Today on Financially Savvy Friday, I am expanding on last week’s lesson on compounding. Now that you understand the magic of compounding, over the next few weeks I will outline vehicles and methods to make the most of it and maximize your financial future, whether it be saving for your first home or dream home, your children’s college funds or your own retirement. This week, I will begin with the 401K: what it is, how it works, and why you should max out your contribution annually at the limit the IRS will allow.
What is a 401K?
A 401(k) is a defined-contribution pension account granted special tax treatment by the IRS as defined in subsection 401(k), hence the commonly known name. In English? It is a retirement savings account provided as an employment benefit by your employer. Contributions to the account are deducted directly from your paycheck BEFORE taxes (the special tax treatment), and automatically deposited in your retirement savings account, or 401(k). The money available to you in retirement is equal to your contributions, and any investment returns they generate.
Employers often offer additional contributions to 401(k)s either by matching your elected contributions or having company profit-sharing programs that make contributions to your 401(k). More on this later. Similar employer-provided plans are available in specific sectors: 403(b) plans for nonprofit organizations and 457(b) plans for governmental employees.
How does a 401K work?
Your employer typically contracts with a benefit provider to manage its employees’ retirement savings accounts. Just as they contract Aetna or United Healthcare to provide employee health insurance, they contract with a large financial services firm, like Fidelity or Charles Schwab, to manage your retirement account. As the beneficiary, you will determine the following:
- The annual contribution you wish to make from your salary
- How you want your contributions invested
- Who you want the account beneficiary to be in the event of your death
Annual Contribution Limitations
It would be great if you could avoid paying any taxes and defer all your compensation to be invested on a pre-tax basis… But Uncle Sam doesn’t allow that, and you need some current income to live on. The IRS sets an annual limit on the maximum pre-tax contribution you can make to your 401(k). For 2015, the limit is $18,000. This limit typically increases slightly every year to keep pace with the cost of living, so be sure to reference the latest annual limit when making your contribution elections each year.
For the average person, your payroll department will be keenly aware of these limits, and won’t allow you to make an election that exceeds them. However, if you change jobs mid-year, make sure you don’t exceed the annual limit between the two different employers. There are penalties for it, particularly if it is not corrected before you file your annual taxes, as well as potential penalties for early withdrawals from your account. It’s messy – don’t do it!
Additionally, as I mentioned above, employers may provide added contributions to your 401(k) plan via matching contributions or nonelective contributions, like those from a profit sharing plan. Employer matching contributions occur when your employer, as an added employee benefit, will match your annual elected contribution up to some set percentage of your salary. According to the ProfitSharing/401K Council of America, the most common employer match rate is 3% of your salary. Therefore, if you make $50,000 a year, and contribute 3% of your salary to your 401(k), or $1,500, your employer will contribute an additional $1,500. FREE money! Yes, please!
If your employer makes nonelective contributions, those are typically related to company performance and designed as incentives to retain employees and align their interests with the firm. At a prior firm, my employer made additional contributions via a profit sharing plan, linked to the firm’s financial performance. Those contributions vested over 5 years, so only 20% of it accrued to my account each year. The IRS caps these contributions as well. For 2015, the total annual contributions to your 401(k), including your elected contributions, and any additional contributions from your employer, may not exceed the lesser of 100% of your salary or $53,000.
Still with me?
The financial services firm that manages your 401(k) provides a list of investment election choices. Typically included in this list are various mutual funds, some of which are index funds, designed to match the performance of specific market indices like the S&P 500 or investment grade (high quality credit) bond market, or sub-sectors of market indices, like small cap (smaller companies) or energy. Others may be more actively managed based on specific investment strategies, all of which should be made available to you in the fund’s documentation.
Lastly, you may be given the option to invest in Target Date Funds. These may be named something like, Freedom 2040, and are designed for investment for someone who plans to retire in a specific time period. They are comprised of a mixture of strategies and asset classes designed to match a risk profile appropriate for your age and stage in life. In short, younger investors can take more risk and be more aggressive in their investments – they should have investments weighted more heavily toward riskier, higher return equities with the aim of growing capital. Conversely, as you approach retirement, you want to invest more conservatively, with the goal of preserving capital so you have greater certainty going into retirement. These investors should have investments weighted more heavily toward high quality fixed income investments, and eventually high yielding investments (paying out cash dividends) during retirement. A Target Date Fund makes all these risk profile adjustments for you automatically over time.
More specifics on asset classes, risk profiles and investment selection could be a whole post in and of itself, but just keep an eye on the management fees and total annual fees associated with your elections. These are also not elections you want to change frequently, as you are investing for the long-term, but you do want to make sure your risk profile and equity/bond mix is consistent with your age and retirement goals. You can always review them, and when you make changes to your investment elections, you can elect to change your entire existing portfolio or just change the allocation of future contributions.
When you first set up your 401(k), you will be asked to name a beneficiary in the event of your death. If you name no one, it is typically automatically your spouse. Before I got married, it was my parents – after I was married, I made sure to change the election to my spouse. Otherwise, this isn’t something you should have to change very often.
Why you should max out your annual contribution
So, you’ve made your annual contribution election, selected your investment allocations, and picked your beneficiary. Now what? Each paycheck, you will see a deduction for your 401(k), pre-tax. This is huge! According to the US Census Bureau, for 2013, the most recent year data is available, the median household income was just under $52,000. At that income level for a married couple filing jointly, the marginal tax rate for 2015 is 15%, or in a state like mine with state income taxes, add another 5% to that, for 20% total. That means, if you max out your elective contribution this year and put $18,000 into your 401(k), you will have deferred $3,600 in taxes. Maxing out your election means maxing out your current year tax savings; less money for the IRS, more money for your future retirement, compounding annually in the interim. Also, when you do pay taxes on it when you collect it in retirement, you will likely be earning less overall income and pay taxes at a much lower rate.
What does that $3,600 in deferred taxes really mean? Let’s go back to last week’s example of investing in the S&P 500. Over the last nearly 2 decades, the S&P 500 had a total compound annual return of approximately 8%. If we assume that continues (which you should never assume past returns are indicative of future ones, but for example’s sake, let’s assume), in 2040, the $18,000 you invest today, will be worth over $123,000. Alternatively, if you didn’t put it into your 401(k), and invested it on your own in an S&P fund after-taxes, you would only be investing $14,400, and in 2040, it would be worth just over $98,600, a difference of almost $25,000, which could be nearly a full year’s worth of retirement income! That is the magic of deferred taxes in conjunction with compounding. Now repeat that every year for the next 25 years, and the numbers really get big!
Each paycheck, your 401(k) contribution is being allocated to your investment selections and the compounding begins. With every paycheck, your base investment gets a little bigger and the compounding has even greater effect.
If you can’t afford to max out to the annual elective contribution limit, at a minimum, try to contribute the maximum your employer will match. The employer match is literally free money – for every dollar you put in, your employer is putting in an additional dollar. In simple terms, if your employer matches 3% of your salary and you earn the median household income of $52,000, to earn the full match, you need to elect to contribute at least 3% of your salary, or $1,560. That works out to $130/month, or $60/bi-weekly paycheck. Cutback on your cable package, reduce your cell phone data plan, eat-in a few more times each month – whatever you do, contribute that 3% so you can effectively contribute 2x that for your future.
What if you don’t have a 401K?
Not every employer offers a 401(k), and even if they do, sometimes you must be a full-time employee to receive those benefits. Many government employees, public service professionals, and employees of large corporations, often with unionized workforces, participate in defined benefit pension plans. While a 401(k) is a defined contribution pension plan with retirement proceeds equal to your investments and their returns, held in an individual account for which you retain full ownership, a defined benefit plan specifies a set monthly benefit upon retirement based upon a formula, typically tied to the employee’s earning history, tenure and age. More on these, and the risks and benefits to you as an employee later.
If you do not have any tax-deferred investment options or pensions available to you via your employer, next week, I will talk about Individual Retirement Accounts, or IRAs, which are available to everyone and also provide tax advantages for retirement savings.
I know all this stuff can be boring – but it’s also information that impacts your everyday life and every adult should understand, and so many do not until it is too late. My goal with Financially Savvy Friday is to equip parents, as the household CEO, with the basic financial knowledge they need to manage their household budget, plan for their children’s college education and their future retirement.
Have a question about anything you read above? Please ask. Have a different household finance question? Ask way! Be more than frugal… be financially savvy!