FinanceDad

Set up 401(k) and never look back

Ever since I started working, I’ve been putting money away into a 401(k), except for the two years I spent in grad school and wasn’t working in the US. I certainly max it out now, although I don’t recall if I was maxing it out in my first few years. I probably was. In any case, it’s almost impossible not to have a million dollars saved in a 401(k) account at retirement age if you regularly max it out throughout your working life.

A 401(k) plan is an employer-sponsored retirement account defined in subsection 401(k) of the Internal Revenue Code. It basically allows you to put away a part of your paycheck before it gets taxed. Eventually, you get taxed on this money when you retire and withdraw the funds, but that’s after years of compounding growth and probably at a lower tax bracket than when you were working and putting this money away.

I love this piece of the IRS code because it comes from an understanding of human nature and helps people develop a very financially healthy habit without much effort.

Here are the key benefits I love:

My favorite benefit is that once you set this up at work, it will just automatically pay your future self first every two weeks before cutting a paycheck for you to take home.
The other benefit I already described: it doesn’t take out income tax until later.
Some employer plans come with an additional benefit of matching employee contributions up to a certain amount. That’s what people call “free money” and most financial advisors would recommend staring with a contribution amount that at least maximizes that match.

The only downside to this kind of account is that you can’t withdraw this money early (before you are 59.5 years old) without a penalty. So, if you wanted to retire early, you better have other savings to last you until 59.5 so you don’t have to get hit with that penalty. I actually think of this penalty as a key feature that helps many people save themselves from themselves. It forces you to keep the money there longer, and time is the tastiest ingredient when it comes to wealth building. So I think the penalty is a feature, not a bug.

Now, how much money can you put away in a 401(k) account? That changes from year to year. In 2020, that amount is $19.5K, and if you are over 50 years old you can add $6.5K more as a catch-up contribution. That’s because those older people are closer to retirement and every dollar they put away won’t have as much runway to grow and compound as a dollar of someone younger. Remember how I said time is tasty?

So, if you put away $19.5K every year for 45 years from the working age of 22 to 67, not accounting for any employer matches or growth and compounding, that adds up to $877.5K. If you assume a modest 5% annual return (conservative for the stock market), compounded annually, you should be able to retire with over $3M. You will still pay taxes on that as you take the money out in retirement, but that’s still a nice number, don’t you think?

Play around with this calculator to get a taste for what delicious time can do.

What does it mean to be financially independent?

Where would you be and with whom if you didn’t have to be anywhere else?

From an early age, I heard about the importance of financial stability and standing on my own two feet. I heard that some things should only be undertaken when that stability has been achieved. For example, I heard that one should only get married and certainly to have kids once one is financially stable. Why? What does that even mean?

A huge percentage of Americans and the World live paycheck to paycheck. That means they don’t really have any savings and spend the money the get from their employer throughout the month after getting it. This is one of the reasons 40% of Americans don’t have $400 for an emergency. You could live like this for a long time, but you would be highly vulnerable to the random events that may occur and not really in control of your life.

So, one way to define financial stability is when you have enough savings to handle random events and not have to spiral out deep into debt, etc. Some financial advisors (e.g. Dave Ramsey) say you should have 3-6 months of cash to cover your regular expenses in your “emergency fund.” That’s a great step on the path to getting control and to be able to take a punch of a job loss or a health emergency.

Still 3-6 months is a short period of time and can only get you through a short-term emergency. I think that true financial stability is when you can be truly independent and not depend on anyone for your financial health. One way to describe this is through the 4% rule. This is a rule of thumb that says you can withdraw 4% of your portfolio value each year without incurring a substantial risk of running out of money, even if you don’t have other income coming in (e.g. from a job). Using this rule, for every $100,000 you have, you’d withdraw $4,000 a year. In other words, if your annual expenses are $40,000, then your portfolio should be $1,000,000. It’s important to note that for this to work, the suggested $1M is not just a cash pile, but a portfolio of stocks, bonds, etc. It should be generating a return. There are many different nuances associated with this rule of thumb, but the basic concept is backed by lots of research: that you can take your annual expenses, multiply them by 25, and that’s how much of a portfolio you should have for financial independence (meaning that you don’t have to work to survive if you don’t want to). Directionally, if you plan to retire early, the rule goes down to 3.5 or 3%, which means your portfolio needs to be larger to provider for a longer time horizon.

There is a financial movement happening now called FIRE, Financial Independence Retire Early. I like the FI part of it but I don’t necessarily think everyone should strive to retire early. Instead, I encourage you to do what you love so you never want to retire and you just get better in your field of work over time and more excited about waking up each morning to get to work. Warren Buffet, who is a very successful investor and is currently 90 years old, says he tap dances to work each day. I wish you the same. That is more likely to put you on the path to financial independence and happiness than many other things.

What’s your Net Worth?

Net Worth is a very important personal finance term that I’ll describe below. Before I do that, I want to make one thing clear: while it’s perhaps my favorite personal finance metric, it is a dangerous phrase because some may mistake it for a person’s actual worth. Despite economists’ attempts, there is no financial way to value a person’s worth. Each one of us is so much more than the money we have in the bank. We are parents, children, spouses, brothers, sisters, friends, doctors, pilots, teachers. We are funny, smart, kind. We are so many things. We are complex.

Since this blog is about personal finance, let me share my thoughts about Net Worth anyway.

At a high level, net worth is just a number that is a sum of two things: Assets and Liabilities. Assets are those things which you own, and liabilities are those things which you owe. Assets are things like savings, brokerage, retirement, college savings accounts, as well as tangible assets like house and car. Liabilities are things like credit card debt, college loan, car loan, mortgage.

Net worth is a great measure of your overall financial health. If you have more assets than liabilities, you have positive net worth. Congratulations. If your liabilities outweigh your assets, then you have negative net worth and it’s time to address your financial health. If your assets are larger than your liabilities by $1 million, then you are a millionaire. Big congratulations!

I like tracking metrics because I am a big believer that what you measure is what you improve. I started tracking my net worth in my twenties in a spreadsheet. In my 30s, I discovered a free app called Personal Capital and have been using it pretty much daily. Once you connect all your accounts, you can see where you are today in terms of net worth – all in one place. The app also lets you track the ins and outs of your money, which I find quite helpful to see when I earn dividends across different brokerage accounts and when my purchases go through (it’s a good way to occasionally catch fraudulent credit card transactions).

I don’t think everyone needs to check their net worth daily, although transactions could be good to check frequently if you have many. I do recommend establishing the cadence that’s right for you and sticking to it. If you do well, you’ll probably increase the check-in frequency. If you start to fall behind, you’ll gravitate towards not checking. I encourage you to stay close to it in good times and bad.

It’s never too early to start building wealth

The earlier you start, the better off you’ll be. This applies to many things in life, and certainly to personal finance. Here are some specific steps you can take:

Whether it’s your first paycheck or the first time you get money for your birthday, put some of it away into a brokerage account. A simple savings account is better than buying stuff, but you are much better off investing in stocks. The $100 you invest early in your life will do a lot more work for you than the same amount of money later in your life through this amazing thing called compounding (like a snowball, your money will grow faster and faster because it will keep adding to the base).
Set up an automated way for you to invest. I put money away towards investing every month automatically, and so should you. This will protect you from yourself and from human nature. The future you will really thank you for it. One of the coolest things about investing regularly is that it lets you dollar cost average (essentially, if a stock price for a given investment goes down, you are able to buy more of it with the same $100 and less of it if the price goes up).
Stocks is probably the asset class that will give you the highest return, so I recommend putting whatever you can allocate to investing to stocks. I think it’s fine to spend a little money on individual stocks of companies you know and in which you see potential. However, I recommend you invest in index funds (these funds simply track a number of companies). Key reasons why I like index funds are: a) they give you an easy way to diversify your risk across many companies, b) they are inexpensive because they are not actively managed.
Vanguard is my favorite brokerage company. John Bogle, who founded the company, is one of my heroes. He invented the concept of index funds and set up his company in such a way that really benefits investors with low costs and simplicity. Check out the index fund VTSAX (Vanguard Total Stock Market Index Fund). This fund basically covers the full United States stock market.
Consume content from which you can learn about personal finance (books, blogs, videos), especially from people who know what they are talking about: Warren Buffett, John Bogle, Napoleon Hill, JL Collins.
Invest your time wisely. You will spend most of your time in your job/career, so make sure that it’s something you love doing. Financially, if you pursue the business field like I did, strive to not just work for a paycheck. You can do this by either owning your own business or by working in companies, which give you stock as part of the compensation package. I have done the latter and have seen a significant return on my investment of time in the companies where I’ve worked.

Key takeaways and actions:

Always put away some portion of your income and do it regularly, ideally into a Vanguard index fund, such as VTSAX. Be a sponge and learn everything you can about personal finance. Be very strategic about your job and lean towards having ownership of the company stock.

Introducing me…

I came to the US as a 12-year old kid. Like many immigrants, my family didn’t have much. We started on welfare and used food stamps to buy food. My parents worked multiple jobs to pay for me to attend a private high school. Eventually, I got into Stanford, where I worked every year and received financial aid. My parents instilled in me the value of education and hard work, and I want to do the same for my kids but with an added bonus. I want to teach them everything I learned about personal finance that, for some unknown reason, educators at schools won’t teach. I plan to share what I know in person. In case I can’t, they will have this blog. I welcome anyone else who may find value in this material to read, comment, and share.