“THEN YOU CAN log in to the benefits portal and learn more about how to set up your 401(k) as well as your pre-tax transit card and health savings account.”
I smiled tightly and nodded at my new manager as if I had any idea what she’d just said to me. The term 401(k) sounded familiar, but those other two terms meant nothing. I made a mental note to call my parents after work and ask what those were and if I should use them. Then I returned my attention to the piles of starting-day paperwork and informational videos on office safety (even though the biggest threat I faced was a paper cut in this open-floor-plan public relations office).
A couple weeks later, I finally got around to evaluating my benefits package. The retirement package one-pager outlined that I’d get up to a 4 percent match from my employer and that the contribution would be vested immediately. There were two options: Roth and, from what I could tell, not-Roth.
Still a bit dazed from all these terms, I created a profile in an effort to be an adult and figure it out myself. That’s when I found myself confronted with a scrolling list of investment options featuring names like large cap, small cap, and Dodge & Cox®.
Nope, this wasn’t going to get figured out solo. So, I did what any enterprising twenty-three-year-old would do. I called my dad.
Surely his thirty-plus years in the business world would mean he could translate these terms into regular English, I thought to myself.
I was sort of right. He knew how to help me set the account up, but the man was so far along on his own investing journey that his attempt at simplifying the process still felt too complicated. But he did give me advice on which funds would create an aggressive portfolio in a Roth 401(k), given my long-term time horizon and, at the time, very low tax bracket. (It’s okay if that last sentence overwhelms you. It meant little to me at the start of my investing journey, too.)
SAVING FOR RETIREMENT is not just important, but arguably it should be your first investing priority because:
It helps lower your tax liability either today or in retirement.
You’re (possibly) getting free money from an employer.
It can easily be automated, so building your nest egg is habitual, with minimal effort from you.
You’ll eventually want to achieve financial independence and be able to walk away from the need to earn a paycheck.
If you’re not saving for retirement yet, I’d like to point back to the example of Stacey and Jake in the introduction. Jake tried to catch up to Stacey after waiting ten years to start contributing to his 401(k). Stacey contributed only 4 percent of her salary in order to get the employer match. Jake contributed 10 percent, more than double what Stacey did, but he was still $100,000 behind her when they both retire at sixty-two.
Now, allow me to momentarily stay on my soapbox a bit longer and refer you to the following scenario and table to explain why it’s imperative that you start now. Like, “Put this book down after my rant and go sign up for your 401(k) or open an IRA” kind of now.
Assume twenty-one-year-old Kim saves $300 per month (or $3,600 per year) from now until she retires at age sixty-eight and receives a real rate of return of 4 percent. She would have approximately $500,000 at retirement. If Kim waits ten years to start saving, at thirty-one, she would need to save approximately $500 per month (or $6,000 per year) to achieve the same balance at retirement.
|
Assumptions: |
|
Real Return 4.00% |
|
Savings Annually |
Savings Monthly |
Balance after the following number of years |
|||||||
|
1 |
5 |
10 |
15 |
20 |
27 |
37 |
47 |
||
|
$1,200 |
$100 |
$1,200 |
$6,700 |
$14,800 |
$24,700 |
$36,800 |
$58,400 |
$101,800 |
$166,500 |
|
$1,800 |
$150 |
$1,800 |
$10,000 |
$22,200 |
$37,000 |
$55,200 |
$87,600 |
$152,700 |
$249,800 |
|
$2,400 |
$200 |
$2,500 |
$13,300 |
$29,500 |
$49,400 |
$73,600 |
$116,800 |
$203,600 |
$333,100 |
|
$3,000 |
$250 |
$3,100 |
$16,600 |
$36,900 |
$61,700 |
$92,000 |
$145,900 |
$254,500 |
$416,400 |
|
$3,600 |
$300 |
$3,700 |
$20,000 |
$44,300 |
$74,100 |
$110,400 |
$175,100 |
$305,400 |
$499,600 |
|
$4,200 |
$350 |
$4,300 |
$23,300 |
$51,700 |
$86,400 |
$128,800 |
$204,300 |
$356,300 |
$582,900 |
|
$4,800 |
$400 |
$4,900 |
$26,600 |
$59,100 |
$98,800 |
$147,200 |
$233,500 |
$407,200 |
$666,200 |
|
$5,400 |
$450 |
$5,500 |
$29,900 |
$66,500 |
$111,100 |
$165,600 |
$262,700 |
$458,100 |
$749,500 |
|
$6,000 |
$500 |
$6,100 |
$33,300 |
$73,900 |
$123,500 |
$184,000 |
$291,900 |
$509,000 |
$832,700 |
|
$6,600 |
$550 |
$6,700 |
$36,600 |
$81,300 |
$135,800 |
$202,400 |
$321,100 |
$559,900 |
$916,000 |
|
$7,200 |
$600 |
$7,400 |
$39,900 |
$88,600 |
$148,100 |
$220,800 |
$350,300 |
$610,800 |
$999,300 |
|
$7,800 |
$650 |
$8,000 |
$43,200 |
$96,000 |
$160,500 |
$239,200 |
$379,400 |
$661,700 |
$1,082,500 |
|
$8,400 |
$700 |
$8,600 |
$46,600 |
$103,400 |
$172,800 |
$257,600 |
$408,600 |
$712,600 |
$1,165,800 |
|
$9,000 |
$750 |
$9,200 |
$49,900 |
$11,080 |
$185,200 |
$276,000 |
$437,800 |
$763,500 |
$1,249,100 |
|
$9,600 |
$800 |
$9,800 |
$53,200 |
$11,8200 |
$197,500 |
$294,400 |
$467,000 |
$814,400 |
$1,332,400 |
|
$10,200 |
$850 |
$10,400 |
$56,500 |
$12,560 |
$209,900 |
$312,800 |
$496,200 |
$865,300 |
$1,415,600 |
|
$10,800 |
$900 |
$11,000 |
$59,900 |
$133,000 |
$222,200 |
$331,200 |
$525,400 |
$916,200 |
$1,498,900 |
|
$11,400 |
$950 |
$11,700 |
$63,200 |
$140,400 |
$234,600 |
$349,600 |
$554,600 |
$967,100 |
$1,582,200 |
|
$12,000 |
$1,000 |
$12,300 |
$66,500 |
$147,700 |
$246,900 |
$368,000 |
$583,800 |
$1,018,000 |
$1,665,400 |
Table courtesy of Vanguard.
Compound interest. She’s a beautiful, beautiful thing—when she’s on your side. She’s a real bitch when it comes to paying off debt.
A 401(k), 403(b), or IRA is often a person’s first experience with investing. But just figuring out how to pick investments in a 401(k) can be dizzying, as I mentioned in my own experience. The paradox of choice can leave you frozen, akin to logging in to Netflix with the intention of finding a new show to watch and then defaulting to that same series you’ve watched all the way through at least four times.
Colleen Jaconetti, CFP®, a senior investment analyst for Vanguard Investment Strategy Group, explains the three simple steps you should take when setting up your first retirement plan:
“At least try to save up to the point where you get the employer match,” advises Jaconetti.
“It’s important to know what your time horizon is. Young folks will probably have a much longer time horizon, and generally speaking, the longer your time horizon, the more likely you can incur some kind of risk. Obviously, it’s a personal decision, and people need to gauge their comfort with risk,” says Jaconetti.
“I would recommend, if possible, for people to consider an all-in-one fund. They could have a balance of stocks and bonds, or some funds (like lifecycle funds) that would get more conservative through time. Those funds also rebalance themselves, so an important thing when you’re figuring out what asset allocation you’re comfortable with is sticking to that allocation through time. Generally, we would say people have to rebalance, but if you pick an all-in-one fund, you wouldn’t have to worry about rebalancing. The fund would do it for you. If you pick a fund that becomes more conservative through time, then you don’t have to consider when you want to become more conservative.”
I should jump in here and mention that some financial advisors rail against the all-in-one fund (also known as the target-date fund). Historically, target-date funds have come with higher fees than when building your own portfolio, and in some cases, investors could find themselves invested at a risk level that doesn’t align with their tolerance when nearing retirement. While the criticisms are all fair, the advantage of a target-date (aka all-in-one) fund is that it gets you started. It removes the overwhelming paradox of choice and makes sure your retirement money is invested in a manner that’s somewhat aligned with your time horizon. Besides, you can always jump back into your portfolio in the future and rebalance or build your own once you’re more confident in picking your own investments.
“It’s important to consider cost. It’s not the most important factor, but it is a significant factor to figure out over the long term that every dollar you pay in fees is a dollar less you have for yourself or for future growth,” says Jaconetti. “Some funds can charge higher fees, which just eats into the amount you have in retirement.”
In chapter 6, we’ll give a more comprehensive overview of fees, how to understand them, and the impact they have on your portfolio.
Now that you’re convinced you must contribute to a retirement plan (or you’re feeling smug about your decision to already do so), let’s chat about those retirement-specific terms you should know that I promised to overview in chapter 2.
401(K) AND 403(B): Both 401(k)s and 403(b)s are retirement savings plans, typically offered by an employer, but 401(k)s are offered by for-profit companies and 403(b)s by nonprofits. Your company may offer only a traditional 401(k) or 403(b), but some, like my former employer, offer a Roth option as well.
TRADITIONAL: Investing with pre-tax dollars up to the annual limit. You have the potential to lower your taxable liability today by contributing to a traditional retirement plan.
ROTH: Investing with post-tax dollars up to the annual limit. The Roth 401(k) doesn’t give you a tax advantage today, but you do get to withdraw the money tax-free in retirement.
You can generally invest in mutual funds, index funds, ETFs, company stock, bonds, and other forms of investments in your 401(k) or 403(b). Employers sometimes contribute to an employee’s retirement plan, known as an employer match. You usually are required to contribute to the plan yourself in order to get the match from your employer.
EMPLOYER MATCH: One of the few terms that is just exactly like it sounds. Your employer puts money into your retirement plan, matching your contribution up to a certain percentage, but usually on the contingency that you contribute as well. For example: “We match you 100 percent up to 4 percent.”
Say Hillary earns $40,000. In order to get her full 4 percent employer match, she must contribute at least 4 percent of her salary into her 401(k). That means she puts $61.54 per biweekly paycheck into her 401(k), and so does her employer. Hillary saves $1,600 a year in her 401(k) and receives an additional $1,600 from her employer, for a total of $3,200.
This is why you’ll hear that failing to take advantage of an employer match is like leaving free money on the table.
VESTING SCHEDULE: Alas, sometimes an employer adds in fine print that the match will be subject to a vesting schedule. A vesting schedule determines when you’ll actually be able to walk away with the money your employer is putting in your retirement account. Keep in mind that you get to keep the money you’re putting in. The vesting schedule applies to the contributions your employer is making. There are three main types of vesting schedules:
Immediate: This is the ideal vesting schedule, which also makes it less common. The money is yours as soon as your employer matches your contribution. You could work there for three months and leave with the contributions your employer made.
Cliff: You will get all the money, as long as you wait out the vesting period. This could mean you need to work at the company for five years before you get to walk away with any of the employer match. But as soon as you hit your fifth anniversary, all that money has vested and is yours. If you leave before it’s fully vested, you don’t get any of the employer match.
Graded: A percentage of the employer match vests each year. Often it will go something like: 0 percent in year 1, 20 percent in year 2, 40 percent in year 3, and so on, until you’re 100 percent vested. If you leave the company before reaching 100 percent, then you could take the eligible percentage. Say you left a job after three years and your employer had contributed $6,000 to your plan. You get to take 40 percent of $6,000, or $2,400.
Vesting schedules are used as a tool to retain employees because you may be incentivized to stay until the end of the vesting schedule. If you don’t stay, then it can save the company money, because when you forfeit the employer match, the money goes back to the company. Again, the money you contributed is yours to take. This only applies to the employer match.
TARGET-DATE (AKA ALL-IN-ONE) FUND: Target-date funds are a convenient way to save for retirement, especially when you feel overwhelmed about which investments to put in your 401(k), 403(b), or IRA. You select a year that’s closest to when you believe you’ll retire, such as Target Date Fund 2055. Usually the funds are offered in five-year increments, so choose the closest approximate year. The fund’s managers will then automatically invest you in a primarily aggressive portfolio now and then rebalance it to be a more conservative portfolio by the time you plan to retire.
INDIVIDUAL RETIREMENT ARRANGEMENT/ACCOUNT (IRA): IRAs are another way to save up for retirement by investing in stocks and bonds or by leaving money in cash reserves. There are tax advantages to putting money into an IRA, which differ depending on the kind you use. Two of the most common IRAs are traditional or Roth, just like with a 401(k) or 403(b).
TRADITIONAL: Investing with pre-tax dollars up to the annual limit. You have the potential to lower your taxable liability today.
ROTH: Investing with post-tax dollars up to the annual limit. The Roth IRA doesn’t afford you a tax advantage today, but you do get to withdraw the money tax-free in retirement.
If you’re under fifty-nine and a half, you can’t withdraw the funds in your IRA without paying a tax penalty. There are some loopholes to this rule. For example, Roth IRAs provide more flexibility for penalty-free withdrawals before retirement age because you’ve already been taxed on your contributions. Also, when you buy your first home, you may be allowed to raid some of your IRA without triggering a tax penalty. But please don’t make any rash decisions about early distributions from a retirement plan before speaking to a tax professional and understanding all the implications.
The IRS does impose limits on how much a person can contribute at what age. In 2018, for example, those under fifty could contribute up to $5,500, and those aged fifty and older could contribute $6,500. Your tax deduction for contributing to a traditional IRA may be limited depending on your income and whether you or a spouse is eligible for a workplace retirement plan. Your eligibility to contribute to a Roth IRA can be limited and even phased out based on your modified adjusted gross income (MAGI), which you will find out when filing your taxes.1
ROLLOVER: You don’t want to leave your retirement savings behind when you leave a job, so the option is something called a rollover. You can, without triggering tax penalties, take your money out of your existing retirement plan at work as long as you’re moving into another retirement plan (e.g., a 401(k) with your new employer or an IRA). It is possible to leave a 401(k) in the hands of your old employer, depending on the stipulations of your plan. However, it’s often nice to simplify and bundle all your retirement accounts together instead of having a plan with each of your former employers. Companies like Vanguard, Fidelity, Charles Schwab, and Betterment make it pretty painless to roll over your old 401(k)s or IRAs. I found talking on the phone to a real human helpful the first time I had to do a rollover, just to be extra certain I wouldn’t screw anything up.
BENEFICIARY: The person who will receive your money in the case of your death. You’re usually asked to designate a beneficiary upon opening a retirement account. You can update your beneficiary at any time, and doing so should be on your to-do list right after any major life events like marriage or becoming a parent. Fun fact: beneficiaries can override a will. A professor of mine shared a story once about karma and beneficiaries. His client’s ex-husband had cheated on her and divorced her for his mistress. He died unexpectedly, and while he’d updated his will, he’d never bothered to update his beneficiary on many of his investment accounts. So much of his estate actually went to his first wife instead of the mistress.
HEALTH SAVINGS ACCOUNT (HSA): It may seem strange to include an insurance product in the retirement investing chapter, but an HSA offers you both a tax-advantaged savings vehicle and a way to prepare for future medical expenses, even as far out as retirement. Contributions to your HSA lower your taxable liability, then the money grows tax free, and withdrawals used for qualified medical expenses are also tax free.
You aren’t required to spend the money within a certain period of time like you are with a flexible spending account (FSA). There are contribution limits depending on your filing status: e.g., in 2018, they were $3,450 for an individual and $6,900 for a family. Unfortunately, you’re eligible for an HSA only if you have a high-deductible health plan.
Now for the reason it makes sense to include this term in a retirement investing chapter (other than the fact that you can save for medical expenses in retirement): The money in your HSA can be invested instead of just sitting in a savings account waiting to be used on medical expenses. Your HSA investment options depend entirely on your provider, but generally there are mutual-fund options.
A shout-out to all my fellow self-employed (or side-gigging) readers.
SIMPLIFIED EMPLOYEE PENSION IRA (SEP IRA): Don’t get too excited by the word pension. We often wax poetic about the glory days of employers offering pension plans, but this is really just a retirement account for small businesses and the self-employed. It works akin to a traditional IRA: you get a tax deduction for contributions, and your investments grow tax-deferred until you begin to make withdrawals in retirement. In terms of earning potential, a SEP IRA can trump a traditional IRA because the contribution limits are (potentially) much higher.
In 2018, you can contribute the lesser of 25 percent of your compensation* or $55,000—or in some cases 20 percent of compensation for sole proprietors. That really blows the $5,500 contribution limit on the IRA out of the water. For simplicity’s sake, let’s say you earned a net profit of $50,000 in self-employment income in 2018 and contributed 25 percent to your SEP IRA. That’s $12,500 instead of getting capped at $5,500 for a traditional or Roth IRA.
You’re also allowed to contribute to a SEP IRA with side-hustle income, even if you’re contributing to a retirement plan through your full-time employer.
A drawback of the SEP IRA is that if your business grows and you acquire employees, you could be required to contribute the same percentage of income to your employees’ SEP IRAs as you take yourself.
SOLO (OR INDIVIDUAL) 401(K): This plan is a good fit for a self-employed person who isn’t planning to hire full-time employees. You can set it up for yourself and a spouse. A big perk of the solo 401(k) is that you can contribute as both employee and employer, which, depending on your business income, could mean contributing more than you could for a SEP IRA. In 2018, an employee could contribute up to $18,500, and the employer can contribute up to 25 percent of compensation, with a cap of $55,000.2 The solo 401(k) can also come as a Roth option.
MAXING OUT (AKA CONTRIBUTION LIMITS): Putting the maximum allowable contribution into your retirement account during the year. In 2018, that was $18,500 for an employee contributing to an employer-sponsored 401(k) or 403(b), or up to 100 percent of your income if you made under $18,000. You can find tax information, including the latest contribution limits, at https://www.irs.gov/retirement-plans.
Uncle Sam gets an early payday! I jest, a little bit. Tapping into your retirement accounts early, which is generally defined as taking money out before you turn fifty-nine and a half, can result in your paying a penalty to the IRS. (This penalty, in 2018, was 10 percent in addition to any federal and state taxes you owed.) Plus, you lose out on the gains of compound interest.
There are some particular loopholes about withdrawing money from your retirement accounts without triggering penalties—as mentioned earlier, the Roth accounts give you the most flexibility because contributions have already been taxed—but frankly, I don’t want to share them lest you consider using one! And because rules are always subject to change and I don’t want to outline an option that may not exist in a few years. It’s generally best to think of your retirement savings as just that: money to be used in retirement.
Considering a 401(k) loan? As long as you pay it back, taking out a loan against your 401(k) won’t trigger tax penalties, which is a positive if it’s a last resort. The loan terms usually require you to pay the money back within five years, plus interest that’s ultimately paid to you. However, please proceed with caution: if you’re fired or quit before the loan is repaid, then you’ll probably need to pay it back in full within sixty days.
Leaving a job and unsure what to do with your 401(k)? You may be able to leave it in the current account, or you can roll it over into the 401(k) with your new employer or put it into an IRA.
Oh, here’s a fun twist. You’re required to start taking money out of traditional IRAs and 401(k) or 403(b) plans once you turn seventy and a half. This is called required minimum distributions. Uncle Sam wants to get his cut of your tax-deferred money, so the government requires you to start taking distributions.
I once received an email from a Millennial woman named Jessica asking if it was really necessary to invest outside her retirement account. Jessica was maxing out her 401(k), which in 2018 meant she was putting $18,500 a year into her employer’s retirement plan, and she had $80,000 in an emergency savings fund.
In truly dramatic fashion, I nearly did a spit take when I read that number.
Eighty thousand dollars is a huge emergency savings fund for most twenty-somethings. Nine months of living expenses is at the high end of what financial experts recommend for an emergency fund, and something told me Jessica didn’t need nearly $9,000 a month in case of an emergency. So, I opened up a dialogue to find out why she felt the need for such a high buffer; or if she was saving for a major purchase, like a down payment on a home; or if, as I suspected, she just didn’t know what else to do with that money.
Yup, my smell test on Millennial financial behaviors proved correct. Jessica’s parents only ever invested in their retirement accounts, and she had no model for why and how she should be putting her money in any investments other than a 401(k) or an IRA.
Jessica’s high savings rate and significant emergency fund aren’t common for your typical Millennial or, really, any generation, considering that more than half of Americans can’t come up with $400 in an emergency.3 But Jessica’s confusion and even concern about investing outside of a retirement account is quite common. I’d argue that plenty of people who do contribute to a 401(k) or 403(b) through work still don’t consider themselves investors. I’ve had many a conversation with a friend that goes something like this:
FRIEND: I don’t invest.
ME: Do you have a 401(k) at work?
FRIEND: Yeah.
ME: Do you contribute to it?
FRIEND: Yeah.
ME: Then you’re investing, unless it’s sitting in cash.
Now that you’re starting to think of yourself as an investor, even if it’s just in an IRA or 401(k), let’s talk about why you need to invest outside your retirement accounts. Not to mention that you’ll have trouble gaining easy, tax-free access to that retirement money before age fifty-nine and a half.
Saving for retirement is important, but it’s an incredibly long-term financial goal that’s decades away for most Millennials. You’re going to have other major financial goals between now and retirement age, which is why you absolutely need to invest outside your retirement accounts.
“Your money, when you invest it, is doing some of the lifting,” explains Jill Schlesinger, CFP®, CBS News business analyst and author of The Dumb Things Smart People Do with Their Money.
Trying to save your way to your financial goals will require you to have a significantly higher savings rate than if you invested as well. Just take retirement for example:
Lillian wants to have $1.5 million saved by age seventy in order to comfortably retire. She’s currently twenty-five years old and puts $250 out of each biweekly paycheck (i.e., $500 per month) into her 401(k). Assuming an average 7 percent return, Lillian will have more than $1.7 million by the time she reaches her retirement age of seventy.
If Lillian decided to just put $500 a month into a savings account for forty-five years, she’d only have a little over $270,000, especially if it’s in a measly 0.01 percent APY savings account. Even if she put that money in a savings account earning 1.00 percent APY, she’d only have about $341,000.
As Schlesinger said, investing allows your money to do some of the heavy lifting.
Investing needs to be coupled with goal setting. After all, knowing your time horizon is part of how you build your portfolio. “I tell my clients all the time, ‘I don’t care what you spend your money on. I care what your goals are,’” says Douglas Boneparth.
When it comes to your goals, Boneparth recommends that you consider three things: identification, quantification, and prioritization.
Here’s how that looks in your life:
Identification: What are my financial goals in the next year, three years, five years, ten years, and so on?
Quantification: How much money will I need to meet each one of those goals individually?
Prioritization: Which goal am I going to focus on first?
Keep in mind: just because you’re prioritizing one goal doesn’t mean you stop funding your other goals. Paying off student loan debt aggressively doesn’t mean you press Pause on funding your 401(k) enough to get the employer match.
Once you identify, quantify, and prioritize your goals, it becomes much easier to put an investing strategy in place. Some financial goals won’t require you to invest, such as paying off your student loans or credit card debt. But others, especially medium- (i.e., four to ten years away) and long-term financial goals (ten-plus years away) could seriously benefit from you letting your investments do some of the heavy lifting.
An Example of Goal Setting in Action
When Heather and I found out we were having our daughter, we would’ve loved to have accelerated our student loan payments, we would’ve loved to max out our 401(k)s, but top of our priority list was buying a house and handling life logistics: schools, transit, basically getting our life where it needed to be to accommodate the change that was happening. By using the goal system, we were emotionally honest with ourselves about what was important to us. That really puts the “personal” in personal finance.
Heather and I started saving for a home in 2012, and we bought our home [in] August 2016. Take a look at what the market was doing during that time period—it was pretty good. So, you can imagine me as a financial advisor saying, “Man, if I’d just put my money in something as simple as the S&P 500, maybe we could’ve bought that home a little sooner.” Well, what’s the flip side? What if there’s a correction and things went the other way? I now delayed a goal that needed to happen. There was a kid on the way! The flip side would’ve been Heather would’ve removed limbs from my body had I told her we’re unable to close on the house because the money we were saving for it went down 20 percent. Imagine if it were 2008. It would’ve gone down 40 or 50 percent. So, it’s a very real example of why, for short-term goals specifically, there is no reward out there appealing enough to outweigh the risk of not accomplishing the goal within the time frame you need. Buying that home a month earlier, because I invested the money, wouldn’t have helped my life. But what would’ve really hurt my life was not being able to close on the home when I really needed to.
—Douglas A. Boneparth
The next logical question is “Should I invest my savings for short- or medium-term goals?” Here’s the truthful but potentially infuriating answer: it depends.
There is always a risk when it comes to investing because the market is going to go down at some point during your time as an investor. Your need to liquidate an investment could coincide with a downturn in the market, which means you either won’t get as much bang for your buck or you’ll lose money. So, yeah, I get why you could be hesitant to invest for your goals. Saving it just sounds so much safer.
And for short-term goals, I agree with that sentiment. Cash or cash equivalents help mitigate any risk, particularly if your short-term goal isn’t a flexible one. Jill Schlesinger advises a one-year rule (two years if you’re risk averse). “You’re going to business school and planning to write the check or [you’re] making a down payment on a house or you need a car,” she says. “None of that money can be at risk if you need it within a year.”
My husband and I started saving for our honeymoon eighteen months before we planned to take the trip. We had a hard deadline of when we’d need that money, so I wasn’t going to invest it in the stock market, because we weren’t going to push back the trip if the market tumbled and we needed to wait for it to rebound.
The way in which you’d invest for your medium-term goals depends on your time horizon and on how flexible that deadline can be, and your risk tolerance. A medium-term goal with a deadline of a decade away is one for which you could take some risk early on by investing in stocks and then adjusting your portfolio from moderately aggressive to more conservative—think either bonds and cash or all cash—as your deadline to liquidate and use those funds to make your purchase grows closer.
But if your medium-term goal has a deadline of three years away, and you absolutely must have that money in three years, with no wiggle room to push it back if the market is going through a correction or recession, then it’s probably not worth the risk.
“Maxing out” a retirement account simply means contributing the maximum allowable contribution. In a perfect world, you should be able to max out your 401(k) with ease and then move on to investing in taxable accounts. Retirement accounts are tax-deferred, so I’ll refer to nonretirement investments as “taxable accounts.”
“From a sheer growth-of-money perspective, all else being equal, maxing out retirement accounts will be more beneficial due to that fact that you’re either saving taxes on the front end, through the pre-tax contributions, or saving taxes on the back end, via Roth, by taking money out tax free,” says Boneparth. “If there aren’t any other goals or personal preferences and you just want to grow money in the best way possible, there is your answer.”
Again, that’s in a perfect world. But let’s face it, being able to put aside $18,500* into a retirement account is wishful thinking for many, if not most people of all generations.
Saving more than $1,500 per month in your retirement account in order to max it out is a great “reach goal,” but before you let it stress you out, reflect on how much you actually think you’ll need to live a comfortable life in retirement. Now, there are a lot of variables at play (e.g., inflation, whether your home is paid off, health care, the size of your family), so it can be difficult to know how much you’ll need in thirty or forty years. Despite these factors, you can probably come up with an educated guess based on your current lifestyle, factoring in paying down debts or adding children.
The Multiply by 25 Rule is a calculation based on the assumption that your retirement will last thirty years and that you’re using the 4 Percent Rule. The 4 Percent Rule is a commonly used rule of thumb for a safe withdrawal rate that comes from the 1998 Trinity study,4 which basically states that if you withdraw 4 percent or less of your portfolio per year and have an appropriate mix of stocks and bonds for your current risk tolerance and phase of life, then your money should last you at least thirty years. You can apply the Multiply by 25 Rule to the amount you think you’ll need in retirement in order to determine how much you have to save today.
Some experts prefer people act even more conservatively than the 4 Percent Rule allows and use a 2 or 3 percent annual withdrawal rate, to ensure they won’t outlive their nest eggs. Honestly, it’s always better to err on the side of caution when it comes to ensuring you won’t outlive your money, but I digress.
The Multiply by 25 Rule in Action
Lauren and Dan are currently both twenty-eight and want to retire at age sixty-five. Lauren runs the numbers and decides that she and her husband could comfortably live on $50,000 a year in retirement. Their home would be paid off, any children they plan to have would have graduated college and (hopefully) left home, and neither one of them currently has any sort of chronic medical ailment.
($50,000 x 25 = 1,250,000)
Lauren and Dan would need $1,250,000 saved in retirement. Now it’s time to do the backward planning to determine how much they’ll need to save today in order to reach that goal.
Simple situation: Lauren and Dan can each put $500 per month into retirement savings, for a total of $1,000 a month. Assuming a 6 percent annual return over the thirty-seven years they’re saving until retirement, that would result in just over $1.5 million saved. That’s $300,000 more than they calculated needing, which provides a healthy buffer. Putting $400 each (or $800) away for thirty-seven years would result in their reaching their goal of $1.2 million.
More realistic situation: Lauren has already saved $6,000 in her employer-matched 401(k), which she first got access to at age twenty-five. She receives a 3 percent match on her $45,000 salary. That means her employer contributes $1,350 annually, or $112.50 per month. Lauren contributes 10 percent herself, so she’s putting $4,500 a year into her 401(k), or $375 a month. Between Lauren’s contribution and her employer’s, that’s $487.50 a month.
Dan’s employer doesn’t offer a retirement plan, so he’s proactively contributing to a Roth IRA. He’s currently contributing $4,000 a year ($333 a month). Assuming the average 6 percent interest rate over the thirty-seven-year period, he and Lauren will have $1.3 million at age sixty-five.
Notably, I’ve ignored Social Security income in this example and the fact that they’d both receive raises over the years and probably also switch jobs, but you can certainly include all those factors into your own calculations. Have access to a health savings account? Don’t forget to factor that in to your retirement planning. Those are super-helpful when it comes to saving tax-deferred money for future medical expenses!
Another factor to consider when deciding whether to max out your retirement accounts: your medium-term goals.
“Here comes personal preferences: if you think you need that money for something else, like you want to buy a house at some point or you plan to make an investment in your business, maybe having accessibility makes sense,” says Boneparth.
Investing in a taxable account affords you flexibility. You aren’t required to wait until you’re fifty-nine and a half to start taking money out without facing a penalty or jumping through hoops. You also aren’t required to withdraw your money at any point from a taxable account, as you are with many retirement accounts. Does it make sense for you to lock up all your money for life after age fifty-nine and a half instead of investing it for more medium-term goals?
Now, it is possible to pull money out of your retirement accounts early and, in some cases, without a tax penalty, but as a general rule, just leave your retirement money alone until retirement arrives.
☐ You don’t have any high-interest-rate debt.
☐ You’ve already fully funded your emergency savings with a minimum of three months’ worth of living expenses.
☐ You’re either maxing out your 401(k) or other retirement savings vehicles already or you have a pre-retirement short- or medium-term financial goal for which you’re investing.
☐ You’re maxing out your health savings account, if you have access to one.