So your employer either does not provide a 401(k), you are too new, you are an intern or part-time employee. That is okay, you still have options. Just because you do not have access to a 401(k), doesn’t mean you shouldn’t start thinking about long-term goals. If you did have access to a 401(k) it would be a no-brainer to take advantage of the full matching that your employer provides because it is essentially free money. However, when you don’t have this access, it is not always as clear to know what you should be doing. Here are the financial areas to consider in lieu of a traditional 401(k) plan:
Why Employers May Not Offer 401(k)s
Usually the cost of implementing a 401(k) plan is not expensive to the employer because the employees actually pay a bulk of the cost through their investments built-in expense ratios, but still, the biggest benefit of an employer 401(k) is the matching percentage. The matching percentage can increase the cost to employers pretty dramatically, which is why some employers forego plans altogether. Maybe your employer does offer a plan and you are not currently eligible based on your status. This too is to reduce cost, the employer does not have to worry about matching employees who have been with a company less than a year, works than a certain amount of hours a year, or are seasonal/interns (depending on the plan rules).
One problem many run into if they do not have access to a 401(K) is they just spend their whole paycheck. That is a huge mistake and starts a horrible habit of living paycheck to paycheck, which is a common statistic in the US you do not want to be a part of.
What you should do, is act as if you do have retirement accounts and begin saving what you can reasonably afford to target these long-term goals, where your funds will not be easily accessible. Early on in your career, you are probably used to living off of a tight budget. I know when I was working my way through college that I miraculously made a $100 grocery budget last all month. I am not saying you have to be extreme, but realize that you don’t have to spend everything you make just because you want to feel like a baller.
The recommended amount that should be saved as soon as you enter the workforce to give you the most flexibility of achieving your goals and being able to retire at a reasonable age is 15% of your gross income. Since you don’t have a 401(k) with an employer that offers free matching contributions, all of the heavy lifting will need to be done by you. This is obviously a general target, which means your scenario may allow you to save less or require you to increase it above the 15%. Most often this 15% is meant to be true long-term savings, but early on in your career, you may be trying to achieve short-term goals, and pay off debt. Saving at a high clip and not allowing yourself to sink deeper into debt allows you to live well within your means and makes it easier to make adjustments when opportunities present themselves.
Building emergency savings is a good place to start with your monthly savings if you haven’t built one up yet. Again, the recommended balance varies depending on your household comfort level and income sources. The normal recommended ranges are 3 months for dual income household and 6 months for single income households. There are many variables that may adjust these targets to ensure you are able to sleep at night, but you can use this range as a starting point.
An emergency savings is not meant to be a catch-all for expenses that you should expect to occur like vehicle maintenance and irregular expenses like travel. A true emergency savings is reserved for truly unexpected costs, which means you should not be hitting it up multiple times throughout the year. The importance of this account is that when a truly unexpected large expense pops up you are able to handle it easily without turning to high interest debt like credit cards or personal loans.
Once you have established a comfortable emergency savings, than it would be a good next step to analyze your debt situation. The biggest factors to consider are the balance of what is owed, interest rate, and monthly payment.
If you have balances with extremely large interest rates you will want to make those a focal point of where to allocate your excess funds. Keep in mind, most financial institutions will not apply your excess payments towards principal unless you clearly indicate with your payments that the extra funds should be applied towards the principal. Credit cards do apply your excess payments towards principal, so you do not need to specify the requests on those balances.
As your higher interest debts are paid off and your interest rates are closer to the mid-single digits or lower, than paying off debt faster than the normal payoff periods may not provide the best long-term results. This is one of those things that requires you to factor in a handful of preferences in order to determine the best move with the excess income once you reach this point.
Now that you have an emergency fund well established and knocked down your debt to more appropriate interest rate levels, you can begin to weigh the opportunity of long-term investments. Just because your employer does not provide you access to a 401(k) plan doesn’t mean you cannot invest or have access to retirement accounts.
There are no tax benefits when opening a general brokerage account for investing, but you also will not have limitations to accessing the funds like you will find with your retirement account options. I only recommend my clients use investment accounts if they truly have a long-term investment horizon of 4 years or more, but it is nice to know that if you absolutely needed to access the funds unexpectedly that you could do so without penalty. Whether the value of their investment would have gone up or down in that time frame, no one truly knows. P.S. don’t trust anyone who says they can predict what the investment markets will do in short-term conditions.
The biggest difference when compared to general brokerage accounts is the traditional IRAs have special tax treatment, as well as, a whole list of rules and limitations. If you are eligible to contribute to an IRA account than your contributions are tax deductible, which means they will reduce your tax burden for the year your contributions are applied to. Your contributions for 2018 are limited to $5,500 per individual (not per account). When you retire and begin to make withdrawals from your account, you will then be required to pay taxes according to the tax code at the time of withdrawal. Another important piece of information to be aware of is that the IRS provides these tax benefits as an incentive to save for retirement, which requires under normal circumstances, you can not withdraw funds until you reach age 59.5 without penalty. There are a few ways around this, but the ability to do so is not very common.
A Roth IRA works very similarly to the traditional IRA with a few unique exceptions. Contributions are not tax deductible. However, your investments are allowed to grow tax-free and you never have to pay taxes on them again. Penalties may apply if you withdraw funds sooner than they are allowed. A really great feature of Roth IRAs is that you can actually remove your contributions without any penalty at any time. This unique feature makes them a very flexible planning tool.
Regardless of where you find yourself at on this strategy guide, I cannot stress to you enough how important automating these savings or debt repayments. If possible, have your employer apply these straight out of your paycheck. If not, maybe you set up a specific account where these funds pop into and set up automatic deposits and payments from that account. Automating these things to occur without requiring you to manually touch all of these different areas ensures that it will actually do it and that you do not make excuses on why you should use these funds for something else before they ever make it to their targeted destination whether that be savings, debt repayment, or investment accounts.
Not having access to a 401(k) account does not mean you are off the hook from being an adult and doing the right things. As you have seen, there are many areas of your financial life that can be improved in lieu of having a traditional 401(k) account. Should your situation ever change in the future where you then have access, you will be in a significantly greater position to maximize your new benefit.
Need help getting organized and staying focused? That’s my specialty. Feel free to reach out for a free consultation to see if I may be a catalyst to your financial success!