May, I can leave knowing my 401K has been taken care of for that calendar year.

Let me give an example of maxing it out early. One of my employers did not implement a 401k plan until October. They graciously offered equal matching. While all the other employees were directing 5% of their paycheck toward the plan, I put the majority of my paycheck in it. Instantly doubling my money before the calendar year ended. I kept up the aggressive contributions into next year, quit my job in May and ended up with two full years of contributions in 8 months with matching. Sweet!

How do I invest in company 401K plans? That is a full topic in itself, but one of my beliefs is that risk in equities is much higher than is being represented by so-called financial experts. Anything you can’t afford to lose should be in fixed-income. Know your risk tolerance. Don’t reach for yield if you can’t stomach the loss, especially as you get closer to retirement.

The best thing about losing your job is you can move your 401K money away from your company selected plan and into a self-directed account. I really like TD Ameritrade, but there are other online brokerages. From this account I can buy and sell stocks or numerous mutual funds. Unlike an employer plan, your investment options are almost unlimited. You can even set up your account to trade options. TD Ameritrade offers investment classes and will help you pick funds if you need help. If you do ask for help, be honest with your risk tolerance.

In the post Mr. Financial Planner – Go Home and Get Your Shine Box!, I showed how the best performing fund offered by my employer yielded just 0.97%. Meanwhile, my TD Ameritrade account allowed me to invest in bear funds such as Prudent Bear and Grizzly Short, which had much higher returns.

This is getting to be a long post, so I’ll wrap up with a quick summary.

  1. Max out your 401K.
  2. Avoid borrowing against the 401K since it is protected in bankruptcy.
  3. Respect risk.
  4. Don’t get as bummed out when losses occur. At least you didn’t pay taxes on that money and often times half of it was free money from your employer.
  5. As soon as you leave a job, move your money into your own self-directed account, such as TD Ameritrade. Do not roll it into the 401K plan of your new employer.

Published by

MAS

Critical MAS is the blog for Michael Allen Smith of Seattle, Washington. My interests include traditional food, fitness, economics, and web development.