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Investing in Your 401(k) in Your 20s

by on January 18, 2014

You may not realize it, but your 20’s is the most important investment decade of your life! I’m not a financial planner—I’m a human resources practitioner—but I’m writing this article for my children and their friends as they make their way through college and into the “adult” world. Many ask very basic questions about investments, and investment advice can be overwhelming. This article is an attempt to put the larger pieces into perspective and make sense of it all. Here’s to your investing future, kids!


401kgraphicMany recent college grads mistakenly assume that they’re too young to begin investing when they’re fresh out of college. Times are tough—college loans, rents, and bills in today’s world make investing seem like a far-off wish list rather than something they could do on a practical, real-life basis. But launching your retirement investments in your 20s is the most important decade in your life—if for no other reason than because that extra decade adds an incredible “kicker” to your long-term investment results. Here’s how personal finance guru Suzie Orman puts it:

“In a perfect world, let’s say you invest $5,000 a year starting at age 25. Assuming your money grows at an annualized 6 percent, you’ll have approximately $820,000 by the time you’re 65. Now let’s suppose you don’t start investing until age 35. You’ll have to sock away about $9,800 a year to wind up with the same nest egg. (A $5,000 annual investment for 30 years will yield just $419,000.) And don’t kid yourself that it’s easy to save money as you grow older; you’ll likely have children and a mortgage tugging at your purse strings.”

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So don’t be overwhelmed by what you’re about to read. Just start investing in your company’s 401(k) plan—even if it’s just a small amount each payroll period. Over time, you can ratchet up your investment contributions as you make more money and feel more confident. The key, like in anything else in life, is to just start doing it. So if your company’s 401(k) plan (or 403(b) plan, if you’re in a non-profit organization) offers a matching contribution, always invest up to the match. Here’s how to do just that . . .

The First Rule of Retirement Investing: Invest in Your 401(k) Up to the Company Match

You can’t get better advice. Many companies will match your investment at the rate of $.50 on the dollar up to a certain percentage of your gross annual income (common = 6%), meaning that they’re guaranteeing you a 50% return on your investment. Never leave that free money on the table! For example, if you gross $30,000/year, then 6% of $30,000 equals $1800. If you invest $1800 in a given calendar year, they’ll add 50%, or $900, to the pot. So your $1800 investment is now worth $2700 before you’ve done anything.

More important, investing in your 401(k) up to the match is practically free. Think of it this way: If you invest $1800 in a Traditional 401(k), that $1800 amount is placed into a tax-deferred retirement account that has 40+ years to grow and benefit from compounding and share price appreciation. But the benefits don’t end there . . . That $1800 investment in your Traditional 401(k) is also shielded from income tax. That means that, rather than taxing you at the end of the year as if you grossed $30,000, the IRS will only tax you as if you earned $28,200 (i.e., $30,000 – $1800). Since that $1800 is hidden from income tax, you’ll save roughly a third of that in taxes at the end of the year, or $600. The result? Your $1800 investment yielded $900 in company match and $600 in tax savings. So for your $1800 investment into your retirement account, you got roughly $1500 of it back in one form or another. In essence, you paid $300 out-of-pocket and ended up with $2700 in your retirement account to show for it in one year alone. Can you imagine what that will look like after 40 years? Not bad math, ha?

How Much Should I Invest?

When you launch your career, investing an amount equal to your company’s 401(k) match is a great place to start. In fact, some organizations will automatically enroll you to contribute 2% or 3% of your pay, unless you specifically opt out. (Don’t opt out!) Ideally, though, you’ll want to invest up to the company’s full matching portion, if possible. In our example above, that would be 6% (or in some organizations, 5%). If anything, start at the 2% automatic rate and then increase your percentage over time to the full 5% or 6% threshold.

Simply log onto your organization’s 401(k) website, open an account, and choose the deferral percentage that you want (e.g., 2% – 6%). The money will then be deducted from your payroll check beginning one or two pay cycles later. It’s that simple . . .

What Should I Invest In? Keep It Simple and Always Think Diversification

When you open a 401(k) account, besides choosing a percentage to invest, you’ll need to select a mutual fund. You’ll probably have the option of choosing an investment fund for your money from various investment / mutual fund companies: Vanguard, Fidelity, and T. Rowe Price are the three largest and most respected investment companies, but many others exist, and they all offer their own brands of stock mutual funds, bond mutual funds, and money market funds.

The investment firm that I like to recommend is Vanguard, and the fund that I typically recommend for recent high school or college grads is the Vanguard Target Retirement 2060 Fund (VTTSX). Don’t worry, though, if your company’s 401(k) doesn’t offer Vanguard funds—other mutual fund companies offer similar “target date” retirement products. This particular fund is specifically targeted for investors who are now in their late teens or early 20s. When you purchase shares in this target date fund, or “all-in-one fund,” as it’s also known, you’re buying the four major indexes that cover the majority of all the investments on the planet. Here’s how Vanguard’s 2060 Fund is allocated:

63% Vanguard Total Stock Market Index

27% Vanguard Total International Stock Market Index

8% Vanguard Total Bond Market Index

2% Vanguard Total International Bond Index

100% Total

And there you have it—A perfectly balanced and diversified 90% stock – 10% bond investment allocation that covers the world’s largest and smallest companies, blue chips, emerging markets, and bond holdings (corporate bonds, high-yield bonds, treasury bonds, and the like)—you name it! It’s an all-in-one solution that takes all of the guesswork out of what you need to invest in. Oh, it’s also very efficient in terms of fees and expenses at just 0.18% (compared to the average actively managed, no-load stock mutual fund, which exceeds 1.40%).

An important caveat: When you invest in stock and bond funds, their “price per share” fluctuates every day—sometimes wildly. You’ll have years, for example, where the fund is up 25%, which is great! But you’ll also have years where the fund is down 25% (or more), which is kind of scary. What all investment advisors will tell you, however, is not to fear even severe market fluctuations: With a 40-year investment horizon, your portfolio will have plenty of time to weather any temporary storms and recuperate. And stocks and bonds historically outperform their alternative—the money market (AKA bank accounts and CDs) and real estate—handily over long periods of time. So when market plunges occasionally happen, see that as an opportunity to buy more shares so that you can follow that age-old mantra “Buy low, sell high.”

Finally, if available, don’t forget to download the free app that will let you keep track of your investments from your smart phone. Apps from Vanguard, Fidelity, and other investment companies offer great features—real-time updates on your investments as well as articles, podcasts, and webinars on investing both for retirement (i.e., 401(k)s and IRAs) as well as for your regular, taxable accounts (also known as “brokerage” accounts). It’s a great habit to begin following and understanding investments. If you’re looking for a good book on the subject, pick up a copy of Suzie Orman’s The Money Book for the Young, Fabulous, and Broke (Riverhead Trade, 2007).

Now that you know how much to invest and what to invest in, it’s time to take the plunge, kids. By the time you’re 65 and looking back on this decision, you’ll be very happy you did!