Investing 004: Opening a 401K Retirement Account

As you enter the workforce as a young adult, you are faced with many questions such as finding a good career, finding a place to live outside the parent’s nest, paying off student loans, and others. Many of these factors and more also play a key role in how you prepare for retirement. One of the most important decisions you will make is how you plan to fund your retirement. One of the most common themes I often hear from employees in all walks of life is that they simply do not think they have enough money to save or invest. As mentioned in previous blog posts, a key strategy to my retirement plan is to automate my savings and investing. As millions of baby boomers are set to retire in the next decade, they are now more aware than ever of their retirement account balances, or lack thereof. In order to hep facilitate savings, many employers have begun employer sponsored retirement plans such as the 401(k) that help employees automatically set aside funds in tax-advantaged accounts. Tax advantaged accounts can significantly change the amount of money you are left with during retirement if you plan correctly. Many 401(k) plans take small amounts of funds selected by the employee and directs it into the employee’s beneficiary account. Furthermore, many employers offer a matching program on all or a portion of their contribution up to a certain limit to entice their employees. Lets take a deeper look into the anatomy of a 401(k) and how you can get started:

What exactly is a 401(k)?

A 401(k) retirement plan was established through section 401(k) of the Internal Revenue Code (IRS) that gave employees the ability to defer taxes on their contributions towards their retirement up to the annual limit, or in the case of a Roth 401(k), allowed them to pay taxes when they contribute, but draw funds tax free at retirement. Furthermore, it allowed employers to contribute company funds towards their employee’s retirement through an employee match, providing additional perks and incentives to retain key employees for longer periods of time. In general, Companies typically partner up with mutual funds (e.g. Vanguard, T.Rowe Price, Fidelity, Charles Schwab, to name a few) to pick a handful of investments that employees can use to allocate their funds in the portfolio. An advantage is that most of these large mutual fund companies provide lower fee structures for institutional (Companies) clients, but a drawback is that there are limited options if an employee wanted a “specific” vendor or fund to invest in. The biggest takeaway in setting up a 401(k) early on in your career is the ability to lower your taxable income in the amount equal to your contributions. As such, if you made a $100K/year, but contributed $15K towards your 401(k) retirement, ignoring tax credits and deductions, you will have reduced your taxable income by $15K, which at a typical 25-30% tax bracket for single workers in California, equates to about $3,750-4,500 in cash savings per year.

How to open a 401(k)

Now that we have looked into what a 401(k) is, lets find out how to get one started. Assuming that your Company offers this plan (not all Companies do this as there are cost/benefits in maintaining this service), you can first talk to the hiring manager or human resources to find out if you are eligible, as some companies require a minimum time of service prior to enrollment. Next, you will need to identify how much you want to invest per pay period, whether it is a fixed dollar amount or percentage of your paycheck. Once that is determined, you will need to select the allocation percentage from different fund options selected by your employer. For example, lets say you decide to contribute a fixed amount of $500/month towards your 401(k) retirement, or $6,000/year. Out of 12 mutual fund options, you decide to choose 3: SP500, international stock fund, and bond fund. You can decide to allocate 50% to the SP500, and remaining 25% to each of the funds, or you can split equally in 33.33%. Please note you can “rebalance” your portfolio as they balances move up and down throughout the year, and also re-allocate funds from one to another if you feel like doing so.

Managing your 401(k)

An importance piece to owning a 401(k) plan is that this offering is typically reserved for “employees” only. Meaning that if you ever decide to move to another company or simply quit/retire, you will generally have three options: 1) Move the 401(k) funds into the new employer’s 401(k) through a trustee to trustee transfer 2) Move the 401(k) funds into an IRA (Individual Retirement Account) 3) Withdraw funds. Its very important to note that when you are going with option #1 and #2, you cannot request the funds through check/wire into your bank account and send it to the next institution. Even though you send the exact same amount that may have come in, it may trigger a taxable event identified as a withdrawal, that will add penalties if you are not of retirement age. As such, please consult your CPA and retirement plan administrator prior to making changes and to understand the implications of the transfer.

As mentioned previously, a huge benefit in 401(k) plans is the possibility of an employee match. For example, if your employer is providing a 50% match on the first 6% of contributions, your contributions can look as follows: Employee makes $100K /year and decides to contribute the maximum employer match of 6%, which is $6,000/year. In this scenario, the employer will contribute $3,000/year total towards the employee’s account. That is a guaranteed 50% return on investment on the employees contribution, even if the mutual fund does not go up or down a single penny throughout the year. Please note that some employers do not allow employees to front load or back load their contributions, meaning contributing $6,000K in January and pausing month 2-12, or vice-versa. Employers may only provide matching when employees are consistently contributing to their account with each paycheck, so please check with your plan administrator.

In conclusion, saving and investing for your retirement is going to be an important decision. Making good choices early on will allow you to take advantage of compounding interest and time. Whether you invest in real estate, or individual stocks, a 401(k) may be a great way to diversify, automate your savings, and also take advantage of company matching (aka free money). My personal investing strategy consists of 70% real estate and 30% stocks (IRA/401(k)), but I sometimes use 401(k) funds to purchase rental real estate through a 401(k) loan or use as reserves for the Fannie Mae underwriting requirements. I will post more blog posts about creative financing with 401(k) loans in a new blog.

As always, please make sure you do your due diligence and talk to your CPA/Attorney/Financial Adviser before making any investment decision.

Good luck!

Investing 003: Simple strategies for higher retirement savings

Saving for retirement is important, now more than ever, as Social Security continues to dry out and people live longer lives. However, its somewhat difficult to truly gauge how much you need to be currently saving to hit your target. Some people choose an arbitrary number, say 10 or 20 percent of their gross income, whereas others may contribute up to the employer match. The better question to ask yourself is to figure how what type of lifestyle you want to be living in retirement, when will retirement be, and where will you retire. Those questions will factor in differently when considering your savings rate and method.

According to Vanguard, the average 401(k) savings rate was 6.8% of gross income in 2017, with the average balance being around $103,866. However, it is important to note that the amount that people are able to save significantly increase as they grow older.

See the chart below to see whether or not you’re ahead of the curve for your age group:

Under age 25

Average 401(k) account balance: $4,773

Average 401(k) savings rate: 4.8 percent

Age 25 to 34

Average 401(k) account balance: $24,728

Average 401(k) savings rate: 5.9 percent

Age 35 to 44

Average 401(k) account balance: $68,935

Average 401(k) savings rate: 6.3 percent

Age 45 to 54

Average 401(k) account balance: $129,051

Average 401(k) savings rate: 7 percent

Age 55 to 64

Average 401(k) account balance: $190,505

Average 401(k) savings rate: 8.3 percent

Age 65 plus

Average 401(k) account balance: $209,984

Average 401(k) savings rate: 9 percent

Source: Vanguard 401(k) data, 2017.

While retirement account balances certainly rise the longer you stay in the workforce, there are other strategies you can implement to help achieve a higher savings and better results:

1. Avoid Job Hopping

Unless the new job is providing a large pay raise and/or promotion, studies show how staying at your company may yield positive results for your retirement portfolio. Vanguard reports that employees who stay with the same employer for 10 years or more had an average balance of $188,744. Also, if the employer has matching contributions and profit sharing that vests with a certain period of service, this can also impact the balance that the employee will retain once they decide to move jobs. It's important to note than when you are moving to a new job, you can always roll over your old plan to an IRA, or create a self directed IRA to control your investments. Further, you may be eligible to move your old 401K balances to your new employer’s 401K program to keep the accumulation going.

2. Make use of tax-advantaged retirement accounts

As mentioned in previous posts, the key in achieving any success is consistency. By using a tax-advantaged account, you are avoiding or deferring the number one destroyer of wealth, which is taxes. By letting the portfolio compound and grow tax-deferred or tax-free (Roth 401K/Roth IRA), your savings will have a significant leg up on its non tax-advantaged competitor. In order to facilitate consistent saving, enroll in your 401K as soon as you join the company and also setup your IRA/Roth IRA for automatic contributions. While you are able to contribute a lump sum (up to $5,500 as of 2018) for your IRA, by consistently saving across a period of time, you will be able to avoid large market fluctuation losses through dollar cost averages.

3. Lower your fees

When investing in your employer’s 401K program or investing through an IRA brokerage, its important to be mindful of the fees which is another destroyer of wealth. According to USA today, approximately 95% of 401K plans have admin fees that cover such things as record keeping, legal fees, customer service, and transaction coordination. Furthermore, these fees are charged by the funds you invest with you 401K and is listed as “expense ratios”. Expense ratios basically represent a cost based on a percentage of assets. For example, if a million dollar S&P 500 fund has a 1% expense ratio, that means $10,000 of the fund goes to pay for expenses each year. My company uses Vanguard for our 401K plan. Vanguard is known for their low expense ratios which are driven by the fact that the Company’s shareholders are also the investors. This means that they are incentivized to keep costs low and provide maximum value to it’’s investors. However, this can vary from brokerage to brokerage. Especially when the funds are public companies with revenue targets, and need to satisfy the needs of it’s private investors, they may consider increasing fees to keep up with increasing costs and the need to generate a profit. In summary, be sure to review your 401K funds and choose funds that make sense for you (risk/reward) but also review the expense ratio to ensure you are not being gouged in fees.

4. Investing is a long-term play

The market has been going up and down in 2018, and it's understandable that investors are feeling uneasy, and want to move towards more cash in their portfolio. While this strategy may make sense if you are at or nearing retirement and want to reduce your portfolio risk, it's never easy to time the market. If you are a relatively young investor with decades left until retirement, you do not want market fluctuations to determine your investment decisions, which may lead you to sell low and buy again high. The average investor has limited knowledge and understanding of the macro economic factors and cycles that influence market changes. The best strategy one could implement is to “ride the wave” and continue to contribute to your account over a long period of time.

Take the advice of wise investor Warren Buffet, “Nobody buys a farm based on whether they think it’s going to rain next year,” he said on CNBC’s “Squawk Box. ” “They buy it because they think it’s a good investment over 10 or 20 years.” Simply put, Buffet decides a business is worth investing in because it will last, not because it’s doing well right now. He purchased See’s Candies with longtime business partner Charlie Munger in 1972 and spent more than $1 billion on Coca-Cola stock in 1988 — both of which turned out to be good bets and both of which he still owns today. “Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value,” Buffet wrote in his 1996 letter to shareholders. “If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes.”

As always, please make sure you do your due diligence and talk to your CPA/Attorney/Financial Adviser before making any investment decision.

Good luck!

Investing 002: 4 habits for a better financial future

Charles Duhigg, author of The Power of Habit: Why We Do What We Do in Life and Business, says “Change might not be fast and it isn't always easy. But with time and effort, almost any habit can be reshaped.” Think of the last time you decided to get fit and went to the gym, you don’t get the results you want by working out 10 hours a day once a month, but you may see results when you work out 30 minutes a day consistently over 20 days a month. I  believe that with consistency and persistence, an average person will be able to achieve great success. Now that we have covered some of the basics of retirement accounts such as 401Ks and IRAs, you may be wondering, how you can save the money to invest in these accounts, let's think of 4 ways we can start building habits that will create a better financial future for you and your family:

1. Increase your income

Have you ever heard that the average millionaire has 7 or more streams of income? Depending on your current situation, you may not be able to start a business or invest in real estate immediately, as it is important to plan ahead for things such as reserves, as well as maintain liquidity in case there are unforeseen life changes. However, there maybe opportunities at your current W-2 job that may result in a salary increase, or a side hustle that you can start (e.g. E-commerce, blogging, driving for Uber, tutoring, etc.) to build a bigger nest egg. By increasing your income and maintaining the same lifestyle, you will be able to re-allocate the excess income into other assets sooner than you thought possible.

2. Decrease your expenses

This advice may seem obvious, but its important to note that if you increase your income and your expenses grow with it, then the net effect is the same, or in some cases, your worse off as our tax system is a progressive bracket, meaning you pay more taxes the more you earn. Don’t take your promotion as sign to “keep up with the joneses” and buy a bigger house, and purchase that newer model car. Although there is a time and place to celebrate your hard work and reward yourself, you have to take time to think if it is worth delaying your financial freedom X more years. Instead of comparing yourself to your peers, look inward and find out what makes you happy. When you identify what makes you truly happy, you will end up using your money with more purpose and be less inclined to buy what you may think will impress your peers.

Alot of financial advisers may say that cutting expenses is a “scarcity mindset” and you should grow and increase your income. While I wholeheartedly agree that growing your income should be emphasized, you also have to review your expenses to ensure that there aren't any holes that are causing leaks in your ship towards financial freedom. By using apps such as Mint or Personal Finance, you should be able to have a birds eye view of where your expenses are being allocated. Check the latest cable bill, phone bill, and other variable expenses such as eating out and clothing to make sure that whatever your spending your after tax dollars on are truly necessary. As investors, we have to have a different mindset. If you cut your phone bill in half from $150 to $75 a month. Not only are you saving $75, you can factor in $22 (assuming 30% tax bracket) and $8 (assuming you are re-investing the funds into an index fund or rental property generating 10% in annual returns). Remember, these small changes in habits will create big changes over a long period of time.

3. Life-long education

Another important piece of building habits for your financial future is to educate yourself. As you may have taken courses throughout your life that will be useful towards your current job, it is crucial that you take ownership of your financial future and not rely solely on other people. I personally like to know enough to be dangerous, and that is when I rely on the advice of experts such as my CPA, lawyer, and real estate partners to help me solve problems and plan my finances. However, if I didn't spend time educating myself through books, courses, podcasts, and meeting other investors, I would have to take people’s word at face value, and would not have the opportunity to ask good questions that may result in further benefit. Remember that this is a long journey and you are the captain of the ship. No one is going to care more about your financial well being than yourself.

4. Start early and often

Continuing with the theme of building habits and maintaining consistency. It is important to start sooner than later. As Albert Einstein was famously quoted for saying, “compound interest is the eighth wonder of the world”, which simply means, time is on your side. Without being attached to the different market cycles and trying to determine if you’re at the bottom of the market before diving in, it's important to start early and often. Going back to my example of hitting the gym once a month for 10 hours at a time, versus going for 30 minutes a day for 20 days a month, with all things equal, you will see that the person with consistent effort will have better results over time.

Good Luck!