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The 401(k)

November 16, 2016

It just happened to be the end of 2013 when I was riding bikes around town with my friend Anna. She was heading to graduate school after living and working in Jackson for a couple of years. I was being the nosy finance nerd I was pestering her with questions about her student loans, current salary, expected salary range and her past job benefits (being a helpful and caring friend, I was also giving her my best advice on these matters too!). The old job had a 401(k) plan with a generous match, and I was relieved to hear that she had been contributing at least enough to get the full employer contribution. She knew that it was important to save for retirement and knew to take advantage of the benefit.

"Yeah, the stock market scares me, though, so I have it in what they said was the safest option. I think it is called a money market."

Cash.

She had her whole 401(k) in cash in a stretch of time when the S&P 500 returned over 50%! Even a moderate, can't go wrong choice, balanced fund returned 14% in 2012 and 21% in 2013! If she had invested her money, her $200/month savings could have grown to over $6,000 instead of being just $4,800. This would have been an amazing return for such a short time.

This just happened to be a time with particularly high returns. Other stretches of time and other investments would produce different returns.

Retirement is the biggest financial decision most people will make. In recent history, employers have typically provided some sort of mechanism for people to have income or assets after they finish their careers. With people living longer and longer these days, employer sponsored retirement plans have become more and more important. Though unfortunately, they have become more and more rare too.

 

 



WHAT IS A 401(K)?

The 401(k) is a type of plan known as a deferred compensation plan. It is called this because you are deferring income from your current paychecks until later - hopefully until you retire. Essentially it works like this:

 

  1. You decide an amount of money that you want withheld from your paycheck. Sometimes you can choose if you want this deferred before you pay taxes on it or after.

  2. This money is withheld and placed in an account for you.

  3. Your employer may or may not add a contribution on top. Typically contributions are matching contributions up to some percentage of your pay, but can also include flat contributions or profit sharing contributions.

  4. The money in the account is invested according to your instructions.

  5. Money accumulates as you work.

  6. When you retire, you have essentially free access to the money.

If you deferred the income before you paid tax on it, when you withdraw it in retirement, you will owe taxes on it like income. If you did post-tax contributions, also known as Roth contributions, you will never owe taxes on it again.

 

There are also some limits to the amount of income that you defer into your 401(k) each year. For 2016, you can defer up to $18,000. You can never contribute more than your income. These limits may change from year to year, so if you are looking to max out your contributions, check with your HR or the IRS about your limits.

 

There are a few key considerations to make when starting with a new 401(k). This should help guide your decisions. Also, for the record, there are a bunch of different names to retirement plans at work, I will just use the term 401(k) liberally and generically to cover defined contribution plans. These may include Roth 401(k)s, the TSP, SIMPLE IRAs, 457(b)s or 403(b)s or others.

 

HOW MUCH SHOULD I CONTRIBUTE TO MY 401(K)?

 

All of it.

 

Contribute as much as you can.

 

As a rule of thumb, you need to save somewhere between 16 and 20% of your income to fund your retirement. At 16%, saving and investing over a 40 year career will result in a balance that can support your likely expenses in retirement.

 

If 16% is too steep for you right now, here is how to get started: Take advantage of any matching contributions your employer makes. It is reasonably common for employers to make a matching contribution of some sort. This can take many shapes, but is generally a match up to a percentage of your income. If you company says they offer a 3% match, that means that if you defer 3% of your income, they will contribute another 3% on top. If you defer 4% or more, they will stick with the 3%, but if you defer less, they will match your lower contribution.

 

So, take advantage of the employer match.

 

Next you need to save more tomorrow. Every time you get a raise, defer a little bit more into your 401(k). If you get a 2% raise, split the gain - increase your contribution 1%. Even if you didn't get a raise, look at your budget annually and see if you can afford to raise your contribution. One feature that a lot of plans are starting to offer is that they will raise your contribution for you automatically every year. Automation in the 401(k) industry is an excellent behavioral tool for saving that you should take advantage of.

 

Target deferring 16% of your income, but don't hesitate to keep climbing.

 

Once you have worked your way up to the basic target of 16%, you can start aiming higher. The more aggressive you get with your saving, the earlier you can retire. Early retirement is the dream, right? I ran the numbers, and if you save 20% of your income, 35 years of work should support a comfortable retirement. Saving 33% will bring that down to 25 years of work. If you save 50% of your income, you only have to work about 16 years to retire with enough money to cover your expenses! These numbers are really loose, obviously, as it depends on how much you plan on spending in retirement and other costs not being considered, but that is the general idea - if you save more, you can meet your financial goals faster.

 

All that being said, the percentage to save is independent of the vehicle. If your 401(k) is not actually that good, it may make sense to save in a personal IRA or a taxable account for the same purpose. That is a topic for another chapter, however.

 

HOW DO I INVEST MY 401(K)?

 

The 401(k) is many peoples first experience with investing. They are handed what is called a plan menu and told to select some investments that match their investor profile. If you have never invested before, you probably don't know what any of that means. You may have heard of the trade-off between risk and reward, and your 401(k) paperwork may indicate that as well. The basic idea is that higher returning investments are more volatile in the short run. So while stock investments may give you 8% returns over ten or more years, they do have the risk of significant loss in any given month or year. Bonds, on the other hand, may only promise to return 3%, but won't fluctuate in value quite so much from month to month or year to year.

 

Your plan menu is a list of investments available in your 401(k). There are a few different types of funds available.

  • Stable Value or Money Market funds. These are basically cash.

  • Fixed Income. These are funds with bonds of various types. They may contain US Government Treasury bonds or corporate bonds but the idea is that they will all pay interest to you and a supposedly reliable pace. A much deeper dive for a different day reveals that this is not the case when they are pooled into funds.

  • Stocks. These may be divided up into US and International funds. Or maybe divided by size and shape. Stocks are shares of companies. The value fluctuates with the successes and failures of the company. Funds can be either actively managed by someone trying to pick the companies with the best future, or can be a passively managed index fund, just keeping track of a basket of stocks without much interference or cost.

  • Balanced Funds. A mix of the other types of funds.

  • Target Date funds. These are a special flavor of balanced fund that adjusts as you age. They typically have a retirement year in the name. They start off with aggressive, risky investments in stocks to drive return when you have a long time to grow, and get more conservative moving to bonds and cash as you retire.

Target Date Funds are usually an acceptable default option. Just pick one that matches up with when you think you will retire and call it a day. If you have a little more experience or are working with an advisor, you might want to assemble a portfolio of low cost index funds that are appropriate for the long term nature of the 401(k). Generally speaking, the longer before you need the money, the more aggressive or risky your investments can be. The closer to retirement, the higher proportion of bonds and cash you want in your portfolio.

 

WHAT IF I CHANGE JOBS?

 

If you leave your employer, you will no longer be able to contribute to their 401(k). Each 401(k) is tied to both the individual and the company. You have a few options once you move on. This where vesting comes into play. If your employer has been making contributions, particularly if they have been making profit sharing contributions, you may not be entitled to parts of those. Some employers will contribute to your 401(k) but have a vesting schedule dictating when the money becomes yours. Typically this is done over a period of 5 years. This is not the case with every employer, and the money you contribute form your paycheck is always yours.

 

The worst thing you can do is take all of your money out and spend it. Even if you don't spend it, you will owe income tax and possibly an early withdrawal penalty of 10% if you take the money out. Don't do this.

 

If you have a 401(k) with your new employer, you may be able to roll your old 401(k) into it. This makes sense if you knew plan has good, low cost investments that are the best for your situation. As this is rarely the case, the last, and often best option is to roll your 401(k) into a personal IRA.

 

Roll your previous employer's 401(k) over into a personal IRA. This is the best option if you can invest the money better in a personal IRA than you can in the old 401(k) or your new 401(k). If you already work with an advisor, they would likely be able to manage that for you as well. There are a lot of options here, but 401(k) providers typically have a very limited slate of investments and you can find a more complete, lower cost account elsewhere.

 

OK, I'VE GOT IT. CAN I FORGET IT?

 

Hopefully! The idea with 401(k)s now is that you can set them and forget them. You can set your contribution to automatically raise up to your target savings rate, and you can set investments to rebalance to your original allocation periodically. All of these tools mean that without a major change in your situation, your account will be adequate without any more input from you.

 

But that isn't quite right. I advise people do a deep dive into their personal financial situation at least once a year, and the 401(k) is an important part of that deep dive. If you have not had a major change in your life, won the lottery, lost all of your worldly belongings or planned a retirement party for yourself, you probably will not need to make any changes, but here are a few things to look at in an annual review:

  1. Are you contributing enough? Are you hitting the 16% target? Can you contribute more?

  2. Have the investments changed in your plan? Plan menus do change, if an old option is not available, search for the next best alternative. If your plan had target date options, it is unlikely that these have changed without keeping you up with the times.

  3. Do the investments work with your total portfolio? You cannot view your 401(k) in isolation. It is an asset like your other assets and needs to be viewed in that context. Say you have $100,000 in your 401(k) and $100,000 in outside investments and your overall allocation, based on your needs and risk tolerance, is 50% stocks 50% bonds. If both accounts are 50/50, fine, but if your outside investments are all stocks, then your 401(k) should be all bonds.

 

BUT WAIT, I DON'T HAVE A 401(K)!

 

Slow down.

 

You read this whole post knowing that it was completely irrelevant to your life? Thank you for the views! Please share!

 

As I said, retirement is the biggest financial decision that most people will make. It is important that you prepare for it and by prepare I mean save money. Self-employed workers or people just not covered by a 401(k) or other retirement plan at work have a few options to avail themselves to.

 

Self-employed workers can save in a SEP IRA. This is useful as it allows you to defer as much income as a W-2 employee gets to defer, PLUS what the company could add.

 

If your company just does not have a plan, you can open a personal IRA. This can either be a Traditional IRA that is Pre-Tax or a Roth IRA that is post tax. For younger worker and people who will face a higher tax bracket in the future, the Roth is the best deal going in tax avoidance. While you pay taxes on it now, while you have a low tax bracket, you will never pay taxes on it again, even when it has grown and you withdraw it in your wonderful golden retirement.

 

So there you have it, retirement is a big decision, and it is important that you face it prepared. There are a number of tools available and the 401(k) is fast evolving to be one of the best tools you may have. There are a lot of features and facets to consider, to be careful and work with a professional if you have any questions. Most importantly, however, save!

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