As financial advisors, we are constantly being asked how best to save for retirement? In most cases, the answer is simple, start with your employer-sponsored plan. Why? Employer-sponsored qualified retirement plans such as 401(k)s are some of the most powerful retirement savings tools available. If your employer offers such a plan and you’re not participating in it, you should be. Once you’re participating in a plan, try to take full advantage of it.
Before you can take advantage of your employer’s plan, you need to understand how these plans work. Read everything you can about the plan and talk to your employer’s benefits officer. You can also talk to a financial planner, a tax advisor, and other professionals. Recognize the key features that many employer-sponsored plans share:
The more you can save for retirement, the better your chances of retiring comfortably. If you can, max out your contribution up to the legal limit (or plan limits, if lower). If you need to free up money to do that, try to cut certain expenses.
Why put your retirement dollars in your employer’s plan instead of somewhere else? One reason is that your pre-tax contributions to your employer’s plan lower your taxable income for the year. This means you save money in taxes when you contribute to the plan — a big advantage if you’re in a high tax bracket. For example, if you earn $100,000 a year and contribute $10,000 to a 401(k) plan, you’ll pay income taxes on $90,000 instead of $100,000. (Roth contributions don’t lower your current taxable income but qualified distributions of your contributions and earnings — that is, distributions made after you satisfy a five-year holding period and reach age 59½, become disabled, or die — are tax free.)
Another reason is the power of tax-deferred growth. Your investment earnings compound year after year and aren’t taxable as long as they remain in the plan. Over the long term, this gives you the opportunity to build an impressive sum in your employer’s plan. You should end up with a much larger balance than somebody who invests the same amount in taxable investments at the same rate of return.
For example, say you participate in your employer’s tax-deferred plan (Account A). You also have a taxable investment account (Account B). Each account earns 6% per year. You’re in the 24% tax bracket and contribute $5,000 to each account at the end of every year. After 40 years, the money placed in a taxable account would be worth $567,680. During the same period, the tax-deferred account would grow to $820,238. Even after taxes have been deducted from the tax-deferred account, the investor would still receive $623,381. (Note: This example is for illustrative purposes only and does not represent a specific investment.)
If you can’t max out your 401(k) or other plan, you should at least try to contribute up to the limit your employer will match. Employer contributions are basically free money once you’re vested in them (check with your employer to find out when vesting happens). By capturing the full benefit of your employer’s match, you’ll be surprised how much faster your balance grows. If you don’t take advantage of your employer’s generosity, you could be passing up a significant return on your money.
For example, you earn $30,000 a year and work for an employer that has a matching 401(k) plan. The match is 50 cents on the dollar up to 6% of your salary. Each year, you contribute 6% of your salary ($1,800) to the plan and receive a matching contribution of $900 from your employer.
Most employer-sponsored plans give you a selection of mutual funds or other investments to choose from. Make your choices carefully. The right investment mix for your employer’s plan could be one of your keys to a comfortable retirement. That’s because over the long term, varying rates of return can make a big difference in the size of your balance.
Note: Before investing in a mutual fund, carefully consider the investment objectives, risks, charges, and expenses of the fund. This information can be found in the prospectus, which can be obtained from the fund. Read it carefully before investing.
Research the investments available to you. How have they performed over the long term? How much risk will they expose you to? Which ones are best suited for long-term goals like retirement? You may also want to get advice from a financial professional (either your own, or one provided through your plan). He or she can help you pick the right investments based on your personal goals, your attitude toward risk, how long you have until retirement, and other factors. Your financial professional can also help you coordinate your plan investments with your overall investment portfolio.
When you leave your job, your vested balance in your former employer’s retirement plan is yours to keep. You have several options at that point, including:
In closing, you have several options to choose from when saving for retirement. More often than not, starting with your employer-sponsored plan is a good starting point.
At Austin Asset, we are Fee-Only Financial Advisors. We seek to bring clarity and purpose to wealth through authentic and enduring relationships. For Life.