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What is a 401(k) Retirement Plan?
A 401(k) plan lets you contribute a portion of each paycheck into a growing retirement account.[ref link=https://www.irs.gov/retirement-plans/401k-plans] The biggest mistake people make with their 401(k) is not investing in one as soon as possible.
Although retirement seems a long way off for some, saving for retirement offers many short and long-term financial benefits!
Here are the basic steps to get started with a 401(k):
- Sign up for your employer’s 401(k) plan (if they offer one)
- Automatically invest a portion of each paycheck
- Select a professionally managed fund to start growing your retirement savings
If your employer doesn’t offer you a 401(k), you can invest into an individual retirement account (IRA) instead.
Overview of 401(k) Benefits
Investing in a 401(k) offers several obvious benefits, allowing you to:
- Efficiently grow your retirement savings through compound interest
- Afford a comfortable or luxurious retirement
- Retire earlier
What’s more is that both the federal government and your employer offer benefits to help with your retirement goals.
For example, the IRS lowers your tax bill when you contribute to a 401(k) plan. You can then choose to reinvest these tax refunds to make even more money! Or you could also use it to pay off a loan.
Meanwhile, your employer may offer you free money simply for contributing to your 401(k) (more on this later)!
Growing Your 401(k) Retirement Funds
Thanks to compound interest, the more time you give your investments to grow, the larger they get. Therefore, it’s best to start contributing to a 401(k) as soon as possible.
In simple terms, compound interest is when the money you earn helps you earn even more money.
Disclaimer: These numbers are for demonstration purposes only. The historical return of the stock market’s S&P 500 index (including dividends) is about 10% a year. Your return on investment may vary.
To demonstrate compound interest at work, suppose your 401(k) balance of $1000 earns 10% interest a year. Here’s how that money would grow every year:
- Year 1: You earn $100 (10% of $1000), bringing your total to $1100.
- Year 2: You earn $110 (10% of $1100), bringing your total to $1210.
- Year 3: You earn $121 (10% of $1210), bringing your total to $1331.
As you can see, compound interest increases your payout each year. Over a 40-year career, your 401(k) would grow to an astonishing $41,114 from a measly $1000.
If you start your 401(k) at 20 and hold off from taking 401(k) distributions (withdrawals) until 70, these funds would more than double ($106,718). But if you delay making 401(k) contributions for 10 years, you’d more than halve your nest egg by retirement ($15,863).
Time is of the essence when compounding interest. Delaying may cost you a lot of money in the long-term.
Funding Your 401(k)
For most people, the best financial decision they can make is to contribute as much funding to a 401(k) as possible.
Having said that, you should only put in what you can afford into your 401(k). Although it will grow substantially throughout your career, you can’t withdraw money until retirement (special exceptions or penalties apply).
Therefore, consider whether your finances are in order before maxing out your account. There are some reasons you shouldn’t max out (or contribute at all) to a 401(k), including:
- Contributing to a 401(k) will affect your ability to pay for short-term needs (food, rent, utilities)
- Lacking emergency funds in case of financial hardship
- You have outstanding high-interest debt that will accumulate faster than your 401(k) returns
- Your investments have greater return on investment and tax benefits
In these cases, you may decide to invest in a Roth IRA instead, which gives you the freedom to take out your contributions at a moment’s notice.
Contribution Limits to a 401(k) in 2021
When funding your 401(k), you can contribute a specified percentage of every paycheck (up to a certain limit).
In 2021, the IRS limits most employees to $19,500 in annual 401(k) contributions. Employees over 50 years of age are eligible to make ‘catchup contributions’ of $6500, for a total of $26,000 a year.
If you’re getting employer matches on your 401(k) contributions (more on this soon), the limit is $58,000. Those eligible for catchup contributions have an increased limit of $64,500.
Keep in mind, the IRS may increase these annual limits from yearly to account for inflation.
Automatic Contributions
Some companies automatically enroll their employees into a 401(k) plan. For example, they may deduct 1% of your paycheck and deposit it into your 401(k) for you. In addition, they may even increase your contribution in small increments each year.
Naturally, you can opt out of this, but most employees probably won’t miss (or even notice) the 1% that goes missing. If anything, it may even be a pleasant surprise when you end up taking your 401(k) seriously and find out you already have thousands of dollars stashed away.
Employer Match on 401(k) Contributions
One of the best benefits to contribute to your 401(k) is the employer match, where employers put their money into your retirement account to reward you for saving.
If you’re not sure whether you should invest in a 401(k), you should at least get the full employer match for free money.
To get the most out of the employer match, note your 401(k) plan’s employer match rate and match limit.
Employer Match Rate on 401(k) Contributions
The match rate is the percentage of your contribution that your employer will match. Match rates may differ across employers.
A 100% match effectively doubles your contribution (i.e., a $5000 contribution earns a $5000 match, for a total of $10,000).
A match rate of 50% means your employer contributes half of what you put in (i.e., they match your $4000 contribution by depositing $2000 at no extra cost to you).
Finally, some employers have a tiered match rate. For example, they may have a 100% match rate for the first $5,000 you contribute, then 50% for any additional contributions.
Employer Match Limit on 401(k) Contributions
The match limit is the maximum amount your employer will contribute to your 401(k). Usually, your employer will match up to a certain percentage of your salary.
A 10% limit on a $100,000 salary means you’ll only receive up to $10,000 in matching contributions.
While you can still contribute up to the annual contribution limit, your employer will only give you up to $10,000 in matching contributions.
Employer Match Vesting Period
Some 401(k) matching contributions require you to wait a vesting period before you truly own them. During the vesting period, leaving your employer will cause you to forfeit all or a portion of your matching contributions.
Depending on your employer’s 401(k) plan, the vesting period may be immediate (the 401(k) match is yours immediately) or you may have to remain employed up to several years.
Types of 401(k)
Before investing in your 401(k), it’s essential to understand the difference between a traditional 401(k) and a Roth 401(k).
Although similar, they have subtle differences that have tax consequences (or benefits). Choosing the right one will maximize your earnings and reduce your tax bill.
Traditional 401(k)
A traditional 401(k) allows you to make pre-tax contributions towards your retirement savings. In other words, you won’t owe taxes on the portion of your paycheck you contribute to your traditional 401(k).
Suppose your taxable income is $75,000 and you contribute $15,000 to your traditional 401(k). With a 22% tax rate (for singles) in that income bracket, a $15,000 tax deduction would save you $3300 (22% of $15,000).[ref link=https://www.irs.gov/newsroom/irs-provides-tax-inflation-adjustments-for-tax-year-2020]
Basically, the government is paying you $3,300 in tax refunds to make a 401(k) contribution. Taking home your entire paycheck would trigger a tax bill of $3,300.
While you can avoid paying taxes now, the IRS will reclaim taxes on that money when you make a 401(k) distribution (withdrawal) during retirement.
However, certain tax-saving strategies may reduce or negate your tax bill altogether on 401(k) distributions.
Roth 401(k)
A Roth 401(k) allows you to make after-tax 401(k) contributions in exchange for tax-free distributions during retirement. So, although you’ll have to pay taxes before you contribute, you owe nothing when you take money out.
Furthermore, unlike the traditional 401(k), you can easily avoid taking required minimum distributions from a Roth 401(k) without triggering a tax bill.
By converting your Roth 401(k) to a Roth IRA through a rollover, you can avoid required minimum distributions indefinitely. That way, you can continue to let your account compound interest.
In case your retirement funds outlive you, you can pass it on with little tax consequences. Your designated beneficiary who inherits the Roth IRA will receive similar tax benefits when they take distributions.
Roth Conversion on a Traditional 401(k)
If you ever decide you want to convert your traditional 401(k) to a Roth 401(k), you can perform a Roth conversion on your 401(k).
Note that this may increase your tax bill because you’re still responsible for paying taxes on your contributions. If you convert $10,000 from a traditional 401(k) to a Roth 401(k), you’ll increase your taxable income by $10,000 in the same year you performed a conversion.
However, a Roth conversion may make sense for some people who are at a low tax bracket.
For example, suppose you have little to no income one year due to quitting or losing your job to unforeseen events (like the coronavirus pandemic). While you’re still at a low tax bracket, a Roth conversion will have only a minor tax consequence.
With enough tax deductions, you may end up paying $0 on the conversion. So, if you can perform a conversion without paying any taxes, you’ll no longer be responsible for paying taxes on qualified distributions.
Choosing a Traditional or Roth 401(k)
Depending on your financial situation, some people may benefit more from a traditional 401(k) while others are better off contributing to its Roth counterpart.
As a rule of thumb, determine your current taxable income and your anticipated tax bill in the future.
If you anticipate paying lower taxes in the future, invest in a traditional 401(k) now to reduce your current taxes. Then during retirement, you’ll be able to take qualified distributions for a lower tax bill.
But if you anticipate having a higher future tax rate, invest into a Roth 401(k). You can pay fewer taxes now and have a much smaller tax bill in the future.
For example, if you work a high-paying job and decide you want to retire early, select a traditional 401(k). You’ll be able to contribute much more and pay fewer taxes now, while performing Roth conversions throughout your early retirement.
In some cases, you may never pay taxes on your 401(k) using this method!
This also works for anyone looking to quit their job to freelance or start their own business. If you ever anticipate any years in which you won’t have significant income or will have a lot of tax deductions, you can invest in a traditional 401(k) now and convert it to a Roth later.
Selecting 401(k) Investments
Once you’ve made contributions to your 401(k), you can start deciding how to invest that money.
Your retirement goals, investment timeline, and risk profile will generally determine the performance of your 401(k). However, it may also depend on your asset selection, from individual stocks, bonds, index funds, mutual funds, or target date funds.
Aggressive Investment Portfolio
Your risk profile determines how much risk you allow fund managers to take on your behalf.
An aggressive investment portfolio has higher overall returns but is highly volatile in the short-term. They have high exposure to market crashes which can temporarily reduce your retirement fund’s value.
Younger 401(k) contributors can safely choose aggressive investments for higher returns. Since they have a longer investment timeline and cannot access the funds soon, they have time for the market to pull out of correction/crash territory.
Conservative Investment Portfolio
Meanwhile, conservative investments generate slow and steady returns with low volatility. With safer investments, there is almost no risk of significant drops in their portfolio.
A conservative risk profile is better for older employees who will need their retirement funds soon. It would be much harder for a retiree to wait out a weak stock market when they need the funds to get through their retirement.
Mixed Investment Portfolio
Although this is only a simplified explanation of aggressive and conservative investment portfolios, many 401(k) contributors will have a mix of aggressive/conservative assets.
Younger investors will start off with many decades of aggressive growth until they near retirement. They have the time to wait out market crashes and experience greater growth during the stock market recovery.
But as they age, they’ll likely rebalance their portfolios to a higher ratio of conservative assets. Doing so will reduce the impact of potential market crashes as they near retirement.
Investing in Individual Stocks/Bonds/ETFs
Sometimes employer 401(k) plans allow employees to select their own stocks and bonds. However, this is generally a risky move, considering the average employee is not sufficiently knowledgeable in the market to make well-informed choices.
Generally, it’s safer to invest into electronically traded funds (ETFs) with low fees. ETFs contain a variety of stocks, minimizing your risk exposure to any single company. This significantly reduces your risk of any losing most (or all) of your savings if that one company fails spectacularly.
Investing in Index Funds
Index funds consist of many stocks that mimic the performance of the broader stock market (i.e., a market index like the Dow Jones or S&P500). The investor never has to pick individual stocks because the index fund manager manages the portfolio on their behalf.
Index funds work well because they diversify their risk across multiple stocks/bonds. Therefore, should any one company fail, the investor still has investments in other related companies that can continue to generate interest.
Index funds give up risky, but higher potential returns in exchange for stable returns with a lower risk. But make no mistake; even professional fund managers have difficulty outperforming index funds.
Index funds generally perform better than conservative investment portfolios that include stocks and bonds.
Investing in Mutual Funds
A professionally managed mutual fund uses the assets from multiple investors and invests it to generate interest for its clients. The choice of investment is at the fund manager’s discretion.
The fund manager may choose to invest in a batch of related stocks and/or bonds or to reduce risk by diversifying among many unrelated stocks/bonds.
The fund may choose to capture returns on stocks with similar risk profiles (such as large, stable companies, or riskier startups with high growth potential). It may also invest in a certain market sector (technology, energy).
For example, you may see mutual funds invested in stocks of large and stable companies, risky startups with potential for high-growth, consumer goods, or a healthy mix of all the above.
Investing in Target Date Fund
Target date funds have variable stock/bond holdings until the target retirement date of the investor.
In the earlier years, target date funds select riskier high-growth rate stocks to generate maximum returns. Since the investor will not be able to withdraw the money until retirement, the stocks will perform well in the long-term even with unexpected market downturns.
Over time, the fund rebalances the stock portfolio and includes low-risk bonds. This way, a market crash or correction won’t reduce the retirement funds when the retiree may need them.
Rebalancing portfolios is a customary practice, taking retirement age into consideration to balance risk and returns.
Management Fees
In most cases, a professional fund manager will select investments to help you reach your financial goals in exchange for a fee. While funds exist to generate a return for the 401(k) contributors, they also allow fund managers to make a living.
However, that’s not to say that you’ll always get a good deal on certain index funds. Make sure to read the fine print and watch out for unusually high management fees.
Unless the fund performance justifies the fee, choose a low-fee fund that performs well.
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