It seems as though people in the money industry thrive on confusion. They enjoy knowing cool numbers that mean neat things to boring people. If the discussion of topic doesn’t involve a 1040, 401k, or 403b it involves a SEP, Roth IRA, or HSA.

I won’t go into each of these today. But we should really take some time to talk about the basics of a 401k.

Planning for retirement is crucial. The time-value of money principle has proven itself time and time again. You have to begin saving for retirement as soon as possible. However, you must make sure your financial situation allows it. If you have done the following four things then you are ready to begin investing for retirement:

1. Stop living paycheck to paycheck.
2. Begin budgeting your money and sticking to it.
3. Get out of debt except for your home.
4. Save three to six months’ expenses in a liquid account (I recommend ING DIRECT).

Once you have these four steps down, you can begin thinking about retirement.

I admire the fact that some people want to begin investing for retirement early, but if you have debt, that is probably not the wisest financial decision. For example, suppose you have a $3,000 balance on your credit cards with an interest rate of 9%. You’re anxious to begin putting some money away so you start a retirement fund that could potentially earn 10% per year. If you would simply pay off your credit card balance you would, in effect, be making a guaranteed return of 9%! Make sure you have completed the first four steps mentioned above before you begin worrying about retirement (an exception might apply if you have massive student loans, i.e. they’re the size of a mortgage).

On to the 401k basics. Once you begin investing for retirement, you should first look to your company’s basic 401k plan if there is an employer match involved. The reasoning behind this is pretty straightforward. If you work for a company that matches 2 for 1 then that would mean that for every $1 you invest into your 401k, your employer invests $.50. This is subject to IRS limits that we’ll talk about a bit later. This is essentially free money. To not be contributing to an employer-matched 401k is like flushing money down the toilet. Holding all other things constant, if your employer matches your donation 2 for 1 then you are making a return of 50% on your investment. That’s not too shabby partner.

In general, payments are auto-deducted from your paycheck. This is advantageous to many people who lack the discipline to not spend that money as soon as it touches their hands. It’s also pretty darn convenient – one less thing you have to worry about doing each time you’re paid.

Your 401k contribution, along with your employer’s matching contribution, will usually be invested in some type of a mutual fund. Some companies allow you to invest in company stock – even at a discount. My heart aches for those Enron employees who lost all of their retirement savings when Enron collapsed. Please, please don’t put all of your eggs in one basket. Diversify.

Diversification is accomplished quite easily with a mutual fund. Generally with a 401k plan you’ll be given several fund choices. I am partial to index funds for their ease of administration and low expenses. In the long run, with an index fund you will out-perform 2/3 of investors. You will of course, under-perform against the other 1/3. For a more in depth explanation of this concept, take a look at this article. Make sure to choose a fund with a risk profile you feel comfortable with. If your allocation doesn’t allow you to sleep at night then it’s probably not worth it to you. Understand what you’re investing in and keep it simple.

The tax implications of a 401k are powerful and in your favor as long as you play your cards right. Generally, contributions to your 401k are made pre-tax, which saves you the amount contributed times your tax rate. For example, suppose you have an income of $100,000 without contributing to your 401k. If you contribute $10,000, then your taxable income will now be just $90,000. If you were taxed in the 30% bracket without having made the contribution, you would owe $30,000 in taxes. If you make the contribution however, you would only pay $27,000. You save $3,000 in taxes for contributing to your own retirement!

Another tax advantage to the 401k is that all of your earnings from your investment are tax deferred. Let’s do another hypothetical. Suppose you invest $10,000 just one time into your 401k and then sit on it for 40 years. After 40 years you withdraw the money and pay taxes on the entire amount. You would end up with $316,815. What if you just invested into a mutual fund that had no tax advantages? You would have $149,755. Less than half! The 401k is a powerful vehicle to minimize your tax bill while maximizing your return on investment.

Be warned: the 401k is there for retirement. The IRS imposes a 10% early withdrawal penalty if you’re under age 59 1/2 which can be absolutely devastating to your growing nest egg. Avoid withdrawing your 401k at all costs. If you have followed the steps outlined at the beginning of this article, the chance of you needing to borrow against your 401k balance is very, very slim.

There are limits to how much you can invest in your 401k. In 2004 the IRS has capped the contribution limit to $13,000. Current law provides for growth of the annual contribution limit to match cost-of-living increases. Currently the contribution limits are set to increase by $1,000 each year until 2006, where it will be $15,000.

If you change jobs, start your own business, or are laid off, there are a few options available to you regarding your 401k:

1. Take a cash disbursement. This is the absolute worst choice. Your employer is required by law to withhold 20% of the disbursement amount to pay your taxes, and if you are under 59 1/2 years of age then you will also be assessed a 10% early withdrawal penalty. Something else to keep in mind is that your tax liability for the disbursement may be greater than 20%, which would leave you with taxes to pay that you may not have anticipated.
2. Leave the investment with your employer. This choice is much better than the first. If you choose to leave it with an employer it continues to grow tax-deferred. You would most likely end up opening another 401k at your new employer and begin contributing to that. Switching between jobs can cause quite a bit of confusion with your retirement funds however. Many people find it hard to manage funds when they are spread in many different places, which may lead to sub-optimal investment performance.
3. Transfer your 401k to your new employer. This is a solid choice. You end up having your investment under one adminstrator, which makes it easier to manage and monitor. Not every employer allows you to do this, which might make the last option your best choice.
4. Rollover the 401k to an IRA. This option is a great choice for a couple different reasons. First, you can always rollover and don’t have to worry about whether your employer accepts transferred 401k plans. Second, a traditional IRA offers all of the tax advantages of a 401k plus increased flexibility. You can invest in almost anything you want with an IRA, while a 401k’s choices are limited by the employer plan options (usually 10-15 different funds).

One other important term you might want to be familiar with is vesting. Most companies have certain requirements regarding when the contribution they make on your behalf actually becomes your money. Usually you have to work a certain number of years before the employer contributions are vested. Being vested simply means that those funds now belong to you and you can do with them as you please. If your company’s vesting requirement is 3 years, and they’ve matched your contributions at all, it would be a good idea to stick it out if you’re thinking of quitting with 2 years and 8 months left. You could be leaving a lot of money on the table! Not only would you be letting go of the amount contributed, you’d also be letting go of any capital gains attributed to that amount and any future capital gains that amount would have earned for you.

If you’re over the age of 50 and need to move quickly in planning for retirement then the 401k is still a great vehicle. Current legislation allows anyone 50 years of age or older to contribute an additional $3,000 in 2004, $4,000 in 2005, and $5,000 in 2006. Many plans offer these catch-up contributions, but check with your employer first to make sure.

The 401k is there for your use. It’s a powerful, tax-advantaged tool when used correctly and should belong in your arsenal of retirement savings weapons. Hopefully this basic 401k discussion has helped you. Use it wisely.

Observing wealthy people teaches us three key factors in how they built their wealth. Keep in mind, I’m not talking about Hollywood-type wealthy. I’m talking about the kind of wealthy people we don’t see in the media. “The Millionaire Next Door” type of wealthy people. We would all be well served mastering these three factors of wealth:

Wealthy people:

1. live well below their incomes.
2. believe that financial independence is more important than high social status.
3. allocate their time and energy efficiently in ways conducive to building wealth.

These three factors appear in the e-book “Money for Life”.

Let’s discuss all three.

Wealthy people live well below their incomes.
We could possibly check Webster’s Dictionary to see what the definition of “rich” or “wealthy” is. I’m not going to bother. My home-grown definition is that the rich have more assets than liabilities. The richer have even more assets than they do liabilities, and so on.

I had a conversation with a friend once, where she mentioned how upsetting it was that “only the rich get to drive new cars. All of the middle-class has to drive used.” That shouldn’t be upsetting. That should be motivating. If you want a new car then save your money and buy one. The only person stopping you from doing this is you.

Wealthy people don’t use consumer credit. Now I’m not talking about inheritors or Mike Tyson, not even MC Hammer. I’m talking about those neighbors you have who are worth several million dollars – but you would never know. And frankly, they like it that way.

Wealthy people budget their money. They spend a few hours each month looking over their finances. They communicate well with their spouse about money because of this budgeting process. This allows both spouses to be on the same page about money. It removes unnecessary guilt when one has to buy something – because it’s already been talked about.

A wealthy person might only make $50,000. Does that make you rich automatically? No way! There are plenty of families that bring in way more than $50,000 that are living paycheck to paycheck. What makes the family with a $50,000 income rich? They live on $40,000 of it. What good will saving that $10,000 each year possibly do? My calculator tells me that if they put away $833 ($10,000/12 months) each month into a retirement account, such as a Roth IRA, in 40 years, making an average of 8% per year, they would have $2,909,173. This unrealistically assumes that they never make more than $50,000 per year!

Did they drive used cars? Living on $40,000 a year, you bet they did. Sitting on almost $3 million, do you think they still drive used cars? Oddly enough, they probably do. Because they understand and appreciate the value of a dollar. Could they buy a new car if they wanted? Sure. If they put their nest egg into an ultra-conservative investment making just 4% per year, they would be making a passive income of $116,367 every year.

Where did their unbelievable financial ability come from? They lived well below their income. Now let’s look at how they were able to do this.

They believe that financial independence is more important than high social status.
Let’s admit it. Social pressure is very, very strong. It’s hard to resist buying name-brand clothes, a new car (newer than the neighbors!), or even a larger house.

A wealthy person has an invaluable perspective when it comes to these social pressures. They see them as just that – social pressures. There is no substance behind them. There is no reason to heed them.

The irony about keeping up with the Jones’s is that the Jones family is completely broke. They’re leveraged to the hilt and are enjoying the use of other people’s money. If dad comes home with a bonus they blow it. They don’t think about possibly putting that windfall towards the principal on their house. They don’t consider paying down the debt they owe on their vehicles. The Jones family is broke! Stop trying to keep up with them! You will digress if you follow their financial plan.

The rich see this. It’s as if they have financial x-ray vision. I am trying to develop this skill myself. What do you see when your colleague (who makes just as much as you do) drives up in a brand new car that is valued at half his annual income? Most people see a very nice car. Most people then see an ad for 0% APR for six months on all new vehicles, with a cash-back bonus of $2,000. And most people would go out and “match” their colleague – or maybe even raise him one. Most people are broke.

The wealthy person, equipped with financial x-ray vision, sees a money pit. They see a ball and chain attached to their colleague’s ankle. They see piles and piles of future cash flow that have now been lost to interest. They see a stressed wife who will now have to charge groceries when the end of the month comes because a car payment is devouring the monthly cash flow.

With financial x-ray vision a rich person sees things as they really are. A rich person doesn’t have to impress anyone with material goods. They are satisfied with financial peace of mind – not the next fad.

They allocate their time and energy efficiently in ways conducive to building wealth.
Let’s face it. All of us have some spare time. If you don’t think you have any spare time then I challenge you to do a little exercise for a week. Keep track of what you do for every minute of every day for one week. You will be surprised how much spare time you actually have. Once you gain this realization, begin focusing on using your spare time in a way conducive to building wealth.

Wealthy people do exactly this. How much time does the average millionaire spend watching television? Virtually none. Why? Because the millionaire recognizes the value of his or her time and uses it for activities that add value to life: spending time with family, developing new skills, reading informational and uplifting books, managing investments, etc.

On average, millionaires read one non-fiction book per month. When was the last time you read a non-fiction book? For what reason? Millionaires seek knowledge to improve their situation – they don’t seek a new government program or social initiative. They seek out knowledge to solve their own problems and then they apply that knowledge.

I challenge you to read one non-fiction book per month starting now. If you want a list of great books then check out the many lists of classic books available on the internet. Seek out new knowledge. Turn off the television an hour earlier and read a good book.

Do wealthy people spend their valuable time budgeting? Of course they do. Many millionaires are in their great financial position because they budget. The couple will sit down for an hour or so each month and budget that month’s money. Can you believe that millionaires even keep their receipts and record every purchase? Many of them do. This is one thing that has enabled them to live within their means. They know where their money goes and how it’s used. They devote a couple hours each month to have this absolutely invaluable information – and it pays big dividends in the end.

Do you use your time on the job in a way that is conducive to building wealth? And I don’t mean the fact that you’re paid while at work. How do you use your time at work to increase your skills, marketability, value-adding capability, and prospects for the future? Do you make sure you give your employer an honest day’s work? Do you stay aware of opportunities that present themselves where you could be stretched and grow? On-the-job training is absolutely invaluable when you approach your job with the right perspective. Make sure you make your job an opportunity that will facilitate the building of wealth.

These three factors hold true for any person who’s going to make it in the financial long run. Keep them in the forefront of your mind. Strive to live on less than you earn, treasure financial security over the fleeting fads of society, and spend your time improving yourself, your family, and your financial future.

Not too long ago, Americans’ greatest asset was the equity in their homes. However, banks have targeted the home equity loan aggressively in the last several years. This has caused a dangerous shift in the net worth statements of Americans. What was once an asset is now a liability.

The offer might be extremely enticing: You have nine credit cards, all with outstanding (the credit card companies sure think so) balances. You have to pay nine separate times each month. And the interest rates on these cards are pretty high to boot. The bank comes along and offers you a home equity loan that will pay all of the outstanding debt you have on your credit cards.

Relief…

Now you just make one simple payment per month instead of nine – and the interest on this home equity loan is so much lower. All of the numbers make sense. But have you made a wise financial choice? Probably not.

Picture this. You still have nine credit cards. All of them have zero balances and it feels good. Your consumer side starts to whisper: “You’ve got some leeway, a buffer, a cushion for those extra things you need!” You are not immune to such temptations! Do not underestimate the power of the dark side (advertising) to use mind tricks against you. With a simple wave of their hand your wants have now become your needs.

And the credit card balances begin to climb.

On top of these new and enticing zero balances, your home is now at risk. You have taken on secured debt. But the only people that feel secure are the banks. You fell prey to the illusion of security and have failed to do something extremely critical to your financial security:

Change your behavior.

If you choose to consolidate loans you have probably made a wise choice by the numbers. If you use a zero-percent-for-six-months credit card to which you can now transfer all nine balances then you have probably made a wise choice by the numbers.

But you haven’t changed your behavior.

You are treating the symptom – not the problem.

Scariest of all, now that you have your credit cards consolidated into one card, or a home equity loan, you still have those available lines of credit. And you haven’t learned to live without credit. You haven’t learned to live within your means. You haven’t learned to manage your money. This move of consolidation has brought you to a better place financially for the time being. But if your behavior does not change now, you will end up in a far worse situation than you had even before consolidating. I am not against consolidation (examined on a case by case basis) if you have already changed your behavior. If you can show me that you have one month’s expenses saved, are in control of your money and are just bursting at the seams to absolutely destroy your debt, then I do hereby qualify you as someone who may consider consolidation. The numbers make sense and your behavior has changed.

If you have not changed your behavior then consolidation is the absolute worst thing you can do to get out of your present situation. It will only suck you back in even deeper.

Finance is not about numbers nearly as much as it is about behavior. Make the change.

May the force be with you.