Paying Less Income Taxes on your Money and Contributing to 401K up to company match is a No-Brainer
For many people including me, it can be intimidating to know that money put into a retirement account cannot be accessed easily till the age of 60. Then questions like: Whoa, do I need to think about retirement so early in my life? What if I need to make down payment for that new car or our home? What if there is a family emergency and I need liquid cash to pay for it? I am not even sure if I will stay in the US, so why lock up my money into something I won't even have access to?
Often we forget how much of our income is being drained away as taxes!Understanding ways of minimizing tax impact is crucial! You got to put money away for retirement irrespective of how young you are, as you will not be making money once you retire and with average life spans of humans increasing you need a retirement fund that will keep you going from 60 yrs to 80 yrs or even higher these days. In other words you need to generate a pool of money to pay for your living expenses for decades after you retire. Also remember the concept of compound interest. The more years you allow money to grow, the more rapidly it will snowball into a huge pile of cash later! If you had not put the money into a 401K chances are you would have spent most of it or would have paid income tax on it. So imagine with a 0.01% savings bank interest rate and on that you pay 20-30% taxes, versus not paying those taxes in a 401K and having money grow at 5-10% in mutual funds. Got to do the latter if you can!
In the early days, there were pension funds meaning that after retirement fixed percentage of your current salary was paid after retirement, so the benefits were fixed. Most employers today offer what are called 401K retirement plans. A 401K is an account where you can put away money into mutual funds, and since this money cannot be easily accessed till the retirement age (59.5 years), the government gives you tax benefits on these savings. In a traditional 401K account, you do not pay taxes now and only pay when you withdraw it.Employers sometimes encourage their employees to save in these accounts by matching employee contributions into these accounts up to a certain % of their income. So let us say you make 50,000$ a year as income. The company you work for matches dollar for dollar up to 4%, then every dollar you put up to 4% of 50,000 (2000$) is doubled by the company so you end up with 4000$ in your 401K.This is free money and one should always take full advantage of the company match, as it is a 100% interest rate instantly without a 20-30% tax levied on any of it.
Once you have taken full advantage of the company match, then try to keep track of what mutual funds are being offered for the 401K account at your work place. Try to pick a mix of low expense ratio growth type of mutual funds (expense ratio is a measure of the commissions and management fees for having those funds). Don't invest 401K money into your company stock as the goal is to diversify risk. Your career and time are already heavily invested in your company.
The secret again is to spread your money across multiple low expense ratio funds.
Stocks give much higher returns on investments than bonds, but bonds are not as volatile, so one rule of thumb is that % of money invested into bonds/bond funds in your retirement account equals your age. That way as we get older our retirement portfolio becomes less volatile. We will talk about index funds next where you can spread your money across hundreds or thousands of companies in the market through a mutual fund which is the ultimate diversification and risk reduction tool, and if the economy in general is a growing economy, like the US is over the long run, you always make money without getting blown out during temporary recessions!!
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