I was helping my daughter move into her new place a couple of months ago and struck up a conversation with one of her new roomies. As often happens (to me, at least), we wound up delving into a discussion about finance. In particular, whether she should fund her 401k. My reply was “Absolutely,” but - contrarian that I am - with a few caveats.
Fear and Loathing for Funding Your 401k
Here was her conundrum:
Fear: She didn’t want to put a bunch of money into the stock market and then have it drop 30 percent and wish she hadn’t. Yes, it’s true we’re perilously close to a bear market, meaning the major stock market indexes have dropped by 20% from their high, and often when they hit that mark, they will decline a bit more from there. Her fear is not an irrational one.
Loathing: It can be especially frustrating when you first hit the full tilt adulting/working world. Nobody told you you’d be living paycheck to paycheck. When under the patronage of your parent(s) or legal guardian(s), or even when taking those readily dispensed student loans for college, there was always easy access to money, or at least shelter, food and a place to do your laundry. But on your own, working without a safety net, the squeeze of daily living expenses eating up the vast majority of your available (i.e. post tax) income can be disconcerting. When someone suggests to you, “Hey, why don’t you drop your available income another several percentage points and put them in a “retirement” fund that you can start drawing from when you’ve turned 59 1/2?” It’s easy to see how one might loathe that idea.
There are a few other objections she didn’t mention, but that might apply to you:
59 1/2? THAT’S SO OLD! I don't even know if I’ll be alive that many years from now, so why even worry about it?
401k’s aren’t FDIC insured (true), so it’ll probably all be lost in the next financial depression.
The government will probably confiscate it before I can ever use it.
The Sixth Sense
Before we continue, I’m going to offer up my sixth investing principle: Be an optimist when it comes to investing in general and a pragmatist when investing specifically.
What does that mean? Let’s break it down: First, being an optimist in general. If you are going to be an investor at all - contrary to all appearances in the news and social media - you have to assume the financial world and society as we know it will continue to exist in some form similar to what we know now for your lifetime. If you can’t get yourself to this mindset, you will never be an investor, preferring to spend everything you make or to stuff your money in a mattress or what most incorrectly assume to be the virtual equivalent - a bank savings account.
Choosing to not be an investor will make achieving financial independence before retirement very unlikely, keeping you a debt serf for your entire working life, and may put you in a very bad position in the unlikely (hint: but actually more likely) event you should grow old and the economy/society hasn't collapsed. I’m not saying it can’t happen, but it would be prudent to plan as if it might not happen. Be optimistic that the financial market and society will be there as you know it.
But let’s go there for a moment. Let’s consider the scenario that the economy craters and/or the nation ceases to exist. They’re hardly novel events. It’s happened many times in human history, and even a time or two somewhere in the world in your own lifetime. Just not here. If we experience a total economic failure or country dissolution - short of planning to become a warlord or his financier (moves I don’t recommend for afterlife spiritual reasons) - you would likely lose everything anyway. However, if you gain enough knowledge and become financially independent, you might get opportunities to invest outside the US as a backup plan to such an event before it happens. So, be an optimist. Be an investor and hope for the best.
Okay, so what about that second part?: Being a pragmatist when investing specifically. Understand that in every economic condition - good or bad - there are some investments that thrive and others that fail to the point of dropping to zero (or even negative) value. Case in point: there are many today who would assume investing in fossil fuels would be a bad idea. They’re wrong (and I’ll detail why in a future post), but I could see how they would think so. But maybe I’m wrong and they rightly choose not to invest in it because fossil fuels will soon become a relic of the past.
Investing in relics - or soon to be relics - is generally not a good idea unless you dabble in the collectibles space or have some specialized understanding of where these assets are going. In fact, in difficult financial conditions, which we are most certainly in, one needs to be prudent with what specifically they invest in. Anyone who invested in typewriter manufacturers when WordPerfect was flying off the shelves clearly didn’t do their homework. Today, even investing in stock market index funds is not a given (however, the discussion below explains why it might make sense in your 401k).
Proceed in each investment as clear-eyed as possible. Don’t let fear or greed push you into unreasonable conclusions. When things look especially bad or especially good, look for the gaps between reality and perception since (per investing principle #1) there are always fantastic investing opportunities to be had.
About Funding that 401k
That brings me back to why I advised my daughter’s roomie to invest in her 401k with some caveats. Most companies offering 401k’s also offer a corporate match. What does that mean? It means for every dollar you save in the account up to a specified percentage of your gross income, they will match it with additional money. So, if your employer says we will match 50% of the first 6% that you save in your 401k and you earn $50,000 per year, if you save $3,000 (being 6% of your income) in the 401k, the company will add $1,500 (50% of your contribution) to the same account. On day one of saving that money, you now have $4,500 where you had deposited $3,000. A 50% gain on your money instantly. Not bad!
It gets better - Most companies sweeten the deal as your tenure with the company increases. At one company I worked for, after 10 years they matched over 100% of your first 6% of 401k contributions.
Down 30 but still up! - So let’s say my daughter’s roomie was right about the market dropping 30% right after she put the money into the 401k. With the match, her $3,000 + $1,500 ($4,500 total) dropping 30% would leave her with $3,150, still more than she put in after a severe decline. Since the money is put in one paycheck at a time, you dribble the money into your account, and the match is the same each and every time, so if the market drops 30%, you start buying stocks at a lower cost, and the company adds more buying power to each and every purchase at that lower cost. It’s as close to a no-lose situation (remember to be an optimist in general!) as you can find in investing.
We’re in one giant boat together - And while there are always going to be the risk of a total market collapse or government confiscation, those conditions would affect every investment type there is within the confines of the country, so unless you’re ready to go global in your investing plans (not out of the question, but hardly the realm of novice investors), be an optimist in general.
Legal advantage, you - One less understood but meaningful benefit to funds held in retirement accounts is their superior legal protection from judgements against you, including bankruptcy and civil judgments. So if you were to be in an at fault accident with inadequate insurance for the harm done and a large civil judgement is levied against you, they could drive you into bankruptcy and take most of your possessions, but they cannot touch your retirement savings.
More still in your pocket than you think - If you invest your funds in a pre-tax retirement account, your net income will not drop by the amount invested, but by the amount invested less the taxes you’d normally pay on the earned income, but now don’t because it is going into a tax deferred account. Tax deferred meaning you are not taxed on the money now, but instead when you pull it out of the account in retirement.
Except when going the Roth route - There is an option of an account called a Roth 401k where the money is taxed when it goes in, but is not taxed when it comes out. If contributing to this type of retirement account, your available income will drop by the same amount contributed.
Ways to spread your risk - Finally, since you have a choice of funds to invest in (true they are usually all tied to stock and bond markets - somewhat of a drawback). You can spread your investments across a range of company sizes, geographic regions and industries. You can alternatively put your funds into an ultra-conservative money market or generally more stable bond fund. When there’s a match, you get it no matter what fund in the program you decide to invest in.
The markets aren’t going away - It is reasonable to expect that these markets will continue to exist as long as publicly traded corporations exist, and trust me, nothing short of the apocalypse could eradicate publicly traded corporations from the planet!
The Caveats
There are a few important caveats to investing in a 401k:
If there is no company match, while there are still the other advantages I’ve outlined above, it is no longer a no-brainer to invest your money here. The down side of traditional retirement accounts is that you cannot shift these funds into any kind of investment you like. Once there, they are tied up in the 401k until you no longer work for that employer.
At that time, you can roll the funds into a traditional Individual Retirement Account (IRA), which will grant you more investment options than a 401k, but these funds cannot contribute to you achieving financial independence before retirement unless you take an income tax hit and 10% penalty in addition to move it to an investment opportunity outside of retirement (this is not the case for Roth accounts).
When there is no employer matching, a better choice may be funding your own personal IRA instead. You can still fund it with pre-tax money (or as a Roth IRA) but have access to a much wider range of investments, including industry or asset specific ETF’s, Real Estate Investment Trusts (REITs) and a few other specialized types of investments as you become a more sophisticated and capable investor.
Where there is a company match, try to maximize the opportunity according to their offering, but the 401k managing company will encourage you to save even more in their account, as much as 15% of your income. I do not recommend those in search of financial independence before retirement do so. Instead maximize the match. If the offering is matching 50% of the first 6%, save 6% of your income in that account.
Then save additional funds (I’d say as much as 10-15% or more as you are able to manage it) in non-retirement accounts that will allow you to shift this money into productive assets that can earn you income now whenever the opportunities come along. Unless you save funds outside of retirement accounts, you will have great difficulty finding ways to acquire productive assets
Whether to fund a Traditional 401k or a Roth 401k requires some thought. You can change how your contributions go into these accounts whenever you want, but there are several factors afeecting your journey to financial independence that may influence your decision to go Traditional versus Roth in retirement savings.
In my next post I’ll dive into how Traditional and Roth retirement accounts can impact your journey to financial independence.
Until next time, may peace and prosperity be with you.
The Natural Economist
Next up: Traditional or Roth Retirement Accounts…the Tradeoffs of Pre-Tax vs Post-Tax Retirement Accounts.