Don't short change your 401(k)!

401(k) retirement savings plans offer the best chance that many folks have to contribute towards their own retirement. Therefore it is critical that you contribute as much as you possibly can to your 401(k). How much is that? Well, of course, that answer is the same as the answer to most questions about personal finance: It depends.

Here is how most plans work: You, the employee, sign up to have a specified percentage of your pre-tax earnings put into a special account that will be invested and grow so that you can afford to retire someday. This percentage can be anywhere from 1% to 10% in most cases, although Doc has seen some plans that allow for a 20% contribution.

There is a maximum limit for most individuals of $16,500 for 2011 ($22,000 if you are over 50). This means that if you earn more than $165,000, you might have to do some calculating. However, if you are earning that much, you can probably afford the services of a fee-only personal financial planner to help you with this and other things.

The true beauty of the 401(k) plan is that, in most cases, your employer also makes a contribution on your behalf. Typically, an employer will contribute 50 cents for each employee dollar contributed up to 6% of the employee’s salary. Again, your plan may vary. Check with your employer and your HR department. So, if you earn $40,000 per year and have a typical plan, you can contribute $4,000 (10% of salary) to your 401(k) and your employer will contribute $1,200 (50% of 6% of $40,000).

So what happens to that $1,200 if you do not contribute at least the $2,400 per year to claim your stake in it? I don’t know. One thing is for sure, though: you will never see a penny of it. If you do not contribute enough to your own retirement plan to earn the match from your employer, then that money is still your employer’s, not yours. This is part of your overall compensation, money that you are able to earn, but if you do not contribute your share, than your employer will keep those funds for his/hers/its own purposes. Got that? It’s important. It is your compensation and it is up to you to claim it.

WSJ article related to this topic

If you took a look at the Wall Street Journal linked above, you saw that a lot of people do not contribute as much as they can to their 401(k) accounts, thus missing out on a significant benefit. Do not make this mistake. And don’t be harsh on your employer; they have to look out for their best interests, too. Since 2006, most employers have taken advantage of a law that says they can automatically enroll employees in a 401(k) plan. Typically (a frequently used word when describing 401(k) plans), this number is 3%. So a lot of people come to their first day of work, sign a bunch of papers and save 3% of their pre-tax earnings and call it good. The Employee Benefit Research Institute has found that people are more likely to go with the 3% default contribution than to contribute as much as they need, or even as much as required to claim their full amount of compensation.

But you can do better. First, find out how much your employer contributes. Then, contact your HR department and make sure that you are contributing AT LEAST enough to maximize the employer’s matching contribution and take full advantage of the compensation available to you. It is your money, but you will not have access to it until you take the action necessary to claim it.

For public employees who have 403(b) plans, this is one of the ways in which most of us are not similar to our 401(k) holding counterparts. However, your employer may offer additional ways to save pre-tax earnings, and you should definitely look into those.

Once more, it is your money. Get your hands on it. 

Quiz answers Part II

OK, here are the rest of the answers to the financial knowledge quiz question. This entry covers interest rates/bond prices, mortgages, and portfolio diversification.

3.      If interest rates rise, what will typically happen to bond prices?

a.       They will rise

b.      They will fall

c.       They will stay the same

d.      There is no relationship between bond prices and interest rates

e.       Do not know

OK, this one is hard, and I’m not sure that everyone needs to know or understand this on a daily basis but there you have it. The short answer is: Bond prices move inversely with interest rates, therefore if interest rates rise, bond prices will fall.

Here’s the longer answer. A bond is a financial instrument that represents a form of borrowing wherein the borrower or bond issuer, and this can be a company, a city, state or even the federal government, issues debt in exchange for capital and agrees to a schedule of interest payments and repayment of the principal at a specified date.

ABC Company wants to borrow money, so they issue you a bond in exchange for $1,000 and agree to pay you 3% interest (or coupon) per year for ten years, at which time you get your $1,000 back.

So what happens in a week or a month or so when XYZ Company wants to borrow money and is willing to pay 4% interest for borrowing $1,000? They will still pay back $1,000 in ten years, so this is exactly the same as the ABC deal except for the interest rate. Obviously this is a more attractive option for investors, as a 4% return is greater than 3%.

How much do you think someone would offer you for the ABC bond now? If they could take $1,000 and realize a 4% return, do you think they would want to pay $1,000 for a 3% return? Probably not. In fact, they would probably only pay about $920 for that bond.

The point here is that when interest rates go up, there are investments in the marketplace that will earn higher rates of return. Investments like bonds that are tied to lower interest rates will not be as attractive to investors as newer issues that will pay more. Therefore the prices of investments that are tied to lower interest rates will fall in price.

You can see how this works in the other direction, too. If you own an investment that pays 3% and new investments are only paying 2%, then yours will be worth more because it generates a higher rate of return.

Again, this question may be kind of complex for a quiz like this, but it is important financial knowledge.

4.      Is this statement true or false: A 15-year mortgage typically requires higher monthly payments than a 30-year mortgage, but the total interest paid over the life of the loan will be less.

a.       True

b.      False

c.       Do not know

Most households will purchase a home at some point in time and need a mortgage to do so. A mortgage is a big, long-term loan backed by a substantial asset (like a house). The mortgage gets paid on a monthly basis over the term of the loan. The conventional length of a mortgage loan is 30 years, meaning 360 monthly payments. Some mortgage loans are written for 15 years. This question is asking which of these is less costly in the long run.

So, all other things being equal or ignored, let’s look at two mortgages. One is for 30 years and the other is for 15 years. Both have the same interest rate, 5%, and both have the same principal loan value, $100,000. We won’t go into detail on the math, but the 30 year mortgage is repaid with monthly payments of $536.82. The 15 year loan is paid back with a $702.92 monthly payment. That’s a pretty big difference when you are evaluating your monthly expenses! However, let’s take another look at the total cost of the loan.

With the 30 year loan, you will be making monthly payments for 30 years, or 360 payments. We know that the payments are $536.82. This means that you will pay 360 * $536.82 or $193,255.20. With the shorter loan, monthly payments are made for 15 years, meaning that you will spend 180 * $790.92 or $143,342.20. That’s a difference of almost $51,000! Since the amount of the principal for both loans is the same at $100,000, the difference is in the amount of interest paid.

Thus, a shorter mortgage does cost more on a monthly basis, but the borrower ends up paying less overall with the difference being entirely interest. So this is a true statement.

5.      Is this statement true or false: Buying a single company’s stock usually provides a safer return than a stock mutual fund.

a.       True

b.      False

c.       Do not know

This question is all about diversification. Have you ever heard the statement “Don’t put all of your eggs in one basket”? That’s all about diversification, too. The idea here is to spread the risk of investing over many assets, and not placing all of your faith on just one company. If you buy a single stock and something bad happens, you have lost your entire investment. If you buy lots of different stocks, then you have spread your risk over many different companies and you chances of losing it all are greatly diminished. However, it can take a lot of money to buy stock in several different companies and a lot of time to do the necessary research to manage your investments. Mutual funds are professionally managed financial entities that buy a wide selection of companies and then repackage them and sell them to investors. That way each investor can share the benefits of ownership of many different companies, diversify risk and generally enjoy a safer return than owning stock in just one company.

There are almost as many mutual funds available as there are individual companies, and they are not all created equal. You still need to be a conscientious investor, but generally speaking, mutual funds offer a reduced risk alternative to owning one individual stock. The statement is false.

I hope that these explanations have been helpful and that you feel more secure in your financial knowledge. While financial knowledge is not the one and only key to financial satisfaction, it is an important component. Remember the motto of Faber College: Knowledge is Good (if you are mystified, it's an Animal House reference). 

Quiz answers Part I

This will take a couple of entries. We'll take on the first two quiz questions today, and address the others in due time. 

1.      Suppose you had $100 in a savings account and the interest rate was 2% per year. After 5 years, how much do you think you would have in the account if you left the money to grow?

a.       More than $102

b.      Exactly $102

c.       Less than $102

d.      Do not know

OK, so you go to the bank and deposit $100 at an interest rate of 2%. What does that mean? It means that you leave the money there and in a year you will have 2% more than you started with. Simple math version: $100 + ($100 * .2%) = $100 + $2 = $102.

But the question says that you leave the money in the bank for five years. It’s pretty easy to work through that. We’ve already done Year 1.

Year 1  $100 + ($100 * .02)  = $102.  This can also be expressed as $100 * 1.02 = $102.

Year 2  $102 * 1.02 = $104.04. This is where we start to see the magic of compound interest!

Year 3  $104.40 * 1.02 = $106.12 (We’ll round to the nearest penny.)

Year 4  $106.49 * 1.02 = $108.24

Year 5  $108.61 * 1.02 = $110.41

So, if you leave $100 in the bank earning 2% in annual interest, in five years you can withdraw $110.41, which is more than $102.

2.      Imagine that the interest rate on your savings account was 1% per year and inflation was 2% per year. After 1 year, how much would you be able to buy with the money in this account?

a.       More than today

b.      Exactly the same as today

c.       Less than today

d.      Do not know

We have a good start towards answering this one. We know how to calculate how much money is in a savings account after one year. However, this time the interest rate is 1%.

$100 * 1.01 = $101

However, we are dealing with inflation here. Inflation means that prices are rising. This can happen for a variety of reasons, but usually the cost of the underlying goods is rising for one reason or another. The relevant piece of information here is that inflation is 2%. That means that $100 worth of stuff on January 1 would cost $102 to buy one year later.

Year 1 inflation $100 * 1.02 = $102

This means that even though you saved money and had it earning 1% per year, inflation has outpaced you. At the end of the year you would need $102 to buy all of that stuff, but you only have $101. Which sucks, but also means that the answer is ‘less than today.’ 

That's enough for today. There will be more answers tomorrow!