The 411 On 401(k) Plans

Savings accounts come in many forms, and one of the most popular in the US is the 401(k) plan. It’s essentially a piggy bank that you should not crack open until after age 59 1/2, close to retirement age for most of the workforce which is why it is often viewed as a retirement savings account. To make matters more confusing, it’s named after a tax code, hence a bunch of numbers in the name: 401(k). How it works is quite simple by learning a few fundamentals. And if you work for a non-profit or government agency, most of the following will be true for you too, except instead of a 401(k), you call it a 403(b).

Understanding a 401(k) plan starts with learning how to use it and how not to abuse it. Using it requires being employed by a company that offers a 401(k) plan. This account belongs to you, and you keep it if you leave the employer. A 401(k) relies on a defined contribution, a percentage of your salary (%) that will automatically go from earnings into your 401(k). In many cases, employers will offer a 401(k) match for contributing to the 401(k) plan. You decide how much to contribute, and your employer matches that amount, up to a limit dictated by your employer. So your employer is actually paying you more money than you thought! Isn’t it neat to get an extra $50 or $100 or $200 per month? Just remember though, you have to contribute to the 401(k) in order for the employer to match.

Why use a 401(k) vs. saving at the bank? The difference with a 401(k) is taxation. Money going into the 401(k) is pre-tax, and any growth on that money is tax-deferred. What does that mean? Taxes take a share of any money you make, so as an example, earning $100 really means earning $85, based on a 15% tax rate. However, in a 401(k), that $100 equals $100 going in. If that $100 grows to $150 this year, you keep that $150 in the account, as opposed to taxes taking $7.50 away ($50 growth x 15% tax = $7.50). Keep in mind that this example only illustrates $100. Imagine what this means for $10,000 or $100,000. Now before you go putting all of your paycheck into a 401(k), there is a limit on how much you can contribute each year, set by IRS tax regulations. This year (2019), the limit is $19,000 for the year, with the ability to contribute more if age 50 or older, known as catch-up contributions.

Notice I said that money in your 401(k) is tax-deferred, not tax-free. In a 401(k), taxes take their share when you withdraw money, at your normal tax rate. But the important thing is that your money had more potential to grow because taxes did not eat away at every cent along the way. Thus, the 401(k) is known as a tax-advantaged account, a special type of savings account.

How does growth happen in a 401(k)? Through investing! Often people confuse a 401(k) with the stock market. True, you can place stocks in your 401(k), but stocks are not the only type of investment you can have. Going back to a former lesson when we talked about planting seeds, the 401(k) is just a flower pot, and you get to decide which investments, or seeds, to grow inside. Most employers limit your investment choices to a few, so that you are not overwhelmed by the options.

A 401(k) is not always used as a retirement savings account. Let’s discuss some possible pitfalls with the 401(k). Try to avoid the following:

  • Early Withdrawals. If you withdraw money from your 401(k) before you turn age 59 1/2, you not only pay the taxes owed, but you also get penalized an extra 10% on your withdrawal. That diminishes your earning power.
  • 401(k) Loans. Some 401(k) plans allow you to take a loan. But borrowing from a 401(k) means you lose out on the time that your investments could be growing. Time is something you cannot buy back.
  • Not Capturing Full 401(k) Match. Although you could argue that any contribution to the 401(k) is still savings, not capturing the full employer match is a loss for you. To view it from another angle, if your employer let you choose between $50 more or $100 more per month, and neither option required you to work more, wouldn’t you choose the $100? That’s the same as capturing full 401(k) match!

There you have it! The 401(k). It may seem like a lot to absorb, but just think of the flower pot, and you are well on your way to being an ace at the 401(k)!

Homework: Take a look at your 401(k). Are you capturing full 401(k) match from your employer? Parents can start kids young with a savings match! Learn more by clicking here.

Ace Academy will skip next week’s lesson in observation of Thanksgiving holiday and resume the following week. I also want to take this moment to thank you for reading!

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Credit Card FAQs

Whether you already have a credit card or are thinking about getting one, it’s time to get acquainted. Here’s what you should know.

What is a credit card?

A credit card allows you to borrow money to make purchases and then pay back later. How much you can borrow is based on your credit, or your trustworthiness to pay back the money. There is also a time limit to pay back the money before interest starts to multiply on the original amount borrowed.

Why use credit cards?

Credit cards carry several advantages:

  • Use credit cards in place of cash, which can be bulky in your wallet.
  • Build and maintain credit history. Mortgages and other loans will often check how well you handled past payments. Did you pay on-time?
  • Earn perks like travel miles or shopping points, and sometimes even cash back, with certain credit cards.

What are some key costs of using a credit card?

  • Finance Charges – Do you carry a balance on the credit card after it is due? Then you owe interest on the borrowed money, otherwise known as finance charges. These get calculated as an annual percentage rate, or APR. If you pay in full each month, you have no finance charges.
  • Late Fee – Don’t pay your credit card on-time? There’s a fee for that.
  • Balance Transfer Fee – Trying to move other debt to your credit card, so that you can capture a lower interest rate? Doing so incurs a balance transfer fee, usually a percentage of the amount to be transferred.
  • Annual Fee – Some credit cards carry such good perks or low finance charges that it costs you money to use them. Using these types of credit cards is wise only if the perks outweigh the annual fees.

As you can see, most of these costs don’t apply if you pay your credit card in full each month. Thus, it is actually possible for the cost of using credit cards to be zero!

How does credit card debt happen, and how do I avoid it?

As long as you pay off your credit card in full every time and on-time, you won’t fall into debt. In fact, it should be the only way to use credit cards. Unfortunately, credit card companies give the option to pay a minimum amount, typically 1%-2% of the total credit card balance. Paying the minimum causes the remaining balance to rack up interest, adding to the cost of what was originally borrowed.

To illustrate the real cost of carrying a balance on a credit card, let’s use this example. Say you buy a bike for $100 on a credit card with 18% APR (annual percentage rate). $100 x 18% = $18. You actually pay $18 more dollars on that bike if you let that debt sit for a year. If the credit card company calculates on a monthly or daily basis, and most do, that bike will cost even more. Much like compound interest on investments, debt multiplies itself over time. Avoid debt altogether by buying only what you can afford and paying off the balance in full each month.

Parents can introduce credit cards using a 3-step approach. 1) Start with gift cards. What’s great about gift cards is that you can only spend what you have and nothing more, but you are required to spend in only one place. Nowadays there is the option to get gift cards to use wherever credit cards are accepted. 2) Get a debit card to allow for spending anywhere, keeping within the limits of what is available. A debit card requires an attached bank account to pull funds from, so you will need to set one up if you want children to access their own money. 3) Graduate to the credit card! Only keep the credit card if every statement is paid in full.

Credit cards: Good or Bad?

Only you can decide whether credit cards are good or bad for you. If you can commit to paying off your credit card in full each month, there really is no disadvantage to keeping or getting one. Choose what’s right for you!

Tune in next week to learn about the 401(k) plan. Is it a type of investment? Is it a savings account? Subscribe below to automatically receive weekly lessons in your inbox!

Homework: Know what credit cards are charging you. Become familiar with the costs before getting a credit card, and choose the right one. If you already have a credit card, is it the best one for you?

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Compound Interest

In addition to the seven natural wonders of the world, Albert Einstein believed in an eighth wonder of the world: Compound Interest. What is compound interest? In a nutshell, it’s money making money.

How does one unlock the door to compound interest? Through investing. The easiest way to understand investing is to think of a plant. Start with a seed (investment), and the plant will eventually sprout branches. Some branches will have leaves (interest), but others will sprout new branches, which yield more leaves (more interest). Sure, there may be setbacks, but if your plant thrives, your little seed has grown into something much larger. Imagine if you could do the same with money? You can! That is the power of compound interest. Branches growing more branches.

Time plays an important factor in investing. Just like plants need time to grow, your money needs time to grow interest and then more time for that interest to compound into more interest. The earlier you invest, the more your money can grow on its own. To calculate what time can do for your money, use the Rule of 72.

Rule of 72: Divide 72 by the (%) interest rate you earn, and the answer is how many years it will take for your initial investment to double. For example, if you earn 8% interest on a $1,000 investment, 72 divided by 8 equals 9. Without adding any more money, that $1,000 investment will double to $2,000 in 9 years.

When it comes to investing, your choices vary widely, but they boil down to a few basic types.

Cash

Believe it or not, cash is a type of investment because it has the potential to earn interest. Some common cash investments are money market accounts or certificates of deposit (CD). Although cash tends to be the least likely investment to lose money, it does not typically yield a lot of interest. But for short-term needs, also known as liquidity, this is a good choice to earn a little bit along the way.

Bonds

Have you ever borrowed money and needed to pay interest when you returned the money? When you invest in a bond, you are loaning your money to others, and after some time, they pay back your initial loan with interest. There are many types of bonds you can invest in, so the interest rates and chances of getting your money back fluctuate depending on who you are loaning the money to.

Stocks

Buying stock is essentially owning a part of a company, hence you buy “shares” of that company. A stock earns money when the company is viewed favorably by investors and loses value when the company is viewed negatively. Stocks have vast potential to grow, but also come with the risk of losing money. Much like plants weather different seasons, stocks can take a bumpy ride. This is why stocks should be seen as long-term investments, so that your money is given a chance to ride out any volatility. You may have also heard of investments called mutual funds, index funds, ETFs, options. These are simply variations of investing in stocks and sometimes bonds.

Real Estate

Ever wonder why most people say buying a home is better than renting? It’s because buying a home gives you the opportunity to earn money when you sell the home, assuming the home grows in value. To invest in real estate, do you have to buy a house? No. You can actually invest in real estate companies through real estate investment trusts (REIT) or even buy shares of publicly traded real estate companies on the stock market.

Tying It All Together

When thinking about what to do with your savings, you will most likely take more than one approach to investing. You may even have investments not listed above. The key is to plant those seeds, and then witness the wonder of compound interest!

Tune in next week as we explore credit cards. Good thing or bad thing? Subscribe below to automatically receive weekly lessons in your inbox!

Homework: Do your research! Choose 5 of your favorite companies or brands that are publicly traded on the stock market, and follow their stocks for the next month (or longer). If you initially invested $10,000, how much did you earn?

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Balancing A Checkbook

Ever wonder why the amount left on your account is called a “balance?” That’s because you should get that same number after you “balance” your checkbook.

Like budgeting, all it takes to balance a checkbook is addition and subtraction. However, budgeting and balancing serve different purposes. Budgeting is about looking ahead, whereas balancing is about looking back.

Nowadays with all the available money tracking tools, most people don’t bother to balance their checkbooks. However, I strongly encourage you to add this exercise to your monthly routine, so you can monitor how well you are doing against your budget. Are you spending what you originally planned? Do you need to make tweaks to your ongoing budget?

Let’s Begin!

Let’s use the following example to illustrate how to balance your checkbook. Feel free to substitute your own numbers.

Start with $2,000 in your bank account at the beginning of the month.

Add (+) $3,000 in earned income.

Subtract (-) $1,000 for rent.

Subtract (-) $200 for utilities.

Subtract (-) $200 for transportation.

Subtract (-) $100 for Internet / phone bills.

Subtract (-) $1,000 for purchases related to food and miscellaneous shopping.

After doing the math above, we are left with $2,500. This number should match the remaining balance on the bank account at the end of the month.

There you have it! Now you are an *ace* at balancing your checkbook!

Homework: Balance your checkbook for last month. Did your actual spending match your budget?

What is the eighth wonder of the world? Tune in next week for the answer! Or subscribe below to automatically receive weekly lessons in your inbox!

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