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Beach, Golf Everyday?  It's Possible
Date Added: May 5th, 2005

By Ryan Totka

   When I talk to many people older than me, I typically hear the same thing, "I wish I would've started investing at an earlier age". "I could have bought MSFT in 1985 or AOL is 1992 and been a multimillionaire today." You hear the same could of, would of, and should of stories all the time. Well, the time for younger investors is now! Many college graduates are landing great paying jobs straight out of school and have the skills, motivation and knowledge to be wealthy in the future.

   There is one very effective wealth building tool that every young new employee should take full advantage of. Some have heard the term tossed around, but don't know exactly what it does. It's called a 401(k) and is a very powerful compounding vehicle. I mean, c'mon, who wants to be working when they are over 50? Not me for sure. I'd rather be traveling, catching some rays on the beach and stinking up the golf course.

   The plan is simple to participate in and is always set up by the employer as a defined contribution arrangement. The employees have the option to deduct a specified amount from each paycheck which gets invested is the investment vehicles offered by the employer. The employee contribution for the year cannot exceed the current $10,500 maximum and is adjusted according to inflation. In comparison, the standard IRA, including the ROTH IRA, only allows for $2,000 annually. Further, 401K plans usually offer mutual funds as investment options within the plan. In actuality, they are separate accounts but work like mutual funds and are managed by the same prestigious companies that run the big fund families. The biggest benefit of these separate accounts is that they provide diversity for the investor, plus you decide where you want to invest your hard earned money, based on your risk tolerance and return expectations. Often times, the employee's company stock is also offered as an investment choice in the plan.

   Another benefit of the 401(k) is that your investment growth is tax deferred. This means that you don't pay annual taxes on your gains, until you begin taking withdrawals. With a standard, non-deferred, investment account, Uncle Sam gets his share via taxes each year. That's if you claim capital gains. The money the government takes each year reduces the amount you have in the account available for compounding. In a 401K, this is not the case. Old Sammy can't get his grubby fingers on the money you've saved until much later in life. This helps you take full advantage of long-term tax-deferred compounding.

   A 401K plan also offers some measure of flexibility. It's a long-term investment intended to stay in your account until the age of 59 ½, but you can take out a loan against the plan for a major purchase. There is no penalty if you pay it back. In fact, with a 401k loan, you are simply taking out a loan against yourself. Each month your salary is reduced by an additional amount, over and above your normal contribution, until the loan is paid off. The best part is that you are forced to pay yourself interest during the payback period. That way, you are still earning on your money. Pretty nifty, huh? However, keep in mind that you will be penalized 10% if you take out the loan and don't pay it back, plus income tax on the whole amount. Loans have to be repaid in five years with after tax money.

   Are you ready for the grand finale? Probably the best part of a 401(k) is the employer contribution. Most plans are set up whereby the employer will match a certain percentage of the employee's contribution. Most employees will match .50 to every dollar and up to 6% of the total salary. For example, if you make $40,000 per year and contribute 6% per year, your contribution for the year would be $2,400, while the employee adds another $1,200. Amazing! They actually give you money. This equates to an AUTOMATIC RETURN ON YOUR MONEY UP FRONT. Go to your broker and try getting that deal. Do this year after year and you will find yourself sitting pretty in the long run. In fact, you'll probably find yourself sitting pretty on a sandy beach in sunny Florida, after enjoying 18 holes on the golf course day after day. Doesn't sound like a bad plan to me!

 

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