Purse Strings Approved Professional
It is always best to defer a little more than you believe you can and adjust downward than it is to start lower and never get back to increasing the percentages.
Remember, the only way to have a solid, healthy fiscal retirement is to save because you CANNOT borrow for your retirement.
Whether you want to feel sand between your toes or breathe fresh mountain air, retirement is likely to be the most expensive thing you ever pay for and the only way to have a successful retirement is to save for it.
So, let us talk about one of the easiest ways to save for your retirement, the 401k plan. A 401(k) plan is a qualified plan, meaning that anything you save into it, along with Individual Retirement Accounts and Simplified Employee Pensions, grows income tax-free and you pay tax when you take the money out, and therefore they are called qualified. Conversely, savings accounts and individual stock accounts are taxed as the account grows and are referred to as non-qualified. Tax deferral is the key reason 401(k) plans are so popular.
What is a 401K?
The 401(k) is an account that you can sign up for at work. Employers sponsor these plans to help employees save for your retirement.
How did 401(k) plans start? Congress passed the Revenue Act of 1978, which included a provision that was added to the Internal Revenue Code, Section 401(k). This provision allowed employees to avoid being taxed on income saved. In 1980 the first 401(k) plan with an employer match was created and in 1981 the IRS issued new rules to allow us to fund our 401(k)s through payroll deductions. This is when the 401(k) plan really took off!
Not all employers offer a 401(k) Plan, and you must meet the eligibility requirements set forth. For example, some plans state you must be working for the employer for a year and have attained age 21 to be eligible.
Once you are eligible to join, also known as enrolling in the plan, you will receive information from your employer about the plan details. You will need to decide
1. If you want to save into a traditional 401(k) plan or into the Roth 401(k)
2. How much you want to defer or save monthly
3. How to invest your money. Let us talk about the two types of 401(k) plans.
Your contributions are made before taxes and over the years your money grows tax-deferred. This means the contributions you make help lower your taxable income now, and you do not pay any taxes on either your contributions or investment growth until you begin making withdrawals in retirement. At that point, the money will be taxed as ordinary income.
Your contributions are made after you have paid tax on the income, but your money grows tax-free because you already paid tax upfront and when you withdraw money during retirement, you will not have to pay taxes if you follow the rules. Must be 59 ½ and have had the account open for 5 years.
I typically suggest clients defer salary into both types of accounts to have more options for withdrawing money in retirement.
So now you have an idea of which account to use to save, but how much should you contribute?
This amount is a very personal choice, but there are considerations to help you make this decision. Often you can find useful calculators on the company 401(k) website to help you determine a percentage to save. These calculators will also show you what your take-home pay will be if you deferred salary into a Roth 401(k) and or a traditional 401(k) plan. If you can’t save as much as you’d like, consider signing up to have 1% more taken from your salary annually. This is referred to as step-up savings and is offered by many employer-sponsored plans. It is always best to defer a little more than you believe you can and adjust downward than it is to start lower and never get back to increasing the percentages. Remember, the only way to have a solid, healthy fiscal retirement is to save because you CANNOT borrow for your retirement.
For 2021, you can defer $19,500 into a 401(k) plan at work, plus $6,500 if you are over the age of 50. Those levels are unchanged from 2020. If you are just starting out and you want to participate in the 401(k) plan at the very least, differ enough monthly to capture the employer match. A company might, for instance, match half of the contributions you make on the first 6 percent of your salary or match 100 percent of what you contribute up to a certain dollar amount or percentage of your salary. This is free money! But as I mentioned above, it is always better to aim a little higher than you believe you can afford and ratchet down.
Now that you have selected what type of 401(k) and the percentage of pay you plan to defer, it is time to choose the investments.
What Type of investor are you?
401(k) plan offers a wide selection of investments to choose from and they fall into different levels of risk depending on your risk tolerance. Like the calculators I mentioned earlier, most 401(k) plan websites have a short questionnaire that scored your risk tolerance for you. Whether you are conservative, aggressive, or somewhere in the middle there should be funds that meet your criteria. Many 401(k) plans include target-date funds. These funds are designed with specific retirement timelines in mind. Keep in mind that the closer you get to retirement, the more conservative these funds become which may NOT reflect your true risk tolerance. You may retire at age 60 or 65 BUT that does not mean you should not take some risk. Your money needs to last for many years past the year you retire.
Changing Jobs or In Between Successes?
You have decided to change employers or have left a position, so now what do you do with your 401K balance?
- If the balance is above 5,000 you may want to keep it at the plan
- You can roll it into the new employer’s 401K.
- Open an IRA and transfer the balance into the new IRA. If you have a Roth, you will need to open a Roth IRA too as the two accounts are treated differently for tax purposes.
- Take the money and pay 20% in tax or more PLUS a 10% penalty. That is almost 1/3 of your hard-earned money GONE with lost time and opportunity.
What if You Stay Home to Raise your Children?
Even if you are not currently employed, and if you have not deferred income into a 401K for the year, you can take advantage of tucking away up to $6,000 or $7000 if you are over the age of 50 into a Spousal IRA for 2021 (unchanged from 2020). Of course, you should speak to your tax advisor because there are some limits based on income limits that could prevent you from saving into a tax-deductible Spousal IRA.
Now that you are an expert in 401(k) plans, it is important to not “set and forget” your plan. It is important that you increase the percentage you defer as often as possible. For example, if you receive a bonus or a raise be sure to have that increase in salary reflected in the percentage you differ into your 401(k) plan. It is also a very good idea to look at your accounts periodically and add a minimum every six months to be sure the investments reflect your tolerance for risk.
Vice President, Wealth Management