One of the most common questions we encounter from clients is about their 401(k). While our teacher clients utilize a 403(b) and the federal employees we work have a Thrift Savings Plan (TSP), for the rest of the world – and majority of Americans – a 401(k) is a cornerstone of their retirement savings plan.
According to the Investment Company Institute (ICI), as of September 2018 an estimated $5.6 trillion is held in 401(k) plans – roughly one-fifth of all retirement assets for Americans. Overall, over 55 million American workers were active 401(k) participants with roughly 555,000 plans being available nationwide.
However, while a 401(k) is a familiar term to many and in the majority of portfolios, most people do not fully understand what it is. The folks over at ValuePenguin recently surveyed 2,000 Americans, asking them to define key terms in our industry like credit score and compound interest. When polled to see if they understood how a 401(k) plan works, only 37 percent responded with a yes.
Now, the fact that nearly two-thirds of people in this country do not fully understand how their primary form of retirement savings works is alarming. However, if this applies to you it is nothing to be embarrassed or ashamed of. We are always happy and willing to answer any and all questions regarding your employer’s specific plan and how you should go about fully maximizing its possible benefits. Continuing to be in the dark about the ins and outs of a 401(k) can mean a major missed opportunity for your future. Additionally, a concern we express with some that walk through our door is simply not utilizing their 401(k) in the first place. It is proven to be a great option to at least start and maintain a long-term savings plan and can have many built-in benefits.
In 1978, the 401(k) plan went into law and is named after the corresponding four-character filing that was added to the subsection of the Internal Revenue Code when it was established. Basically, the advantage of a 401(k) is its tax-advantaged setup. Employees are incentivized by being able to use pre-tax dollars directly out of their paycheck to be put in the plan. The growth of the investment is tax-free and only when a withdrawal is made is the tax applied. The idea is that an employee will currently be in a higher tax bracket than when they decide to withdraw from the account in retirement, thus earning an extra windfall on the investment.
In 2006, legislation was passed to offer the same process – but in reverse. Known as a Roth 401(k), any contribution made is with after-tax dollars. However, the growth is tax-free and the withdrawal is also free of any tax.
Since the contribution is taken directly from your paycheck, it in a sense ‘forces’ you to save for the future. It is money that is never actually put into your take-home income, instead being funneled to your retirement savings. For an undisciplined saver, this is a great way to almost ‘set it and forget it’ and ensure that at least some steps are being taken to have a savings plan.
One major ‘catch’ for both the traditional and Roth versions of a 401(k) is that withdrawals cannot be made before age 59 ½ without facing a penalty. There are a few exceptions to this, most notably the ‘Rule of 55’ which allows someone who was fired, laid off or quit a job between the age of 55 to 59 to pull money out of a 401(k) without facing any penalty.
Now, what exactly is in a 401(k)? According to ICI, roughly 67 percent of 401(k) assets are held in mutual funds. The rest is in some sort of company stock (usually the stock of the specific employer) or other individual stocks, bonds, bank trusts, life insurance accounts or other products. According to Investopedia, a typical plan offers an average of 19 funds, most of which are actively managed domestic and international stock funds.
One potential great feature of a 401(k) is an employer match. While it is not mandatory to be offered, many companies will match a certain percentage, providing a literal immediate return on investment. Investopedia states that about 40% of employers contribute 50 cents for every dollar an employee contributes up to six percent of their pay. Another 38% match contributions dollar for dollar.
When we consult a client’s 401(k), the potential match is the very first thing we look for. If an employer is not maximizing enough of a contribution to receive the full employer match, that is ‘free’ money they are missing out on every single paycheck. We will never guarantee returns and certainly never promise ‘free’ money on any financial vehicle or investment. However, an employer match is the only sure-fire guarantee out there to immediately see a return on investment.
In 2019, the maximum contribution for a 401(k) is set by the IRS at $19,000 for workers under age 50 and $25,000 for those 50 and older. Compared to an individual retirement account (IRA) this is significantly more. The 2019 limits for IRAs – both traditional and Roth – was $6000 for an individual under the age of 50 and $7000 for those over 50.
Here at Mission Point, we certainly recommend that people fully utilize a 401(k) at work. If your employer does not offer one we can definitely find other alternatives, but nothing will feature a match like those found on many 401(k) offerings. We’d be happy to sit down with you and fully analyze your plan to ensure that you are getting the full possible match, your in the plan’s best possible funds and you are taking advantage of the tax benefits. A 401(k) is a great piece in the overall puzzle of saving and enjoying retirement and we’d love to make sure yours fits perfectly in your life’s outlook.
“The opinions and forecasts expressed are those of the author, and may not actually come to pass. This information is subject to change at any time, based on market and other conditions and should not be construed as a recommendation of any specific security or investment plan. Past performance does not guarantee future results.”
Securities offered through Securities America, Inc., Member FINRA/SIPC. Advisory services offered through Securities America Advisors, Inc. Mission Point Planning Group and Securities America are separate companies.