If you are employed by a company that has a 401K, you are bound by honor, common sense, and economic self-interest to place that money there. If not: shame on you.
The first reason: Your contributions come of the top line of your tax return. You don’t have to pay taxes on that money until you retire. Remember, you have $4,000 that you are going to invest somewhere. If your effective tax rate (state and local, less exemptions) is 20%, you just saved $800 in taxes…for now.
I say “for now”, because you will have to pay those taxes. Let’s say, just for kicks, that you are 30 years old. That means you won’t be paying those taxes for another 35 years.
Put another way: The tax deferment is the same as spotting you 20% on your investment, before you even made a selection!
And it gets even better if you figure that on average people who retire require only 70% of their average income through their working lives. So you stand a good chance of paying those deferred taxes in a lower tax bracket! I think the technical term for that sense of exuberance is “Boo-Yah!”
The second reason is matching contributions from your employer. We’re going to make a guess at what you make, say, $50,000 a year (not bad money, but not great money, either). That’s 8% of your salary. The good news is that your employer will match the first 2% of your contribution. Last I checked, 2% is 25% of 8%, all day long. And while a 2% match is not especially generous, you just got spotted a 25% return on your money…for that first year.
So, so far, we’re talking a net 20% tax holiday on the 401K contribution, plus 25% from matching contributions in the example here. You could park your money in the Bed Mattress Mutual Fund and be making 45% the first year.
Of course, the returns afterward will depend on what you pick to invest in.
My advice is for a $4,000 initial stake is to keep it simple. For the very long run (as in investing for your retirement) I would suggest just buying Spiders.
Yes, that’s right. SPY contracts, or shares of a market tracking fund. Why? Because while it is possible to beat the market for a little while, the nearest thing to a sure bet in the market IS the market. This is a great way for small investors to get exposure to the overall market. The prices are basically the S&P500 index, divided by 10. So, as of the Jan 3, 2007 close, you’d be paying $141.37 a share for SPY contracts. Oh, and you get quarterly dividends (the last disbursement on the 15th of September was for 57.9 cents/share).
Ultimately, though, returns on the SPY contract are driven by returns over time for the S&P500 Index.
I obtained historical S&P500 closing prices for the past 25 years from finance.yahoo.com (link: http://finance.yahoo.com/q?s=%5EGSPC), and looked at final closing prices for each year.
The average annual return is 11.31%. The standard deviation is 14.93%; sometimes markets do have bad years, and you need to be emotionally ready for that. However, in the long run you win, and win big, with the S&P500 and the SPYs that track it.
Marking down for our 2% inflation assumption, that gets you a rule-of-thumb 9.4% rounded annual return. And you’re getting spotted 35% out the gate
So, what does that mean for our $4,000 investment?
First you get the initial 20% tax break…and we’re going to assume you park that into the SPY contracts, too. $4,800.
Now, your company matches you $1,000. Now you’re at $5,800.
The market averages 9.4% after inflation for the next 35 years.
You retire, and that initial $4,000 is now $134,597, inflation-adjusted. After taxes, assuming you cash out the whole stash right away, that comes to $112,164 (assuming you still pay 20%).
That comes out to an after-tax, after-inflation return is 10.57% a year on your original $4,000.
Now with just an IRA, or a 401K without matching, you’d make 9.97% a year. That comes out to $92,825 on retirement. Again, that’s after taxes and inflation.
Or, you could just take your 9.40%, and have $77,354 when you retire.
Other investment choices are valid, of course, depending on one’s risk tolerance. I stand by this advice: It’s easy to get caught up in the thrill of trading, of picking hot stocks. Play the markets if you want, but do not mess around with your nest egg or cash cushion and expect it to be there when you need it most. There are far worse things than ‘merely’ beating the S&P by a few basis points, and doing so consistently. Not taking advantage of the 401K/IRA option is one of them.