401(k)s: The Beginner’s Guide
July 7, 2020 Author: Tess Downing, MBA, CFP®, Complete View Financial
Retirement, inevitably, is one of the most important components of financial planning. But because we don’t know how long we are going to live or what our future expenses might be, retirement planning can sometimes be rather difficult. As a result, it is important to not only create a retirement portfolio that has at least some degree of flexibility, but to also begin planning as soon as you possibly can. 401(k)s are a great source of retirement savings for the majority of Americans.
Many young professionals avoid the ever-important retirement discussion, for a variety of reasons. Things such as buying a home, paying off student loan debt, and simply getting on your feet will all take precedence to a financial commitment that will not be a part of your life for many decades down the line. But even waiting one additional year can have a huge impact on how much money you’ll end up having in the future. Assuming a 5 percent annual return, starting to save just one year earlier can turn 3 million into a 3.15 million dollar nest egg. In other words, in this scenario, waiting a year won’t cost you $5,000, but $150,000 worth of future capital.
For many people, the most important piece of their retirement plan will be their 401(k). In this article, we will answer some of the most frequently asked questions about 401(k)s and also discuss how you can improve your long-term savings strategy.
What is a 401(k)?
A 401(k) is a specific type of retirement account that enables people to enjoy various tax benefits and, in some cases, matching contributions from their employers (up to a certain limit). With a 401(k), it becomes easier to increase the amount of money that is being contributed to your future savings. However, the primary drawback of using a 401(k) is that you will not be able to access the funds—without penalty—until you are 59.5 years old.
How Much Should I be Saving?
The salary contribution limit for 401(k) contributions, as of 2020, is $19,500 for each employee. However, most people do not contribute nearly this much. According to the Vanguard Group, the average person contributes about 3 percent of their salary each year, which equates to $1,500 in annual contributions for someone making $50,000 or $3,000 in contributions for someone making $100,000 per year. However, it is generally a good idea to contribute more—when possible, contributing 10 percent (or more) of your income to retirement is highly recommended. You may also want to consider increasing your contribution rate as your income increases and/or you are closing in on retirement.
How Should I Structure My 401(k)?
Most 401(k) portfolios are primarily composed of mutual funds. Mutual funds make it easy to enjoy the general growth of the market and also immediately diversify your holdings. When selecting which mutual funds you’d like to invest in, you will need to carefully balance your exposure to risk and your ability to generate strong returns. The risk-reward exposure that is right for you will depend on your personal needs, when you plan on retiring, and the ongoing state of the economy. Target date funds are a great option that allow you to be diversified and auto-rebalanced throughout the years.
Ways to Improve
One of the best ways to improve your 401(k) saving strategy is to set up automatic payments. This will help ensure that your savings are consistently growing and are not just growing when you happen to be thinking about them. Carefully monitoring your 401(k), especially if you have been changing jobs or experiencing other life changes, will also help ensure that your money is actually doing what you want it to do.
When appropriate, you may also want to consider the “rollover option.” Essentially, this option allows you to rollover your 401(k) funds into an Individual Retirement Account (IRA), which will give you greater flexibility and choices. Additionally, considering a Roth 401(k) can enable you to pay taxes on your contributions now, rather than later. The effectiveness of each of these choices will vary by individual, which is why it will be a good idea to speak with a financial advisor.
The 401(k) is one of the most powerful retirement planning options currently available. With a 401(k), you can build a future retirement fund at a rate that is much greater than what you would have otherwise been able to achieve on your own. By taking the time to understand how a 401(k) works and to also understand your other available options, you will be one step closer to creating the nest egg you need to retire.