Overview of 401K and General Guidelines
Disclaimer: This is how I am thinking of investing my money, not necessarily how I think you should do it. I’m not a CFA nor do I have a certified title. Everyone is different in their investing philosophy. Please do your due diligence.
You go to school, get a degree, and you get a job at mid or large size companies. They will likely offer you a 401K plan.
Most companies will match a certain percentage of your salary when you contribute to your 401K account. For example, company X will give you 5% of your salary if you contribute 5% to your 401K. I consider that an instant 100% gain. Where can you get that kind of return? It’s true that you do not get to touch that money until you are 59 and 1/2 years old. But free money is free money. If you decide to withdraw money from your 401k before the before you retire, you are expected to pay a 10% penalty and the amount you take out becomes taxable income. It sounds bad. However, if you look at the number, for example a $100,000 value, but you only put in $50,000 (because your company put in the other $50,000), you will get $90,000 and subtract let’s say 30% of that $90K for taxable income, you will end up with $63,000. That is a 126% return on investment (ROI).
Another use of a 401K fund is for emergencies or to pay off high interest loans. Most 401K administrators will let you take out a loan from your fund—up to 50% and maximum of $50,000. This can be really useful if you have credit card balances where you are paying more than 10%. This is considered credit card interest arbitration.
Wouldn't you rather pay interest to yourself instead of the bank? I guess it’s not a terrible thing. Just kidding, it’s awesome! Let’s run some numbers again. Here is a scenario to consider:
You have a $20,000 balance on your credit cards, which I wish none of you do. You are paying 10% interest on that $20,000. Annually that is $2,000. If you take out a loan of $20,000 from your 401K and pay off that credit card, you do not have to pay that $2000 in interest. That’s a 10% ROI. In addition, you will pay 4% or 4.5% of interest to yourself by paying back your loan from your 401K. So you will get a total of 14%-14.5% ROI every year.
I know some people will argue that taking a loan from your 401K will forgo all market gain from that $20,000 in a year. The way I see it, I like to take money up front. So if my calculations indicate my ROI is 14%, I'd rather take it any day. By the way, this scenario only makes sense if you owe $20,000.
You can also borrow money for a down payment for a primary resident. This loan has no limit on the amount but it has a 50% value limit.
So my suggestion on 401K is if your company offers it, take it. Start putting money into your 401K account as soon as you are eligible.
What do you think of 401K? Let me know by commenting below or send me an email.
Danh Truong CAL BRE#01951829 Realtor at EQ1 Real Estate firstname.lastname@example.org
Danh is a team member of EQ1 Real Estate and a Realtor practicing in the Greater Bay Area. He has been a personal finance student for the last 10 years. As a Coach for United Way Silicon Valley Credit Coaching program, he trained and educated low-income clients to improve their credit reports and scores. He helped them with budgeting and improving their finances. He is passionate about helping Vietnamese-American students manage their personal finance.