Wed 23 Jan 2008
I received the following e-mail and hope that this can be helpful to others. If you have any financial questions, please feel free to write me at email@example.com
I need some financial advice. So I just graduated from college and I am one of the few people that care about saving up for retirement. My company matches the first 6% of my 401(k) contribution. So obviously I want to put at least 6% in there. However then I am not sure what to do. Before I graduated, I always took 10% of my paychecks and put them into an ING savings account. But I feel I can do something better with my extra money. Where should I put it? Put more in my 401(k)?
Also, whats better for my 401(k): before-tax and after-tax contributions?
First, congrats on saving for retirement and managing to save additional income rather than enter the world of debt. Putting enough money into your 401K plan for the company match (6% in your case) is the best first step towards early retirement . Since the company match provides you with an immediate 100% rate of return on your investment, it will contribute greatly towards your growth in net worth and standard of living once you leave the workforce.
What to do after getting the 401K match depends on your situation but here is what I would recommend.
-After getting the full 401K match, focus on making contributions to your ROTH IRA. All contributions to your ROTH are after tax and once into a ROTH account, will never be taxed again if you leave those funds untouched until retirement. You can contribute $4,000 for 2007 until April 15th 2008 and your contributions for 2008 can be up to $5,000. If your focus is to build your retirement accounts, there is no better way to do this than in a ROTH IRA.
-Once you are fully funding your ROTH, you can opt to put more money into your 401K. If your company offers a ROTH 401K (funded with after tax dollars) you should contribute to it. As with a ROTH IRA, contributions are made with after tax dollars and are not taxed again as long as you don’t withdraw funds until retirement. I cover more about ROTH IRAs in this posting : Year Review : ROTH IRA Contributions If you don’t have the ROTH 401K option, additional contributions to your 401K are also an excellent route.
-Once getting the 6% company match and funding your ROTH IRA, you are saving more for retirement than most other individuals in the world. It might them make sense to focus on building taxable account assets so that you can enrich your lifestyle before you reach retirement . You could open an account at Schwab, Sharebuilder, or other brokerage account and start learning about investing in stocks. I would recommend getting a subscription to Investors Business Daily, Forbes, Smartmoney, or major financial publication that can help you to learn about strong investments to help you build your net worth.
Your strongest choices in my opinion are to focus on the ROTH IRA contributions and go from there with whatever fits your long term goals.
One’s choice of what to do with your free cash flow after the 401K match can vary and may depend on the following.
-do you have any other debts?
-do you have some money set aside for emergencies?
-Where do your priorities lie regarding your long term goals? (Home purchase, additional retirement contributions, or building money in taxable accounts for future spending before retirement)
If you have any other debts, it could be in your immediate interest to focus on paying down debt. If you choose this, focus on credit card debt, personal loans, or any form of high interest debt that isn’t a college loan or a mortgage payment. (Since interest payments on these are tax deductible and other forms of investment would give you a better rate of return.)
This isn’t always the case though, if you are eager to get the ball rolling early on your retirement, you might place this as a focus before paying off debt. With the current availability of very low interest balance transfers, a case can be made for the choice of carrying manageable debt levels while choosing to make investments that will yield a higher rate of return. This is the choice I made in The Importance of Saving for Retirement. (I recently re-transferred all of my remaining credit card debt to a Chase credit card on a balance transfer that charged no fees and will charge me 0% interest for 15 months from a 12 month Washington Mutual card offer that was charging me 4%.)
You mentioned that you had been putting 10% into a savings account before graduation. If you are continuing to do this, GREAT! Having a decent cash cushion is important in case an emergency comes up like unemployment, car repairs, or any case where you are facing a cash crunch. While many financial professionals recommend saving anywhere from 6 months to two years of expenses in an emergency fund (and this should be your ultimate goal) I don’t agree with this approach for young individuals just starting out. Putting away 5% of your income into a savings account (like ING or Emigrant Direct) is a great start towards building your emergency fund. It will take a while until you have a large amount of cash and should a drastic life event cause you to need cash quickly, you may end up falling back on credit cards for a short time, but the priority of building a large emergency fund may not be your focus when you are at a young age where you can put more of your income towards investments with a higher rate of return. Start out trying to save at least $1,000 and continue to build your emergency fund to a point where you feel comfortable.
-Make sure you have a budget! If you don’t have a budget, the possibility that you are spending money where you ’shouldn’t be’ or not effectively managing your cash flow is greatly increased.
There are many free budget templates out there, here are a few.
-Set goals for yourself. If you don’t have a goal, how can you measure your progress? I try to set my goals as high as possible so that I can challenge myself. High aspirations can drive you to do things you wouldn’t normally think possible.
There is a lot of information out there about what you should do to become financially successful, index fund investing, real estate, growth investing, REITs…the truth is that there are many ways to become financially successful and everyone’s path is going to be a little different since we all have different needs, goals, and risk tolerance. While I don’t have ‘the best’ plan out there, I’m trying to learn as much as possible and in the end, the desire to learn and better yourself is going to contribute a lot more to your eventual success than a couple pointers. Never stop learning.
Good luck Jay!