Money Magazine is presenting a series of articles focusing on 401(k) accounts. The magazine’s five basic tips can easily be exapnded to cover all long-term investing. Here’s the first tip:
Suppose you started work in 1990 with a $40,000 salary. You saved just 2% of your pay but were such a brilliant investor that you put your 401(k) into top-returning funds every year. You would have finished 2005 with nearly $50,000 in your 401(k). Now suppose you… picked mediocre funds year after year, but you were frugal enough to save a full 6% of your salary. You’d hit 2005 with nearly $120,000. That’s right: more than twice as much as the brilliant saver.
There’s some number play in the magazine’s example, in which the authors neglect to mention the remaining 4 percentage point difference between the 2% and 6% saved. That 4% can also be invested outside of a 401(k), in which case, the “brilliant investor” scenario will undoubtedly beat the “mediocre funds” scenario.
But this isn’t what most people would, do, right? Once that extra 4% is in their paycheck rather than in their 401(k), it will get spent, or so the traditional thinking goes. In this case, the money is lost and the “mediocre” investor who defers 6% wins.
The article suggests increasing your 401(k) investment by 1 percentage point each year. I’ve erratically increased and decreased my 401(k) investment since I began working at my current company. When my rent was less than $350 and I was splitting my utilities expenses four ways, I was investing 12% of my salary. I probably could have done much more than that.
At the moment, 8% of my salary is invested directly in my 401(k).
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I currently put 5% into my 401(k). I just became eligible to contribute with my current employer. At my previous employer, I invested 4% into my 401(k). I get a great match, but I have maxed it out. I will not increase my 401(k) contributions until I max out all other options, including my Roth IRA, my wife’s Spousal Roth IRA, and educational savings accounts for my kids. At that point, I probably won’t care to save more for retirement in a true retirement account, as I could just as easily sock it away in a brokerage account, because earnings are basically tax deferred there, too, and it will help me to retire sooner, as I can withdrawal funds at any time. I am going Roth all the way, though, as I don’t want tax deferred in retirement funds, because you pay income tax rates on these funds, rather than capital gains rates.