401(k) Plan Management
If your employer offers a 401(k), you and your retirement are being given a wonderful gift. A 401(k) is one of the most powerful retirement savings vehicles available. How you use it and when, can make all the difference in your retirement.
To help you get the most out of your 401(k), there are a few things you should know about the plan’s management, from what a 401(k) is and how it works to how 401(k)s are different from IRAs and how to handle taxes with your 401(k).
A 401(k) is a retirement plan offered by employers to eligible employees that lets them save and invest for retirement in a tax-sheltered account. The employer sets up the plan and chooses the investments that are offered within the 401(k). Eligible employee (you) gets to choose how much to contribute and how that money is invested among the options available.
Many employers have elected to use automatic enrollment for eligible employees into their 401(k) plans, which means that you will be enrolled to contribute a portion of your paychecks to your 401(k) account unless you opt out. Chances are this automatic enrollment is a very small amount, but getting started is an important first step.
Your contributions are based on a percentage of your overall salary and are put directly into your 401(k). So, if you contribute 5 percent of your salary, then 5 percent of every paycheck will go into your 401(k) instead of your bank account.
There are two types of 401(k) accounts: Traditional and Roth.
Traditional 401(k)s are by far the most common. In Traditional 401(k)s, you contribute pre-tax money into the plan. This means any money you contribute bypasses not only your bank account, but the IRS, too.
For instance, say 5 percent of your salary is $2,500 and you pay 20 percent in taxes, which translates to $2,000 available to go into your bank account. If you send that money to your Traditional 401(k), however, all $2,500 would go toward your retirement.
Since you don’t pay taxes today on Traditional 401(k) contributions, you’ll need to pay taxes on the money later when you withdraw it. The IRS does have a few stipulations. If you withdraw money from your 401(k) account before you are 59-½ years old, you may have to pay both taxes and a 10 percent penalty on the money.
Some employers also offer a Roth option to their 401(k), which is the reverse of this: The money you contribute to a Roth 401(k) doesn’t get to bypass the IRS. Instead, you pay taxes on it before it goes in. So only $2,000 of your $2,500 goes into your Roth 401(k). But since you’ve already paid taxes on the money, you don’t have to pay any taxes on it when you withdraw (assuming this is after age 59-½, the same stipulations apply). This means your earnings in a Roth 401(k) are not taxed.
Some employers offer a company match in their Traditional 401(k) plans. With a match, your employer promises to match your 401(k) contributions each year up to a given maximum. For example, your employer may match 50 percent of your contributions up to 6 percent. Translation: For every $1 you contribute up to 6 percent of your salary, your employer will contribute $0.50. It’s wise to contribute at least enough to get the full match, because this match is essentially free money.
Whether a Traditional or Roth 401(k) is better for you depends on your tax situation today and in the future. If you’re more concerned with saving taxes today, Traditional may be the way to go. Talk with a financial advisor to help ensure you make the best decision for your situation.
Another popular retirement savings vehicle is an Individual Retirement Account (IRA). IRAs operate a lot like 401(k)s: They come in both Traditional (pre-tax) and Roth (after-tax) options and let you save for retirement in a tax-advantaged way. There are penalties for withdrawing early from a Traditional IRA, just like there are with a 401(k).
However, there are also differences. The key differences between a 401(k) and an IRA are:
- You set up your IRA: Your employer has nothing to do with your IRA. If you want one, you can set it up, usually for free.
- IRAs offer a wider investment selection: Since you set up your IRA and not your employer, you’re not limited to the investment selections your employer chooses for the company 401(k).
- IRAs have lower contribution limits: For 2020, you can contribute up to $19,500 to a 401(k), with savers 50 and older allowed an additional $6,500 annual catch-up contribution. IRA contributions are capped at $6,500 with a $1,000 catch-up contribution. This is an increase from the 2019 cap of $6,000 worth a $1,000 catch-up contribution.
- You contribute to an IRA separately: Money doesn’t go directly from your paycheck to your IRA. Instead, you have to set up regular or one-time transfers. You can then take a tax-deduction for any Traditional IRA contributions you make during the year. Roth IRA contributions are funded with after-tax dollars so they are not tax-deductible.
- You have until April 15th of the following year to contribute to your IRA: The deadline to contribute to your 401(k) each year is Dec. 31. The IRS grants IRA savers some leniency on this deadline by allowing them until April 15 of the following year to contribute to their IRA. So, you have until April 15, 2020 to make 2019 contributions. The 2019 contribution limits were capped at $6,000 with a $1,000 catch-up contribution.
- Required Minimum Distributions (RMDs): An RMD is the minimum amount you must withdraw from your retirement account each year after you reach age 70-½. It is calculated based on your life expectancy and account balance. IRA and 401(k) accounts require RMDs beginning at age 70-½, whereas Roth IRA accounts do not. You can postpone 401(k) RMDs beyond 70-½ (and continue to make contributions) for as long as you are employed, but postponement is not an option for a traditional IRA.
Maximizing your 401(k) contributions is a powerful thing you can do for your retirement. Not only can you save on taxes by investing in a 401(k), but you can also get the added benefit of compound interest. This is when your interest earns interest, and with investments, that compounding happens on a daily basis.
Let’s say you invest the current maximum of $19,000 every year until you retire in 30 years. The stock market returns about 7 percent after inflation on average long-term. Thanks to compounding, this means you could have almost $2 million by retirement. If your employer offers a company match, you could have even more.
If, on the other hand, you only contributed $6,000 per year until retirement in 30 years, you’d be looking at a nest egg of a little more than $600,000.
And don’t forget that if you save in a Traditional 401(k), your contributions go in pre-tax. So, while your 401(k) may receive $730 each paycheck, your take-home pay will only shrink by $584.
The tax-saving benefit of 401(k)s is one of their greatest assets. Whether you choose a Traditional pre-tax 401(k) or a Roth after-tax 401(k), being able to protect your investments from annual taxes can be a huge benefit. In a taxable account, every time you buy or sell, or whenever your mutual fund pays a dividend or distribution, you have to pay taxes on that money. In a 401(k), however, any earnings and dividends grow tax-deferred if it’s a pre-tax account and tax-free if it’s a Roth account.
With a Traditional account, you get to save taxes today. If you’re in a high-tax bracket, this can be a major benefit, especially if you think you’ll be in a lower tax bracket when you retire.
If minimizing taxes today isn’t a primary concern or you think you may be in a higher tax bracket when you retire, a Roth 401(k) may be a better deal. In this case, you pay taxes on your contributions but any earnings are not taxed, provided you don’t withdraw them before age 59-½.
Again, we recommend discussing your options with a financial advisor who is well versed in 401(k) plan management.
The younger you are, the more powerful your 401(k) is. Time is the greatest asset any investor has. A saver who invests $200 every month between age 25 and 35 would likely have more money in their 401(k) account by age 65 than someone who contributes $200 per month from age 35 to 65. So, even if you stop contributing at age 35, your investments could grow to be worth more than someone who puts in more than twice as much money but waits until age 35 to start saving.
When you’re young, it can be hard to put retirement before other, more pressing goals, like paying off debt or buying a house, but these early years can be very powerful.
When you leave an employer, you have the option of doing what’s called a 401(k) rollover. This is when you transfer the money in your 401(k) into another 401(k), or an IRA. You don’t pay taxes on rollovers; the money simply moves from one tax-sheltered account to another.
The 401(k) was set up with ease of use in mind. However, even the easiest places to invest can be far from simple. Sometimes, a little help can go a long way. Here are a few ways a financial advisor can help you manage your 401(k):
- Prioritizing your financial goals: We all have competing financial goals and they’ll likely change throughout life. Having someone to help you strategize how best to save for each of those goals without needing to sacrifice any of them can be helpful.
- Life event planning: You’ll likely experience many life events that can disrupt your finances between now and retirement. Whether it’s having your first child or getting (or losing) a job, a financial advisor can help make sure none of these disruptions upheave your retirement plans.
- Navigating uncertainty: If there is one thing we know about the future, it’s that it is uncertain. This is especially true when it comes to the stock market. No one can tell you what the stock market will do tomorrow, let alone in the next decades. A financial advisor can help you navigate the uncertain road ahead.
- Objective advice: Along with uncertainty comes the challenge of investing through emotional times. Doing what’s right by your investments, like selling high and buying low, is not always what feels right emotionally. An objective third party can provide the unemotional guidance you need to stay on track.
However you decide to proceed with your 401(k), whether it’s with help or on your own; in a Traditional account or a Roth, the important first step is to start investing for retirement. Every year counts, and every dollar you save today can help prepare you for a better retirement.
This is not, and you should not consider it to be, legal or tax advice. The tax rules are complicated and their impact on a particular individual may differ depending on the individual’s specific circumstances. Neither IFG, nor SCM provide tax or legal advice. Please consult with your legal or tax advisor regarding your specific situation. Securities through Independent Financial Group, LLC (IFG), a registered broker-dealer. Member FINRA/SIPC. Advisory services offered through Scarborough Capital Management, a registered investment advisor. IFG and Scarborough Capital Management are unaffiliated entities.