About 59 million Americans are making the biggest mistake possible when it comes to finance... They turn down free money.
The U.S. Census Bureau reports that about 79% of Americans work for a company that offers a 401(k) retirement savings account, but only 41% of these people participate.
This is a huge mistake. Investing in a 401(k) is the No. 1 financial decision everyone should make.
As for that free money, here's how it works...
A 401(k) allows you to sack away pre-tax money to save for your future. And employers often match contributions up to a certain level. At my company, I make an instant 50% on the first 6% I save because the company offers a 3% match. It's the best investment I make every year.
Take someone earning $4,000 a month before taxes. She can contribute $240 on her own (6%) and receive $120 from her employer (3% match). As a result, she'll save $360 a month.
Even if her employer didn't match contributions, she'd still get a nice tax saving since her 401(k) contributions come out of her paycheck before taxes. So if she's in the 25% tax bracket, she effectively saves $60 (her $240 contribution times her 25% tax rate). Her take-home pay is then reduced only by $180 because of that tax savings.
That means she gets $360 for $180... doubling her money on the first day. Plus, it grows tax-deferred as well. No other investment can make that kind of money so fast (with so little risk).
You will pay taxes when you withdraw money from your 401(k). And if you take money out before you're 59 and a half, you'll have to pay an additional 10% penalty.
But having a 401(k) is one of the easiest ways to grow your wealth.
Just remember these two rules:
1. Always max out your contributions. For example, if your employer matches up to 6% of your annual salary, contribute at least 6% to your 401(k). Take advantage of that free money.
2. Don't withdraw early. One of the benefits of having a 401(k) is letting your money grow tax free. Some 401(k) plans allow for what the IRS calls a "hardship distribution" that may let you avoid the 10% early withdrawal penalty. A hardship is an "immediate and heavy financial need," such as medical and funeral expenses or the funds necessary to prevent an eviction.
How to Invest With Your 401(k)
The investment options offered in a 401(k) plan vary by employer, but one of the simplest investments is a stock index fund.
Index funds track a market, like the S&P 500, and don't try to provide excess returns. And since they aren't actively managed, they charge astonishingly low fees. Some are nearly free.
The Vanguard S&P 500 Index exchange-traded fund ("ETF"), which trades under the symbol "VOO," charges just 0.04% a year in fees. That means for every $1,000 invested, you pay just $0.40 a year. The average ETF, which includes those that are actively managed, charge about 10 times that. It really adds up over time.
To get started, set up an automatic account to deposit your contributions and buy shares every month or quarter. (Don't buy too often, or you'll pay more in commissions.)
Since you're fully invested in the stock market, your wealth is going to bounce around. Over the course of the financial crisis in 2008 and 2009, you'd have seen your savings drop by 56% over a little more than a year.
That can be scary, so don't even check your balance. As a stockholder, you're a partial owner of hundreds of profitable businesses. That tends to build wealth over time, even if it's volatile in the short term.
If I told you that you could have an account where you could put $1 in today and immediately have $1.50, and then you can build on it for 30 years tax-free, would you do it?
Of course you would... That's the best return on investment you could ever achieve. And virtually all of us have access to that deal.
So make sure you always contribute to your 401(k) and maximize your employer match. We'd recommend starting your 401(k) even if you've got a little credit-card debt and before really tackling your student loans – at least up to the employer match.
It's free money. And I don't know anyone in his right mind who would turn down free money...
What We're Reading...
- Something different: The first ever picture of a black hole.
Here's to our health, wealth, and a great retirement,
Dr. David Eifrig and the Health & Wealth Bulletin Research Team
April 11, 2019