For many Americans, our first exposure to the investing world is through the company 401(K) plan. While IRAs and discount brokerages are important tools in the investment industry, it’s better to begin learning about investments from an employer sponsored 401(K) plan. By reviewing the terms and conditions of a 401(K) plan, you can learn some very sound investment principles.
401(K) plans allow you to contribute to your investments with a consistent percentage of your salary over time. Unlike an IRA, it doesn’t allow you to make any big one time investments. This prevents you from trying to time the market. Most plans also offer a step up program, so you can increase your investment percentage year after year.
Most 401K plans do not allow you to make a trade immediately, as it takes two weeks or longer to authorize and implement a transaction. This constraint prevents you from investing emotionally. Whether the market is crashing or shooting up, you won’t be able to follow the pack. While it usually “feels right,” emotional investing is often a great way to lose a lot of money. The delayed transaction time prevents you from making poor short term decisions and is a good reinforcement for teaching you to become a long term investor.
Your 401(K) plan will only allow you to invest in a select number of funds that your company has predefined. You probably won’t find any penny stocks in this selection. The funds you can participate in are generally well diversified and reputable funds designed to allow you to capture the average market return over the long term. This feature of the 401(K) plan provides a great quality filter for those who are picking their very first investments.
The current standard for a company matching in the stocks is 10% of the first 6% invested. Regardless about your tolerance for investing, you should at the very least invest up to your company’s matching point to take advantage of this offer. It might not sound like a lot, but it’s essentially free money from your company. I personally like to think about it as a performance buffer – even if your investments do nothing, that 10% is a return you get to keep. Not a huge lesson here: your company is basically saying that investing is a good idea and that they actually care about your ability to retire.
Whether you open a Traditional 401(K) or a Roth 401(K), you will receive a significant tax benefit out of the deal, either through a tax deferral or tax free earnings respectively. The benefit here comes from getting you to think about your tax liability, both in the present and in retirement. The best strategy in deciding between a Traditional and Roth 401(K) is to use a hedge strategy: invest in both types of accounts so that when you retire, you can strategically take distributions from the account that is most beneficial to you.