Everyone wants to retire at some point in their life; however, not everyone is clear on the best path to get there. While social security is one way to get some retirement income once you leave the workforce, for most Americans, social security income alone isn’t enough to lead the sort of life they’d like in retirement. To live on a retirement income of $65,000 a year, you need to have $1.5 million in your retirement account. This means it’s essential to have a retirement savings nest egg to complement your social security benefits when you retire.
Of all the different retirement plans available, a company-sponsored 401(k) is one of the most common options for generating wealth earmarked for retirement. Even if you know that your company sponsors a 401(k) or annuity, if you aren’t familiar with personal finance fundamentals, it may seem as if you need an expert in financial planning to make the most of your investment returns.
While asset allocation certainly plays a role in the investment choices you make for your 401(k) or retirement fund, your savings rate and tax bracket are just as important to consider when making the most of your 401(k). Of course, to make sound financial decisions, you need to have a basic understanding of what 401(k)s are, how they work, and why they’re so essential to take advantage of now. Keep reading to learn more about 401ks and how to make the most of your financial decisions so that you can retire in style.
What is a 401(k)?
A 401(k) is a tax-advantaged savings account offered by many employers to help their employees more effectively save for retirement. “Tax-advantaged” means that you can report these contributions on your taxes to save a bit of money come tax time, and you also can contribute pre-tax dollars from your paycheck to your 401(k) account.
How does this look in practice? You’d want to define an annual contribution percentage that you’re interested in making each paycheck, for starters. Many financial planners suggest that you aim to save 15% of each paycheck for retirement. At the same time, other investment firms offer goal-based advice, such as having one year’s salary saved by age 30 and three years’ salary saved by age 40 — up to ten times your salary by the time you turn 67 and can retire. While this can sound daunting, the fact that a 401(k) lets you make contributions tax-free means that your contributions aren’t subject to income taxes until you withdraw them.
For example, let’s pretend that you currently make a salary of $50,000, roughly the average annual wage in America in the year 2019. About 14% of that salary goes to income taxes, meaning that if you were trying to save for retirement in a traditional savings account, you’d only have around $43,000 of income to save. If you took the advice of many financial planners, that means you’d be saving $6,450 a year towards retirement. With a 401(k), you get to keep your taxable income before the taxes are taken out of your paycheck. This means that instead of saving 15% of $43,000, you get to save 15% of $50,000 — netting you and your retirement fund more than $1,000 extra.
Keep in mind that the above is a simple example to illustrate the point. In the real world, income taxes, health, vision, and dental insurance, commuter benefits, and FSA or HSA contributions also come out of your annual wages. When you factor in housing costs, bills, and utilities, the amount of take-home pay you have that is truly “expendable” and able to be saved for the future is a much smaller number than your annual salary.
This is why the tax benefits of a 401(k) — when combined with the power of compound interest and the general upward trajectory of the stock market — are so important to start taking advantage of now.
Ins and outs of a 401(k)
One significant benefit of using a 401(k) as your retirement fund is that many employer-sponsored programs offer matching contributions up to a certain percentage. For example, some employers may match the first 3% you contribute out of your paycheck, meaning that if you commit to saving 3% of your pay each period, you get an additional 3% in employer contributions free of charge.
Receiving free money is something you should take advantage of whenever possible. An employer match is especially great, considering that your investment savings will grow exponentially over time. Even an extra contribution to your retirement fund of $1,500 a year could net you $7,201.53 in 40 years — and that’s without you or your employer ever adding any more money to your 401k.
As a general rule, you should always contribute to your 401k up until the match to ensure you’re not leaving any money on the table.
Like other stock portfolios, a 401k offers the chance to build up your savings over time using compound interest and the stock market. How you do that is up to you, but most 401(k) options include a mixture of index funds and mutual funds for easy-to-achieve diversification.
To get the most out of your tax benefits, it’s a good idea to fully fund your 401(k) up to the maximum you’re allowed to each year. Most financial advisors suggest starting with a slightly more aggressive asset allocation when you’re younger and then moving to a more conservative and stable investment strategy as you approach retirement age.
According to the IRS, “The limit on employee elective deferrals to a SIMPLE 401(k) plan is $13,500 in 2021 and 2020.” If you can afford to max out your 401(k) each year, you'll make the most of your contributions. While this might not be possible if you’re starting at an entry-level position, it’s a good goal to have in mind. Particularly for those who are getting started with their retirement funds later in life, making catch-up contributions up to the 401(k) limit each year can be pretty beneficial.
One thing to note is that some employers have different vesting schedules that determine when you fully own the money in your retirement fund. Generally speaking, any money you put in from your paycheck is 100% fully vested immediately. An employer may put you on a vesting schedule of one, two, or three years until you can fully become vested in their matching contributions.
While this is a beneficial way to keep employee retention higher, it generally doesn’t come up often. If you do plan to change jobs and are counting on some of your employer match to help buoy your 401(k) over time, it’s a good idea to know when you’re fully vested in your retirement fund so that you can roll over all of your portfolios to a new account.
Since a 401(k) is an investment account specifically earmarked for retirement, you’re not supposed to withdraw from it before you reach retirement age at 59 and a half. Even though those are the rules, there are some exceptions to that rule—although you may wind up paying a 10% penalty on the withdrawal. The IRS permits so-called hardship withdrawals in the face of urgent, large financial needs.
How does the IRS define these immediate costs? Usually, you’ll need to be facing major medical expenses, college tuition, funeral costs, or severe home repairs in the face of life-threatening conditions to qualify for an early withdrawal. Even then, you may still have to pay a 10% penalty. It is worth noting that as a result of the coronavirus pandemic and the CARES Act, individuals whose income was negatively impacted by the virus also qualified for a hardship withdrawal.
While hardship withdrawals are sometimes unavoidable, you should only use them as a last resort if you truly want to make the most of your 401(k). The longer your money stays in your 401(k), the more time it has to accrue value and grow, thanks to interest. If you take that money in the present, you’re often stealing 5 or 10 times that much money from your future self. Asking for financial assistance from friends or family members, taking money out of your emergency fund, or even opening a new credit line with 0% interest during an introductory offer period may be much better than taking money from your retirement fund.
Other types of retirement accounts
The 401(k) isn’t the only type of retirement account out there, although much of the conventional wisdom about maximizing your retirement fund still applies when investing in other options. Here is how the 401(k) stacks up against other popular retirement funds.
IRA vs. 401(k)
An individual retirement account (IRA)
and a 401(k) are investment vehicles that help you save for retirement. Both an IRA and a 401(k) offer a way to save money that grows tax-free (unlike a regular investment portfolio), so you don’t have to pay taxes on your earnings until you’re withdrawing money at retirement.
The most significant difference between an IRA and a 401(k)k comes down to employer-sponsored contributions. Since an IRA is set up by yourself, you don’t get matching contributions to anything you save in an IRA like you would with a 401(k). While this means you also don’t have to worry about vesting schedules, an employer match is a way to supercharge your savings at the end of the day. Some people will choose
403(b) vs. 401(k)
A 403(b) and a 401(k) are virtually the same. Both are employer-sponsored investment accounts to help employees save for retirement. The big difference is what sorts of companies or organizations offer these kinds of programs. While for-profit companies offer 401(k)s, 403(b)s are offered by non-profit organizations, educational institutions, and the government. As a result, they have an exemption from nondiscrimination testing, something 401(k)s must go through.
Roth IRA vs. 401(k)
When it comes to the difference between a Roth IRA and a 401k, it all comes down to what sorts of tax breaks you get—and when. A Roth IRA is funded with income that has already been taxed. It then grows (tax-free) until you’re ready to withdraw it, and you won’t pay any taxes on anything you take out, as the income was already taxed. The only exception is if you face an early withdrawal penalty with your Roth IRA withdrawals.
This differs from a traditional 401(k), where you contribute pre-tax income and then pay income taxes when you withdraw your money in retirement. If you believe that you’re going to be in a higher income bracket (and thus have higher income taxes) come retirement, you may prefer a Roth IRA. However, a Roth IRA is an individual retirement plan, meaning that you don’t have employer-sponsored matches.
Roth 401(k) vs. traditional 401(k)
The significant difference between a Roth 401(k) and a Roth IRA has to do with whether or not it’s through your employer or set up independently by yourself. With a Roth 401(k), which may be offered through your employer, you don’t have any contribution limits and can take advantage of employer matches and tax-free withdrawals when you retire. Again, this is the reverse of a traditional 401(k), where your pre-tax dollars are contributed and invested — only to be taxed with an early withdrawal or at retirement.
Costs and fees associated with a 401(k)
Again, when you withdraw from your 401(k) you owe income taxes on the money you take out of your retirement fund. But there are also other fees and costs are associated with your 401(k), mainly service fees with the brokerage managing your account. These fees are generally relatively small, and will be calculated annually and taken from your account directly. Every brokerage has different fee structures, so make sure to check with the company sponsoring your 401(k) to see precisely how much you can expect to pay each year for administration and management costs.
Pros and cons
- Pre-tax contributions offer a higher savings rate. Being able to access your income before it’s taxed maximizes your ability to save as much as possible for retirement, ultimately giving you tens of thousands of extra dollars in contributions over the lifetime of your retirement account.
- An employer match can supercharge your savings. Contributing to the employer match can be a great way to boost your savings rate, even if things are a bit tight starting. Some employers are particularly generous with their 401(k) contributions, matching 5-8% for employees who meet minimum contributions of 5% or even giving employees a one-for-one match on contributions up to a certain percentage.
- Automatic withdrawals keep you on track. An added psychological benefit of contributing pre-tax dollars to your 401(k) is that you never even have the chance to spend the money. This helps you maintain a specific savings rate without being tempted to spend the money on tacos or concert tickets instead.
- Have to be employed to qualify. Having a 401(k) can sometimes feel like a reason not to leave a job, making it easier to ignore important career moves in favor of security or a different kind of benefit.
- Fees. If you were opening your own IRA, you’d be able to shop around and find an investment brokerage that offers low or no-fee options, whereas you’re stuck with the company your employer picks if you enroll in a 401(k). This means you don’t have as much control over the fees associated with your account, which can eat into your earnings.
- You owe taxes when you retire. There’s a healthy debate about the pros and cons of Roth IRAs or Roth 401ks versus traditional 401(k)s — and most of the discussion hinges on taxes. Having to pay a percentage of your retirement withdrawals to the IRS makes it so that the minimum distributions you need to cover your month-to-month expenses are a bit higher than they would be coming from a tax-free Roth withdrawal in retirement.
The bottom line
Even with some cons, any system that makes it easier for employees to save and generate wealth for retirement is incredibly positive. As such, if your employer offers a 401(k), enroll and contribute to it as soon as you’re eligible.
Even if your company doesn’t offer a particularly generous matching policy, make sure not to leave any money on the table and contribute to receive their match. Beyond that, picking a target-date fund can help automate how aggressively or conservatively your portfolio is managed based on how close you are to retirement. It’s also a good rule of thumb to max out your 401(k) any year you can.
While it’s understandable to be overwhelmed by the concept of retirement, inaction isn’t a helpful strategy to set yourself up for success. Instead, taking advantage of the opportunities given to you—such as the chance to leverage pre-tax earnings towards your eventual retirement through a 401(k) — is key if you want to have a long and fruitful retirement.
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