No matter when you plan to leave the workforce, one important thing you should know is that your retirement isn't going to pay for itself. Unless you have a pension through your employer (which most workers today don't), you'll need to save aggressively for your golden years.
Enter the 401(k).
A 401(k) is a retirement plan that allows individual employees to save for the future by choosing from a number of different investment options. One benefit of saving in a 401(k) is that once you've set up your plan, the funds you contribute will be deducted automatically from your salary each time you get paid; you won't need to actively transfer money into it or write out checks, as is generally the case with an IRA. And in the large majority of cases when your company sponsors a 401(k) plan, you'll also snag some bonus money cash via an employer match.
Below, we'll go over everything you need to know about starting a 401(k), including how much money you're allowed to contribute and how to choose investments.
How do 401(k)s work?
You can open a 401(k) account through your employer if they offer a plan or on your own through a financial institution if you're self-employed. The money you contribute is yours, and can be withdrawn normally after you turn 59 1/2. If you remove funds prior to then, you'll risk a 10% early-withdrawal penalty on the amount you take out.
There are two types of 401(k): the traditional and the Roth. With a traditional 401(k), you tell your employer what percentage of your paycheck you want to contribute, and that sum gets routed into your account before the IRS takes its share. The result is an immediate savings. That money then gets to grow on a tax-deferred basis until you're ready to take withdrawals, at which point distributions are subject to taxes.
Roth 401(k)s work the opposite way: Contributions are made with money you've already paid taxes on, so there's no immediate benefit. But your money then gets to grow tax-free, and your withdrawals in retirement are tax-free as well.
You don't necessarily need to choose between a traditional 401(k) versus a Roth -- you can divvy your retirement money up among both options. But generally speaking, a Roth makes the most sense when you expect your tax bracket to be higher in retirement than it is at present. That way, you pay taxes on your contributions at a lower rate, and take withdrawals tax-free when your rate would otherwise be higher. However, if you need an immediate tax break, or if you think you're in a higher tax bracket now than you'll be in during retirement, then it might pay to stick with a traditional 401(k).
How much money can I contribute to a 401(k)?
The maximum you're allowed to contribute changes from year to year based on IRS calculations. For 2019, 401(k) contribution limits are as follows:
If This Is Your Age in 2019:
This Is Your 401(k) Contribution Limit:
50 or older
The option for workers 50 and over to contribute an extra $6,000 is meant to give them a catch-up opportunity. Because 401(k)s weren't as widely available when today's older workers were first starting their careers, they get to contribute at a higher rate later in their careers to compensate. However, you don't have to be "behind" on your savings to take advantage of catch-up contributions. Even if you maxed out your 401(k) every year you've been employed, you're still eligible to make those larger contributions after you turn 50.
Keep in mind that if you choose to split your savings between a traditional and Roth 401(k), the sum of what you route into both in a given year can't exceed your annual contribution limit. Having two accounts doesn't double your limit.
Why contribute to a 401(k)?
Whichever type of 401(k) you choose, you get a tax break. With a traditional 401(k), it's immediate. If you contribute $10,000 this year and you fall into the 24% marginal tax bracket, you'll shave $2,400 off your 2019 IRS bill. You will, however, pay taxes on those funds and their returns when you withdraw them in retirement.
You won't get an instant tax break with a Roth 401(k). Instead, you will benefit from tax-free growth on your investments. When investing money through a traditional brokerage account, you're required to pay taxes on your gains in any year that you sell assets and make a profit on them. But your gains from assets in a Roth are never taxed. This means that if you contribute a total of $200,000 of your own money over time, and that sum grows to $1 million by the time you retire due to wise investment choices, you won't pay taxes on that $800,000 return. And that's a pretty good deal.
Another benefit of saving for retirement in a 401(k) is the potential for an employer match. The Plan Sponsor Council of America reports that 63% of employers that offer 401(k)s also match employee contributions to some extent. That's free money for you. Furthermore, the amount your employer puts in doesn't count toward your annual contribution limit.
Usually, employers match contributions up to a certain percentage of employees' salary. For example, your company might match contributions of up to 5% of your salary. In that case, if you earn $60,000 in a given year, your employer will add up to $3,000 to your 401(k), depending on how much you choose to save.
How can I open a 401(k)?
If you work for a company that sponsors a 401(k) plan, you may be eligible to participate in it right away. Some employers, however, impose a waiting period, but usually, your employer must let you participate once you've reached 21 years of age and have worked for the company for a full year.
Once you're eligible, your next step involves talking to your payroll or human resources department, and filling out the enrollment forms for that plan. You may be asked to designate a beneficiary for your 401(k) at that time (someone who would inherit that plan if something were to happen to you).
You'll then need to decide between a traditional 401(k) or a Roth (assuming your employer's plan has a Roth option; not all plans do). You'll also need to decide how much money to contribute from your earnings -- the more, the better, but you should, at the very least, aim to put in enough money to capitalize on your full employer match.
Contributions to your account will happen automatically once you fill out the right paperwork. Your employer will deduct them from your paychecks directly, and when you receive your pay stubs, you'll be able to see what you've contributed to your 401(k) per pay period, as well as year to date.
You're also allowed to change your contribution rate as circumstances dictate. Let's say you start out by contributing 5% of your salary. If your rent goes up midyear and you need to decrease your retirement contributions, you're allowed to do that. You'll just need to contact HR or the payroll department and put that request in. Of course, you can also increase your 401(k) contributions if you find that you're able to, as long as you stick to the aforementioned annual limits.
What happens to my money once I open my 401(k)?
Most 401(k) plans come with a range of investment options, all of which are available in fund form (as opposed to individual stocks or bonds). Among the typical ones are:
- Target-date funds: These adjust the risk level of the investments in their portfolios to align with a specific time frame -- usually the year you intend to retire. A fund with a distant target date might start out with a riskier mix of investments (typically stocks) that lends itself to more aggressive growth. But as that date grows nears, the investments the fund holds will be shifted by its managers toward safer options (like bonds). Target-date funds are usually the default savings option in a 401(k) -- meaning, when you first open your account, your money will typically land in one. These funds are a good option if you're not planning (or willing) to take an active role in investing for your golden years.
- Stock funds: These funds offer a bucket of stock investments, and are generally considered riskier, but tend to offer the best opportunities for growth.
- Bond funds: These funds allow you to invest in bonds (as the name implies), so they're less risky than stock funds. However, they typically offer slower growth.
- Blended funds: These funds offer a mix of stocks and bonds. Thus, their associated risk and growth fall somewhere in between the two aforementioned options.
- Money market funds: These funds are essentially a means of keeping your savings in cash. There's minimal growth associated with money market funds.
The funds you choose for your 401(k) should largely depend on your age and appetite for risk. When you're relatively young, you can afford to get more aggressive and load up on stock funds for maximum growth, since you'll have time to ride out whatever market volatility ensues and, ideally, come out ahead. But as you get closer to retirement, you may want to shift toward safer investments. Target-date funds take the guesswork out of the mix in this regard, but be aware that these funds sometimes err on the side of being too conservative, which could limit your savings' growth.
You should also know that there are fees associated with your 401(k) investments. The good news is that your plan is required to disclose what they are, so you'll be able to see which investment choices cost more than others.
Within the categories of stock funds and bond funds, you'll generally get to choose between actively managed mutual funds versus index funds. With the former, you have actual people overseeing your fund's investments, and you will generally pay higher fees for their expertise. Index funds, on the other hand, are passively managed; they simply track existing market indexes, like the S&P 500 or the Dow Jones Industrial Average, and therefore, their fees can be significantly lower. In some cases, and in some years, you might see better returns for an actively managed fund. But in 2018, only 38% of active U.S. stock funds outperformed their passively managed counterparts, according to Morningstar.
Your investment fees will be expressed to you as expense ratios. An expense ratio of 1% means that for every $1,000 you keep invested in a fund, you lose $10. Actively managed mutual funds can easily have expense ratios of 1% per year or higher, whereas it's possible to find index funds with expense ratios of 0.2% or lower. But these are just general guidelines; the options you're given will depend on your plan, so you could end up paying more for either type of fund.
Also, don't confuse investment fees with administrative fees; the latter are what you'll pay for the privilege of participating in your 401(k), and they're generally not negotiable. In some cases, however, your employer will pay those fees so you don't have to, but your investments fees will be your cost to bear.
How do I open a Solo 401(k)?
A solo 401(k) is a self-managed retirement plan for people who are self-employed. You can open one through a financial institution, choose your own investments, and save for your golden years in the same tax-advantaged fashion as employer-sponsored 401(k) allows.
Some financial institutions will charge you a fee to set up your solo 401(k), but others won't. Similarly, solo 401(k)s come with maintenance fees that are usually paid on a monthly basis. It pays to shop around for the most cost-effective option. Note that these fees are administrative in nature; you'll still pay investment fees, the amount of which will depend on the funds you choose.
Solo 401(k)s come with higher contribution limits than employer-sponsored 401(k)s. For 2019, you can contribute up to $56,000 to a solo 401(k) if you're under 50, or up to $62,000 if you're 50 or older.
The rules for funding a solo 401(k) are different from an employer-sponsored plan. With an employer-sponsored plan, you can contribute $19,000 or $25,000 provided you earn at least that much. With a solo 401(k), your contributions are limited to 20% of your net self-employment income (your income minus operating expenses and half the amount you pay in self-employment taxes), assuming you don't own a business and pay yourself a salary. If your net business income is $280,000, you can contribute $56,000 to your solo 401(k). But if your net business income is $80,000, you're limited to $16,000.
Now if you own a business and pay yourself a salary, you can contribute up to $19,000 or $25,000 from that salary, depending on your age, toward that solo 401(k) directly. But from there, the most you can put in from your net self-employment income is the difference between your contribution from your salary and the annual limit that applies to you. If you're under 50 and put $19,000 into your solo 401(k) from your salary, you're then limited to $37,000 in contributions from net income.I know this last sentence is a little redundant but I think the numbers help explain the concept.
What if I don't have access to a 401(k)?
If you don't have access to an employer-sponsored 401(k), and you're not self-employed, then your best bet for saving for retirement is an IRA. Short for individual retirement account, IRAs come in both the traditional and Roth version, and they work like 401(k)s with regard to the tax treatment of contributions and withdrawals. Similarly, IRA funds can be withdrawn once you turn 59 1/2, and you'll risk an IRS penalty if you remove funds prior to that age.
IRAs have a couple of disadvantages. For one thing, their annual contribution limits are low -- in 2019, you can only contribute up to $6,000 to an IRA if you're under 50, or up to $7,000 if you're 50 or older. Also, since IRAs aren't employer-sponsored, matching dollars don't come into play.
Get moving on that 401(k)
The sooner you begin contributing to a 401(k), the more time you'll give your money to grow. Let's say you're able to contribute $500 a month. For the sake of keeping this example simple, we'll assume you don't get an employer match. Let's also assume that you adopt a relatively aggressive investment strategy by loading up on stock funds, and that your investments deliver an average annual 7% return (which is a couple of percentage points below the stock market's average) over time. Here's roughly what your ending balance will look like, depending on how long a savings window you give yourself:
Ending 401(k) Balance*
Notice the difference between a 40-year savings window and one that's just five years shorter. In our example, you're only looking at $30,000 less in actual contributions. But those extra five years of growth, coupled with an extra $30,000, are enough to spell the difference between $830,000 and $2 million.
That's why it pays to start saving as soon as you're able to. If you can't contribute a large chunk of your earnings initially, start small and work your way up as your salary increases, or as you're able to cut expenses to free up more money. A healthy 401(k) could be your ticket to a financially secure retirement, so it pays to participate in one from as early an age as possible.
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