As a successful, young professional, you probably already realize the importance of saving. But are you saving as much as should? Do you know how much is enough? What’s the best way for you to save at this stage in your career?
Most Americans arrive at retirement with far less saved than they wish they had. They didn’t plan to have modest financial resources for retirement. Most never really had a plan at all. They just woke up one day, after decades of working, and it was time to retire.
As a young professional, you have the opportunity to position yourself for the ideal retirement you want. The most attractive way for you to save for your future is through your employer’s 401(k) plan. So, let’s explore how 401(k) plans work.
Types of Work-Based Retirement Plans
There are two basic forms of employer-sponsored retirement plans. In a defined benefit plan, your employer provides you with a retirement benefit that is based on your salary and length of service. Your employer is fully responsible for funding the benefit, which is paid out to you as a lump sum at retirement, or as a regular stream of periodic (typically monthly) payments.
In contrast, in a defined contribution plan, you contribute a portion of your salary to an account in your name. Your employer may match a portion of your contribution, to incentivize you to save for your own retirement. Your employer may also make discretionary profit-sharing contributions to your account, but isn’t obligated to. However, the burden for saving is yours. The 401(k) is the most common defined contribution plan.
During the 1970s, companies found that their highly compensated employees were interested in sheltering more income from tax. The 401(k) plan – named after a section in the Internal Revenue Code – was created in 1978. Originally intended as a supplement to defined benefit plans, 401(k) plans gradually replaced defined benefit plans as employers recognized they could shift the risk of funding employees’ retirement to the employees themselves.
Who can participate in a 401(k) plan?
The Internal Revenue Service says that, “in general, an employee must be allowed to participate in a 401(k) plan, if he/she meets two requirements: The employee must be at least age 21 and the employee has at least one year of service. The plan may require 2 years of service for eligibility to receive an employer contribution, if the plan provides that, after not more than 2 years of service, the participant is 100% vested in the plan.” It’s possible for plans to offer more relaxed eligibility requirements.
The money you contribute to your 401(k) plan is treated as a reduction of your salary for tax purposes. The money is deferred into your plan account and isn’t taxed as ordinary income.
The dollars inside your 401(k) account accumulate on a tax-deferred basis. When you withdraw money from your account, the dollars taken out are taxed as ordinary income.
Your Contribution Limits
You can contribute a maximum of $19,500 (2021) of your salary into in your 401(k) account. If you’re age 50 or older you can contribute an additional $6,500 (2021) as a so-called “catch-up contribution”.
Your employer may match your contribution to your account. The average match is 3% of salary. Some companies match 50% of every dollar an employee contributes up to a limit. Other companies offer a profit-sharing contribution.
As a young professional, you should contribute no less than the amount that allows you to receive 100% of your employer’s match.
Your Investment Options
As a participant in a 401(k) plan, you’ll be offered a menu of mutual funds and/or exchange-traded funds to pick from. The best plans will offer a menu with funds that represent a wide variety of investment categories (also called “asset classes”) – think US and international stocks, emerging markets stocks, real estate, and different categories of bonds. The plan may also include target date funds, which are basically “funds of funds” and are generally designed to become less risky as the target date (typically a planned retirement year) approaches.
Fees and Expenses
401(k) plans typically include a variety of fees related to the administration and operation of the plan. Unfortunately, they’re generally not clearly disclosed or well-understood, and so many employees don’t realize they pay fees at all.
Fees are charged by the plan administrator, the plan record-keeper, the custodian, the investment advisor and the fund companies. The total fees in a 401(k) plan can vary greatly, depending on the size of the plan, the number of participants, the total amount of money in the plan and the plan provider.
There have been several high-profile lawsuits in which employees have sued their employer over excessive 401(k) plan fees. Encourage your employer to support a plan with a low overall cost structure.
Borrowing against your account
Your 401(k) plan may, but is not required to, offer loans. If it does, the plan will likely limit the amount that may be withdrawn as a loan. According to the IRS, the maximum amount that a participant can borrow from the plan is (1) the greater of $10,000 or 50% of the vested account balance or (2) $50,000, whichever is less.
Your employer’s plan must provide the process for both applying for a loan and the repayment terms for the loan. Loans must be repaid within 5 years, and payments must be made in substantially equal payments that include principal and interest and they must be paid at least quarterly.
There’s an exception for a loan that’s taken for the purpose of purchasing a home. These loans may be paid back over a period of more than five years.
Loans aren’t taxable and loan repayments aren’t considered plan contributions.
Withdrawals and Distributions
There are many rules relating to distributions from your 401(k) account. In general, the IRS allows distributions if one of the following happens:
• You die, become disabled, or otherwise separate from your employer
• The plan terminates and your employer doesn’t provide a successor plan
• You reach age 59 ½ or incur a financial hardship
You must begin taking distributions from your 401(k) account no later April 1st of the first year after the later of (a) the calendar year in which you reach age 72 or (b) the calendar year in which you retire.
There are other rules and they can be found on the IRS Publication 575.
If you take a withdrawal from your 401(k) account that isn’t a qualified loan or a qualified distribution, you’ll pay a 10% penalty in addition to ordinary income taxes.
The Rollover Strategy
If you separate from an employer, you should consider rolling your 401(k) account out of the plan and into an individual retirement account (IRA). This will allow you keep track of the account, invest it without the constraints of the menu in your old 401(k) plan and coordinate with your other investments. This rollover, if done properly, is a non-taxable event.
The Roth 401(k)
Some 401(k) plans offer a Roth option. The Roth 401(k) is funded with after-tax contributions. However, as is the case with a Roth IRA, when funds are withdrawn from a Roth 401(k), they’re received tax-free.
As a successful, young professional who’s likely to be in higher tax brackets in the future, the Roth 401(k) may be very attractive. Because you’re funding it with after-tax dollars and the contribution limits are the same, you’re effectively putting more money in the plan than you would in the traditional 401(k). You’ll be paying more taxes today than you would if you were to fund the traditional 401(k). But you’ll very likely end up with more total after-tax dollars when you finally retire and begin taking distributions.
Do you have questions about your workplace retirement plan, or about building a robust plan for your financial future? Contact us today to see how our team at Springwater Wealth can help you.
Get Professional Help
A 401(k) account is a critical employee benefit for young professionals. Make sure you fund it aggressively and manage it carefully.
If you have questions about how to integrate your 401(k) into your overall financial plan, consider working with a CERTIFIED FINANCIAL PLANNER™ (CFP®).