There are two different types of 401k accounts: the standard 401k and the Roth 401k. The primary difference is when your funds are invested in the accounts. A 401k allows a user to invest funds before taxes are taken out, whereas a Roth 401k uses post-tax contributions. This also means that an investor will pay taxes on a 401k when making their withdrawals in retirement, but will be able to make their Roth deductions tax-free. It is a matter of making a decision of when you would like to pay your taxes- Uncle Sam is going to get you either way. For most early retirees, it makes sense to contribute to a 401k. The reasoning is two-fold. First, you can reduce your current taxable income which allows you to save more aggressively in lieu of paying taxes. You may even be able to lower your overall tax bracket, check out the current federal tax brackets to see how you stack up (http://taxfoundation.org/article/2015-tax-brackets). The second reason early retirees love 401ks is that their income is often lower in retirement than it is now. We intend to live very simply, and chances are our income is going to be in a lower bracket when we become financially independent. The final factor that will impact your decision for selecting your account type is how you feel about taxes. If you believe that taxes will go up in the distant future, pay them now and select a Roth 401k. If you have confidence that rates will remain steady, or even go down, then a standard 401k will be the way to go.
Placing money in a 401k is one of the rare opportunities in life where there is free money to be had. Many companies include a 401k match in their compensation plans. Failure to take advantage of this is a huge mistake that can severely impede your progress towards financial independence. There is absolutely no excuse for not taking advantage of the full company match in a 401k plan. Typically a company will offer up some percentage (usually 50%) on the first (6-8%) of your income. So if you contribute 6%, your employer will add another 3%, and as we know, 3% can make a huge difference over time. That is essentially a guaranteed profit on your initial investment, and it is far too lucrative for any investor to pass up. Your overall contribution goal should be as high as possible. The maximum contribution for the calendar year 2015 is $18,000. Time to start raising those contributions! In general, you always want to think about maxing out your 401k before working on your taxable accounts.
Now that we have chosen our account type and our contribution, we need to take a look at what funds we are going to invest in. A couple hours of due diligence can help you make an informed decision as to which investments will best fit your strategy. For younger investors looking to aggressively save towards early retirement, a balance of 80% stocks and 20% bonds is an easy way to get started. There will typically be pre-blended funds that you can invest in, or you can attempt to select funds to create your own balance. The fundamental factors you can look at are historical returns, Morningstar Rating, and the expense ratio. Past performance does not guarantee future returns, but taking a look at how a fund has performed over a long period of time can give you an idea of the fund’s stability and performance. We are much more concerned with 5 or even 10 year returns than year to date performance. Consistency is king. Morningstar Rating is also a quick way for a novice investor to get a third party’s perspective on a mutual fund’s quality. The final key factor we are looking at is the expense ratio. This is the amount of money that goes towards funding the management of the fund. Lower is always better. Expense ratios will vary from fund to fund, but in general you should be striving to keep this numbers as far below 1% as possible. The difference between a .05% expense ratio and .90% is enormous. We need every dollar we can get, and we absolutely cannot afford to waste our cash paying management fees.
Investing in a 401k is a bet on you. Every dollar you invest now will have a much greater value to you later on down the road. Your 401k account should be one of the cornerstones of your retirement strategy, and it does not take a genius to get it set up correctly. An hour or two of research and some infrequent monitoring is all it takes to set up and maintain a passable 401k strategy.