The Most Basic Investment Of Them All: The 401(k)
One of the fundamental rules of investing is the mathematical principle of compounded interest, which is known by the folk name of “the rule of 72”. In a nutshell, if you divide 72 by the rate of return on an investment (subtracting the inflation rate from the rate of return), you’ll find out how many years it takes an initial investment to double. There are mitigating factors, like investing in inflation-indexed vehicles like stocks, but this is the bedrock that all investment is laid on.
The 401(k) investment that you can get from your employer allows you to jump start this process.
Now, first, understand that a 401(k) is a long-term investment; there are serious penalties for an early withdrawal from it, save under tight circumstances. So the usual advice (have three months of expenses saved up before you start investing, be ahead on your mortgage and car payment, pay down your high interest rate debt) still applies. In particular, get in the habit of stashing away a little bit every month, just because you can, as ultimately, that’s what a 401(k) is.
A 401(k) jump starts your investment process is three-fold.
First and foremost, up to a certain amount of your paycheck will be matched by your employer. That means that for every dollar you put in, your employer puts in a dollar matching it. This doubles your initial investment right off the bat. That’s shaving, at typical stock market return rates, 8 years off of the compound interest time frame.
Second, it comes out of your pre-tax income. What this means is that every dollar you put in your 401(k) now only reduces your paycheck by 75 to 83 cents, depending on what state you live in, and whether or not it has a state income tax. Compare this to investing in stocks “normally”, where every dollar you spend on a stock market investment is 100 cents you don’t have available for something else.
Third, all the interest that the 401(k) investment earns is tax deferred, meaning taxes aren’t paid on it until you withdraw the funds, rather than being paid every year. With the capital gains tax rate being what it is, this tax deferment means that your effective interest rate for figuring out compound doubling is about 25 to 36% higher, so an 8% rate of return is effectively a 10% rate of return.
In addition to these financial benefits, the 401(k) has another advantage it’s deducted automatically from your paycheck. There’s no “Oops, I forgot” moments of putting the savings away.
Now, choosing the right investment vehicle for a 401(k) program does take some consideration, and like any investment in stocks and bonds, you’re always running some level of risk. Always try and run your 401(k) at the maximum percentage of your check that you can get full matching on, make sure that your investment vehicle is appropriate to the time frame between now and your intended requirement, and, as with anything dealing with compound interest, start early!