Before I started my job here at MoneyAffairs, I went around to some of my friends and asked them what they’d like to see me cover. What, if anything, confused them most about the world of finance? What were they too embarrassed to ask a professional? It was in the middle of one of these conversations that one friend burst out, “What the eff is a 401k?”
I laughed, then realized she was serious. (Let’s dispense with the mystery, for all of you who have asked this very question: So named for the part of the internal revenue code that authorized its creation, a 401k is a workplace savings plan that lets employees invest a portion of their paycheck before taxes are taken out. The savings can grow tax free until retirement, at which point withdrawals will be taxed as income. A large majority of employers will match an employee’s contribution – up to a point – thereby boosting the employee’s savings rate.)
Fortunately for her wallet – and financial future – this friend was saving at a rate above the recommended 10% of her income; such is the beauty of a workplace savings program with auto-enrollment and a more-than 5% employer match. But not every employee is so lucky. Only about half of Americans work for a company that offers a 401k, and of those, recent studies show, little more than a third of companies sweep their employees into the plan automatically. This means that the majority of you have to actively open a retirement account on your own if you want any hope of building a nestegg for your golden years. And if inertia is one of the biggest obstacles to success in savings, imagine how hard it is to decide to do something you don’t fully understand.
Here’s the good news: you don’t have to be an expert in order to start saving for retirement. You just have to – at least in the beginning – make the decision to save and, as Nike has told us for years, just do it.
“You don’t actually have to know how a transmission works in order to successfully drive a car,” reasons Stuart Ritter, a financial planner with T. Rowe Price. “Likewise, you don’t have to know what a price to earnings ratio is in order to invest and achieve your financial goal. You don’t have to know all the answers to all the questions before you start. ”
Stephany Kirkpatrick, a senior director of financial planning at LearnVest, agrees with Ritter. “The advice I give to clients is this: if you’re learning something new about investing, don’t let that hold you back from continuing to put money away for retirement,” she says. “It’s not what perfect stock you pick, what is important is that you actively save.”
They’re both right. That being said, there might be some questions you have that feel too basic to even begin to take their advice. With that in mind, here are some questions – along with the answers! – about investing that you might be too afraid to ask:
What exactly is “the market”? When someone refers to the market, they’re talking about the stock market – which, in turn, is shorthand for the three major stock indices: the S&P 500, the Nasdaq and the Dow Jones Industrial Average. The S&P 500 is an index of the 500 most widely-held companies (i.e, the stocks that the most people own) and is seen by many as one of the best ways to track the U.S. economy. The Nasdaq index tracks 4,000 stocks that are listed on the Nasdaq exchange (which, alongside the New York Stock Exchange, is where people can buy and sell stocks). The 4,000 stocks it tracks are weighted towards the information technology sector, leading many to nickname the Nasdaq the “blue chip” index. And the Dow Jones Industrial Average is the third major stock index: first calculated in 1896, the Dow is comprised of 30 well-known companies that have changed 58 times since the index’s inception. While the Dow was initially created to reflect the American industrial sector (hence the name), its current components include the likes of Disney, Microsoft, Apple, Coca-Cola and Nike.
LearnVest’s Kirkpatrick says that when people refer to “the market,” they usually are referring to the Dow – but because some people might mean S&P or Nasdaq when they say “the market’s up!” it can’t hurt to ask for clarification if you’re not sure.
What’s a 401k? Only about half of American workers have access to a 401k, which is a workplace savings plan that lets employees invest a portion of their paycheck before taxes are taken out. The savings can grow tax free until retirement, at which point withdrawals will be taxed as ordinary income. A large majority of employers will match an employee’s contribution – up to a point – thereby boosting the employee’s savings rate.
What’s an IRA? IRA stands for “individual retirement account (or arrangement)” and it allows you to save money for retirement even if you don’t have a 401k from your employers. There are two main types of IRAs: a traditional IRA, which functions nearly identically to a 401k, as taxes come out on withdrawals, and a Roth IRA, in which you pay taxes on the front end but can withdraw money in retirement tax free. (Note that your contributions to a traditional IRA may or may not be tax deductible, depending on your income.)
Why do I need a 401k or IRA, anyway – especially if I’m buried in student loan debt? The short answer is: because if you want to stop working someday, you’ll still need money to live. The long answer is: because the earlier you start saving, the more time your money has to grow, and thanks to the beauty of compound interest, starting to save at an early age can mean a six-figure difference in retirement.
(Note that if you have private loans with very high rates — say, north of 7% or 8% — some financial experts acknowledge the value of getting rid of that debt before you start putting extra money into your 401k, since avoiding the compound interest of the loan is the same as getting a 6% or 7% return in the market. But before you do anything — pay debt, put money in a 401k, etc — you must have an emergency fund! Your debt-free existence won’t mean squat if your car breaks down and you have to eventually charge the price of the new transmission to your credit card.)
Everyone keeps talking about an employer match… what’s that? It’s the money your employer puts in your 401k for you. Many people call this free money, because that’s really what it is: it’s your employer saying (for example) “if you put 3% of your salary into your 401k, I’ll put 3% of your salary into your 401k.”
T. Rowe Price’s Ritter says, however, that “how much your company matches is a red herring,” because their matching percentage doesn’t necessarily mean that’s your savings goal. “The employer match distracts people from the real number they should be paying attention to, which is 15%. That’s how much [of your take-home pay] you should be putting into an account for retirement every year,” he says. “If your employer is putting in 3%, you need to be putting in 12%.”
(If 15% sounds un-doable, try something lower — like 10%, or even 5% — and work your way up 1% at a time. Eventually, saving 15% will feel like a breeze.)
Should I invest in my 401k even if there’s no match? There’s no rule that says you MUST put money into a 401k (though if your employer offers a match, not saving in yours means leaving free money in the table). The important thing, though, is to save something, somewhere — and ideally somewhere other than a money market fund. If you’d prefer to save in a Roth IRA because you think your tax rate is lower now than it will be when you retire, go for it. If you like the convenience of having savings deposited directly from your paycheck into your 401k, and watching that savings grow tax-free, that’s a fine option, too.
It’s also worth noting that many companies now also offer a Roth option within their 401ks – meaning you can contribute to your workplace plan after-tax and then take the money out in retirement tax free. Again, that’s worth considering if you expect your tax rate to be higher later.
How and how much do I need to have to open a retirement account and start investing? That is a trickier question than you realize, as each bank — or robo-advisor — has a slightly different fee structure. Some will let you open an account for free but have a $3,000 minimum to invest in an index fund; others want you to have that money simply to open an account. You can find a breakdown of some of the most popular savings options — and their fee structures.
What’s an expense ratio, and why are they aren’t the same for every investment? LearnVest’s Kirkpatrick says that fees come up a lot in conversations she has with clients, and the easiest way to explain them is “to think about a budget for a business. That cost can be higher depending on what you as the business owner need to pay people to do.” An expense ratio, therefore, is essentially what you pay someone — usually a fund manager – to invest your money in the market. It comes out of the return you get in a year, so if your investments grew 10% and the expense ratio is 1%, you’ll really walk away with 9% growth.
“What can make an expense ratio more expensive is if the mutual fund is actively managed,” Kirkpatrick explains. “That means there’s a team of mutual funds analysts who all weighin on what the mutual fund should look like – versus a passive fund like an index fund that just follows a stock index. In that case, there aren’t as many salaries to pay, and in turn, fewer expenses to deduct from the fund’s annual return.”
Finally, she notes, paying 1% of your money a year as a fee might not sound like much, but with funds out there charging 0.2% or less, it’s worth it to read the fine print and make sure you’re not giving up more of your return than you need to.
What’s asset allocation? “Asset allocation is the mix of stocks, bonds and cash you have,” Ritter explains. “That’s all it is. How much of your portfolio for a particular goal do you have in stocks, bonds and short term investments?” (There are other asset classes too, like real estate and commodities. But at the most basic level of asset allocation, the three main categories are stocks, bonds and cash.)
Speaking of bonds: stocks make sense to me, but what are bonds? As ‘MoneyAffairs’ Sam Sharf explains here, the easiest way to think about buying a bond is to think about buying debt: you’re essentially lending money to a government or company that needs it. This isn’t because you’re a nice person and want to help Puerto Rico(for instance): you do this because interest is paid on the loan, and as the investor, you get that interest. The more creditworthy the borrower, the lower the interest rate, so when investors want a higher yield, they will sometimes buy what is known as “junk bonds” from companies and governments with lower credit ratings. This whole field is also known as “fixed income investing.”
How can I determine my risk tolerance? If you’ve heard of risk tolerance in life, it’s essentially the same in investing: how much risk are you willing to take in order to get what you want? Stocks have the potential to give you a higher return than cash, but since the stock market can go up and down, stocks are riskier investments in the short term; since the value of cash is relatively stable, keeping your savings in a money market account is a more conservative way to approach things. (But note that over time, inflation can eat away at the value of your cash – so that’s a risk too.) Taking a quiz can help you understand how important it is to you to get a high return — and how we’ll you’ll be able to sleep at night in the process. Vanguard, Wells Fargo and Bankrate.com all offer good risk tolerance and asset allocation quizzes (respectively).