You already know that saving for retirement is one of the most important financial decisions you can make. But how, exactly, should you go about it?
The best way to save for retirement is to invest your money so it can go to work for you. The magic of compound interest can turn today’s spare change into tomorrow’s nest egg.
If you’re a full-time employee, chances are the most readily-accessible investment plan available to you is a company-sponsored 401(k). But what, exactly, is that alphabet-soup-sounding retirement account? And how does it work?
What is a 401(k)?
A 401(k) is an employer-sponsored investment account. It helps you save for retirement by combining the powers of time, consistency, compound interest and hefty tax benefits to help set you up for your golden years.
Like other retirement accounts, 401(k)s are available in both traditional and Roth varieties.
In a traditional 401(k), your contributions are tax-deductible (and thus reducing your total taxable income for the year), and grow tax-free until you withdraw them — at which point they are subject to regular income tax.
With a Roth 401(k), your contributions will count toward your taxable income for the year, but they are not taxed upon withdrawal.
Your employer has control over whether or not to offer a 401(k), employee participation eligibility, and at what point the funds you contribute will be fully under your ownership — a process called “vesting,” which we’ll get to later in this post.
(Psst: if your employer doesn’t offer a 401(k) plan, you still have some valuable savings options.)
How does a 401(k) work?
A 401(k) is funded primarily by elective contributions — the portion of your wages that is automatically deducted from your paycheck each period. You have control over how much you contribute to your 401(k), although there are limits imposed by the IRS. For 2020, you can contribute up to $19,500 of your personal income.
Once the funds are deducted from your paycheck, they’re invested in a portfolio of your choosing. You’ll have the opportunity to choose from a variety of available options — an average of eight to 12 alternatives, according to FINRA. These may include individual stocks and bonds, but mutual funds are the most common option.
Depending on where you work, you may also have access to an employer match program — and if you do, it’s a very good idea to take advantage of it to maximize your 401(k) returns. An employer match means just that: your employer will match your 401(k) contributions — dollar for dollar— up to a certain percentage, which basically means free money to put toward your retirement.
Of course, employer matches aren’t limitless. The average match hovers between 3% and 6%, according to Malik S. Lee, a Certified Financial Planner at Atlanta-based financial advisory firm Felton & Peel. Some generous employers will match paycheck contributions up to 8%, or even higher — Lee said he’s seen some Georgia universities matching as high as 10%.
No matter how much — or how little — your employer contributes, it’s well worth it to take advantage of your employer match.
Say you’re making $30,000 and putting 4% of that toward your 401(k), for a total annual contribution of $1,200. An employer match of just 1% puts an additional $300 into your 401(k), which increases your total annual contribution to $1,500.
That might not seem like much. But thanks to the exponential nature of compound interest, that extra $300 could make a big difference down the road. After 10 years of contributions and investments growing at a relatively modest 6% annual interest rate, you’d have $15,816.95 without the employer match, but $19,771.19 with it. That’s a difference of nearly $4,000!
More on employer match programs: Getting vested
Not every employer allows new hires to start contributing to their 401(k) plan as soon as they start — and those who do may not grant ownership of employer contributions immediately. Vesting, the process of earning total control of your retirement account, means your employer’s 401(k) contributions will not be taken back or forfeited upon your resignation or dismissal. Remember, vesting applies only to employer contributions. You’ll always own 100% of the funds you put into your account.
Many employers will gradually vest their employers based on the time they’ve worked for the company. For instance, you may start at 0% and achieve 20% vesting after the first six months of employment, then 40% by the end of the year, and so on.
Other employers utilize a “cliff” method of vesting, wherein employees are 0% vested for a longer period of time (such as the first two years of employment). They achieve 100% vestment after a certain threshold (say, three years).
According to the IRS, “All employees must be 100% vested by the time they attain normal retirement age under the plan or when the plan is terminated” — that is, if the employer decides to end their 401(k) program entirely.
How much can you contribute to a 401(k)?
As mentioned above, there are limits to how much you can put into your 401(k) while still enjoying the tax benefits the account offers. The IRS sets these limits annually and they change from time to time.
For example, in 2019, employees could contribute up to $19,000 of their personal income to their 401(k) plans, but that figure has been raised to $19,500 for 2020. For more information on 401(k) contribution limits, see this MagnifyMoney article.
How much should you contribute?
The answer to this question seems obvious: as much as possible. But as in all parts of our financial lives, your mileage may vary depending on your circumstances. For example, you may still be paying down high-interest debt or trying to bolster your emergency fund, either of which makes hefty retirement contributions more difficult. Getting started is the key, because the earlier you start, the more time you’ll have on your side to take advantage of compound interest.
“You always want to put something away inside your 401(k),” Lee said. “Even if you’re trying to pay down debt or build your emergency reserve.” Ideally, you’ll want to meet your employer match if it’s available — but even if not, you should still contribute what you can.
Accessing your savings: How 401(k) withdrawals work
Generally, you can’t withdraw from your 401(k) savings before the age of 59 and a half without paying an additional 10% tax penalty. The withdrawal will also be taxed as regular income at the time it is taken out of the account.
However, you’ll be required to take minimum distributions once you hit age 70 and a half, unless you own more than 5% of the company or have not yet retired.
There are several exceptions in both cases. For instance, you may be eligible for penalty-free distributions before the age of 59 and a half if you can demonstrate financial hardship or you have a qualifying disability. (See the IRS guidelines for a full details)
You will also incur the 10% penalty if you take money out to perform an indirect rollover, which we’ll go over next.
Got a new gig? 401(k)s are portable
These days most of us hold more than one job over the course of our lifetimes. Fortunately, when you get a shiny new job, your old 401(k) can come with you!
The easiest way to bring your 401(k) funds along on your career move is to ask your account custodian to initiate a direct rollover. Your funds will either be transferred directly to your new account, or the custodian will write a check made out to the new account in your benefit. In either scenario, you’ll never have direct access to the money, which means you won’t incur any penalties or taxes during the process.
You can also opt for an indirect rollover, allowing you to cash in the account and then reinvest it manually; however, this route does come with some tax-related rules and limitations. The IRS requires the administrator to withhold 20%, which means you’ll receive only 80% of the amount you see reflected in your 401(k) account balance. In order to avoid the tax penalty and make up the difference in the form of a tax credit, you’ll need to reinvest the total amount within 60 days of initiating the rollover, which means pulling a potentially significant chunk from your own pocket. Since 401(k)s are eligible to be rolled over into just about every type of retirement account available, a direct transfer is a much more sensible option.
The 401(k) is the workhorse of retirement accounts — one of the most readily-accessible and powerful financial tools in the American earner’s arsenal. If you have access to one through your employer, start taking advantage of it today. You’ll thank yourself tomorrow.