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The Default Settings on Your Retirement Plan and How to Utilize It (Part Two)
Now that we know the rules, it’s time to play the game. The rules were part one of this article, which I suggest you read before this article. There are ways to go outside of the default game plan to reach your retirement goals earlier. The two easiest are investing more and more aggressive investments, with the knowledge of a longer time horizon mitigating our risk. A longer time horizon in the financial planning world is anything over eight years. As I discussed in my “Are Target Funds the Killer of Your 401(k)?” article, people are typically far too conservative in their employer retirement plans. There are two big contributing factors as to why being more aggressive in your 401(k) makes sense, the first one being the time horizon and the second is dollar cost averaging.
Typically, when you are contributing to your employer retirement plan, you are contributing to a tax qualified retirement plan. These plans have certain restrictions as far as to when you can take the money out. Sure, there are exceptions out there, and you can technically pull the money out at any time, as it is your money, however, you will receive a 10% tax penalty if you take it out before the age of 59 ½. If the money is in a traditional account, which if your employer matches your contribution, it most likely is a traditional tax deferred account, you will also get hit with income taxes. Let’s use our case study from part one and say his salary as a single man is $100,000. If he pulled out an additional $50,000 from his traditional 401(k) before 59 ½, he would go from paying an estimated $14,260 in taxes, to paying an estimated $31,075 in taxes for 2023. So, if we know that we will not be touching this money till at least age 60, we can subtract our age from 60 to find our time horizon. Anything over 8 years is considered a long-time horizon, so investing in a target fund, that is 70% stocks, and 30% bonds could be far too conservative and leave money on the table. In the “Are Target Funds the Killer of Your 401(k)?” article, I explain in detail how over twenty years with a similar example, we can see a difference of almost a quarter of a million dollars.
The other reason for a more aggressive investing philosophy is dollar cost averaging. Dollar Cost Averaging, or DCA for short, is what employer retirement plans are set up to do. The old idea of buying low and selling high is great if you have a crystal ball that can tell you exactly what the market will do, but Dollar Cost Averaging allows you to buy more when prices drop, and less when prices are rising. Below we see a table of what it looks like to Dollar Cost Average in a falling market.
Month |
Invested |
Share Price |
Shares Purchased |
January |
$ 500.00 |
$ 30.00 |
16.67 |
February |
$ 500.00 |
$ 29.00 |
17.24 |
March |
$ 500.00 |
$ 28.00 |
17.86 |
April |
$ 500.00 |
$ 27.00 |
18.52 |
May |
$ 500.00 |
$ 26.00 |
19.23 |
June |
$ 500.00 |
$ 25.00 |
20.00 |
Totals |
$ 3,000.00 |
109.52 |
|
Average Cost Per Share |
$ 27.39 |
||
Average Price Per Share |
$ 27.50 |
As prices per share decline over the six-month period shown, we can see the number of shares being purchased is increasing, allowing us to lower our cost basis in a declining market. Cost basis isn’t that big of a deal in a traditional account; however, it can play a factor in both Roth and Brokerage accounts. Now let’s look at a table of what it looks like to Dollar Cost Average in a raising market.
Month |
Invested |
Share Price |
Shares Purchased |
January |
$ 500.00 |
$ 26.00 |
19.23 |
February |
$ 500.00 |
$ 27.00 |
18.52 |
March |
$ 500.00 |
$ 28.00 |
17.86 |
April |
$ 500.00 |
$ 29.00 |
17.24 |
May |
$ 500.00 |
$ 30.00 |
16.67 |
June |
$ 500.00 |
$ 31.00 |
16.13 |
Totals |
$ 3,000.00 |
105.64 |
|
Average Cost Per Share |
$ 27.39 |
||
Average Price Per Share |
$ 28.50 |
As we can see, as prices per share go up over the six-month period, the number of shares being purchased decreases. This allows us to not only buy less in case of a downturn, but also has a rebalancing effect on our portfolio if we are invested in multiple securities.
The “Default Retirement Plan” that I described in part one assumes that you will get an average rate of return of about 7% after fees. However, the S&P 500 has averaged about 10.15% return over the last 66 years (The average annualized return since adopting 500 stocks into the index in 1957). Even if we account for 1.5% in fees and expenses, we should still see 8.65% on average. This may not sound like much, but if we take the 500 a month example from the tables above, and use it over a 20-year period, the difference is about $49,200. This is an easy way to shave one year off work and add it into the retirement bucket. In part three of this series, we will discuss ways to invest more. This strategy can alone take time off of your work life but pairing it with the ability to invest more can take years off of the goal of financial independence. If you would like to take the next step on improving your investment plan you can set up a no obligation strategy call with me using this link here. Part three will be published on September 21st and can be accessed after that date here.