Getting Started: Save in a 401k

OK, we’ve started tracking our finances, got a handle on our expensespaid down debt, and saved up a cash cushion. What’s next?

The next typical step to take is to begin saving for the long-term and the most efficient way to do that is to use a tax advantaged account like a 401k.

Why a 401k?

Simply put, stashing cash in a 401k is a triple whammy of effectiveness. First, you’re saving for the long-term in investments which should generate higher returns. Secondly, many employers will match some of your 401k deposits – which is FREE MONEY! Third, it lowers your taxable income, thereby lowering your state and federal income taxes.

If your employer matches 401k contributions, you should be taking full advantage of that match and saving at least enough to get the full match. If you do not you are literally refusing free money. A guaranteed 100% return!

Even without an employer match, 401ks offer the advantage of lowering your taxable income. This depends on your effective tax rate, but typically means you’re getting ~17% savings on the amount you invest.

Mad Fientist has a great article on the topic showing the relative worth of money pre-tax, post-tax, and in tax advantaged account. Of course I also touched on the topic of earnings getting depleted by taxes as well.

 

What Should I Put it In?

Well, we’ll discuss investment options in greater detail later on but investing any money in a 401k is better than none at all because you don’t know where to put it. Most employer 401ks aren’t very good and won’t give you too many options to select from.

The ideal is to place the money into an index mutual fund if they offer one, or failing that a “target date” retirement fund that matches your expected retirement date given your age (not necessarily your own expected early retirement date, use the traditional “retire at 65” to match the date). Index funds tend to give a good return with built in diversification across the US Stock market and relatively low fees. Retirement date funds offer a blend of stocks and bonds that shifts from aggressive to more conservative as you age, which is what most advisors recommend. You tend to pay slightly higher fees as the tradeoff.

The thing to remember her is that contributing is the most important step. You can always change your mind about what funds to invest in and transfer balances inside the 401k later once you’ve done more research.

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