One of the most common ways to build wealth over time is by investing in your retirement. Retiring from work often indicates that you’ve become financially independent and no longer need to earn an active income in order to meet all your needs and expenses.
It’s a nice place to be financially, but it takes time to get there. Have you ever taken the time to think about which investment options you wanted to use for retirement?
If you work for an employer who offers benefits like a 401(k) plan, that could be a good place to start.
What Is a 401(k)?
By definition, a 401(k) plan is a retirement savings plan sponsored by an employer. It allows employees to save and invest a portion of their paycheck before taxes are taken out.
Generally, with a 401(k) plan, taxes aren’t paid until you withdraw the money during your retirement years.
In 1978, 401(k) plans were born by accident and ultimately changed how American workers could retire. During this year, Congress changed the tax code and established the Revenue Act with a goal to limit executives at certain companies from having too much access to cash-deferred plans.
Their idea was that bonuses and stock options would now qualify for tax deferral. In 1980, a consultant named Ted Benna saw the new law as a way to encourage saving and started the first 401(k) plan. The following year, the IRS started allowing 401(k) plans to be funded through employee salary deductions.
By 1983, nearly half of all large firms offered a 401(k) plan. Today, 94% of private employers offer 401(k) plans according to LearnVest and employees are able to be automatically enrolled in a plan.
Today, most employers will offer a 401(k) to full-time employees as apart of their benefits package. If you work part-time, there's a good chance you may not have access to a 401(k), but it wouldn't hurt to ask.
If your employer does offer a 401(k) and you’re not already enrolled, ask them what you need to do to get started.
Investing in Retirement
A 401(k) plan allows you to pay yourself first since contributions are automatically withdrawn from your paycheck even before taxes are taken out.
The funds you contribute to your plan can be invested in a number of different vehicles like stocks, bonds, and mutual funds. However, it's important to note that 401(k) plans tend not to have many diverse options for investing when compared to IRAs (individual retirement plans).
It’s also one of the easiest ways to contribute to your retirement money because all you need to do is sign up through your employer and choose a percentage of your income that you’re like to automatically contribute each month.
Since the money you invest never hits your bank account, you won’t really miss it. With this ‘set it and forget it’ strategy, you’ll be able to allow compound interest to really work its magic.
Compound interest is a powerful tool for your finances because it helps your money grow and start to work for you. Compound interest is the addition of interest to the principal sum of a loan or deposit. It's also referred to as ‘interest on interest.' It occurs when the interest that accrues to an amount of money actually turns into interest itself making the balance grow, sometimes significantly.
Let’s take credit card debt for example. If you have $100 of debt at a 10% interest rate, you’ll owe $110. A month goes by and you don’t pay that balance. That $110 will now earn interest and keep growing.
This is how many Americans get trapped in debt because it’s hard to pay off the debt itself, let alone pay interest as well. On the other hand, what if instead of having to pay interest, you could earn interest yourself?
This is where the benefits of investing come into play. Instead of paying interest, you can invest in a 401(k) each month and allow your money to earn interest and grow over time. Compound interest is a long-term game, but if you plan on working for the next 20 – 30+ years, it’s always better to start contributing to your 401(k) now so you can build a nest egg for the future.
How much your balance grows due to compound interest does depend on the market, and while the market can rise or decline, it has always recovered and granted a return for the past 100 years.
To better visualize the effects of how investing in your 401(k) and letting compound interest work can impact your retirement, let’s say you contribute $10,000 one year and your earnings grow at an average of 6% each year. You continue to invest around $500 per month and plan to retire in 35 years.
After 35 years, you'll have $797,152.44 saved up. $220,000 of that was a direct contribution (10,000 + 6,000 x 35), while $577,152.44 was due to growth.
That’s almost $800,000—thanks to letting your money grow over time with compound interest.
In terms of determining how much you want to contribute to your 401(k) plan, there are contribution limits that are updated each year.
For 2017, you can contribute up to $18,000 for the year from your paychecks. Once you reach the age of 50, you can make additional catch up contribution of up to $6,000 for a total maximum of $24,000.
The IRS has also set limits on the total amount that may be contributed to your retirement savings account from all sources combined, including any employer matching or profit-sharing contributions, and any employee after-tax contributions. For 2018, the maximum is the lesser of 100% of compensation or $54,000 (or $59,000 for those 50 and older).
Contribution limits tend to increase each year so you can always expect to be able to save more throughout your active working years.
How to Take Advantage Of Your Employer Match
One of the best things about having a 401(k) aside from being able to invest your contributions and reap the benefits of compound interest, is the possibility of having access to an employer match.
What this means is that some employers will help you save in your 401(k) by matching your contributions. For example, if you add 5% of your salary to your 401(k) your employer may match your contribution by adding 5% to your account from their own money or they could match 50 cents for every dollar you contribute.
Again, not all employers will provide a 401(k) match benefit but if yours does, you should definitely take advantage of it because it’s basically free money being added to your retirement account.
In order to make the most of your 401(k) match, you’ll need to read the rules carefully. Most employers will require you to contribute up to a certain amount to have access to the match.
In other words, contributing just 1% of your income may not qualify you and you may have to boost that amount. Furthermore, some employers only allow you to keep the money they’ve added to your 401(k) if you remain employed with them for a fixed amount of time or they may not start matching your contributions right away.
For example, your employer may require you to work at least one year before they start matching your contributions. Or, they may start matching right away but require you to be employed at the company for a full two years in order to keep all the money they’ve added. So if you happen to leave the job before that time has passed, you could lose the money they've added.
Ultimately, these rules and guidelines will depend on your employer so be sure to gain clarity so you can make the most of a 401(k) match if it’s available to you.
Another perk of investing in your retirement with a 401(k) involves the tax benefits. 401(k) plans are tax-deferred which means your contributions are automatically taken from your paycheck even before taxes are deducted.
You also don’t have to pay taxes on your contributions until you withdraw them, so the amount you contribute gets deducted from your taxable income each year.
While most people don’t enjoy going through the hassle of paying taxes each year, this is something to look forward to. If you max out your 401(k) this year, that means you can deduct at least $18,000 from your taxable income and this could even lower your tax bracket.
Even if you’re only contributing a smaller amount like 1% of your income, you could still lower the amount of taxes you’d have to pay as a result of the deduction. Plus, you’ll be investing in your future and will probably hardly even notice the difference in your paychecks.
Keep in mind, you will have to pay taxes on the money you withdraw from your 401(k) during retirement, but it will be taxed at your current tax rate and it’s likely that as a retiree, you’ll end up in a lower tax bracket than your active working years.
When you think about it, you’d probably rather pay taxes on retirement money when your annual income is $40,000 and not $80,000.
Your 401(k) earnings also accrue tax-deferred which means the dividends and capital gains that are earned won't be subject to taxes until you begin withdrawing money. This is huge. If you refer to the example above about compound interest, you could potentially have some significant growth in your account that will be tax-deferred.
If you choose to withdraw funds from your 401(k) before you’ve reached the age of 59 and a half, you will be charged a fee which we will discuss in more detail below and you’ll have to pay taxes.
Considering a Roth 401(k)
Think you might be one of those people who have a higher tax bracket during retirement, and you don’t want it to increase your taxes? This retirement plan was established in 2006 and combines the traditional 401(k) with a Roth IRA. The Roth 401(k) allows you to make contributions with taxed dollars but withdraw your funds completely tax-free.
This is the opposite of what you'd do with a 401(k) where you contribute pre-tax dollars. The nice thing about a Roth 401(k) is that all your contributions can grow tax-free and you still won't have to pay any taxes on the money during retirement.
While the Roth IRA has a $5,500 annual maximum contribution and income requirements ($133,000 if you’re single and $196,000 if you’re married), the Roth 401(k) doesn’t.
This means high earners can invest in retirement with taxed dollars through their employer. See if your employer offers this option and if they have any rules to match your contributions as well.
While 401(k)s are among some of the most popular investment vehicles, no retirement plan is perfect and there are some fees you’ll have to consider.
About seven in 10 401(k) plan holders aren’t aware that they're paying fees to the administrator of their plan to set up, maintain, and provide reports on their account.
According to The Motley Fool, the typical American worker earning a median salary starting at the age 25, will pay an average of $138,336 in 401(k) fees during their lifetime.
You will often be charged a fee by the company that manages your employer-sponsored 401(k) assets. Most fees for this are around 1% of the total assets in your retirement account but this percentage can add up over time and especially as your balance grows due to compound interest.
Some plans also charge you an ongoing monthly or annual fee to manage your account as a recordkeeping fee which can be anywhere from $64 – $70 per participant.
Also, there’s the massive early withdrawal fee to consider. You may have heard people advise against taking money from your 401(k) account early and it’s with good reason.
It may be tempting to consider taking money out of your retirement account to cover a big expense or to act as your emergency fund, but if you make withdrawals before you are 59 and a half, you’ll pay a hefty 10% early withdrawal fee along with state and income taxes.
Depending on how much you withdraw, the fees and taxes could significantly reduce the amount you actually receive.
While you won’t have to pay any penalties to withdraw from your 401(k) after you turn 59 and a half, it could still cost you if you plan to work past the age of 70.
You’ll be required to make minimum withdrawals from your account by April 1 of the year after you turn 70 and a half. If you’re still working by then, realize that you’ll be expected to pay taxes on your withdrawals, and your current income could put you in a higher tax bracket meaning you’ll pay more money to the IRS.
If you don’t make the minimum withdrawal requirements at this time, you’ll have to pay a 50 percent federal tax on the amount you should have withdrawn along with regular income taxes. As you can see, ignoring this rule could cost you.
How to Rollover Your 401(k)
According to the Bureau of Labor Statistics, the average worker is employed at around 12 different jobs throughout their career. Long gone are the days when you’d see people sticking it out with one employer, then cashing in on their pension when it was time to retire.
People are changing jobs often and that would lead one to wonder what they should do with their 401(k) at their old employer. You have a few options in this scenario.
- Keep it right where it is. Your first option is to keep your 401(k) frozen right where it is. Since you’re no longer working with that particular employer anymore, you won’t be able to contribute to their plan but your money can still grow over time.
- Cash out your 401(k). While this is an option, it’s probably the worst one and you shouldn’t consider it due to the early withdrawal fees we mentioned earlier.
- Rollover your account. This is your best option. You can take your existing 401(k) and roll the funds over to your new employer's 401(k) plan or an IRA. This is an ideal way to consolidate your retirement accounts so you don’t have to keep up with money being held in multiple different places.
When it comes to conducting a 401(k) rollover, you can either do a direct or indirect rollover. With an indirect rollover, you will handle the entire process and your 401(k) provider will write you a check that you’ll need to deposit into a new account.
With a direct rollover, your new company will move everything over to your new account and the money never touches your hands. With this option, you just need to fill out a form.
To initiate a direct rollover, you can get on the phone with your 401(k) provider to start the process.
Pros and Cons of 401(k) Plans
- Contribute with pre-tax dollars
- Account grows tax-deferred
- Possibility of employer match
- High contribution limit
- Limited investment choices
- Account fees
- Early withdrawal fees
401(k) plans are a solid way to start building your nest egg and investing in your retirement. Most employers offer them, but before you enroll, you should carefully weigh the pros and cons.
Gather an estimate on the fees and ask about the investment choices. At the end of the day, realize that you have to invest your money somewhere in order to build wealth and depending on your income expectations during retirement years, a traditional 401(k) or a Roth 401(k) should most likely fit the bill.
The key is to start investing early so you are able to grow your nest egg over time and let compound interest run its course. By the time you’re ready to retire, your account will have grown significantly regardless of any management fees you might have to pay.