Many of you have a 401k through your employer. We get a lot of 401k questions at CameronDowning, so it seemed prudent to blog about some of the basics that young professionals should know to make the most of this fantastic employee benefit.
An employer-sponsored retirement plan with 401k provisions allows an employee to defer part of his or her salary to save for the future. Typically, you’ll be given various mutual fund options ranging in risk-tolerance from very conservative to moderate-aggressive. Deferrals into the plan are not taxable and are capped at $18,000 annually in 2015 ($24,000 if age 50 or older).
- To encourage employees to defer into a 401k plan, employers often provide a company match as part of the 401k benefits. For example, a company may match 50 cents on every dollar you defer from your salary into the 401k up to 5%. So if you make an annual salary of 100k, you can defer $5,000 every year into your 401k and the company will match those dollars up to $2,500. By the same token, if you defer $7,000, the company will still only match 50 cents on the dollar up to 5% of salary. That is, $2,500. The first rule of thumb is contribute up to the employer match. It’s free money, so don’t leave it on the table.
- If you want to contribute more than $5,000 per year, assuming the same example above, you have another consideration to make. That is, is it more important to get the tax deduction on salary deferrals now when I’m young, or would I rather have tax-deferred growth and tax-free distributions later in a Roth IRA? This is a critical decision to make, especially if you think taxes will be higher in the future than they are today. Roth IRAs (or a Roth option within a 401k) can be a very powerful supplement to a 401k for the right investor. Generally speaking, a Roth IRA is appropriate for someone looking to invest in the market above and beyond their company match, has a long time-horizon until retirement, and is below the IRS phaseout limit to contribute to a Roth. If it is mutually determined between a client and financial adviser that a Roth IRA is appropriate, it may make sense to defer your salary up to the company match and invest the rest into a Roth. In 2015, if you make more than 116k for single filers or 183k for married couples filing jointly, you are phased out of eligibility to contribute to a Roth. More on this later in my blog entry on Roth IRAs.
- Start early, contribute small, contribute often. There isn’t too much more to this last rule of thumb. Set up an automatic draft and don’t worry about putting in too much. Most people wait much too long to begin a plan. By starting early and starting small, you have a much greater potential to be a successful investor. Start good habits, and think of it as “paying yourself first” before paying the bills. By putting away just $100 per month, after 40 years assuming an average return of 7%, you’ll have $262,481 in your account. Not bad. That does not include a company match or additional employer contributions.
On a related note, you and I know that you won’t be at the same company for 40 years. That just doesn’t happen anymore. But when you do separate from service, you can rollover your 401k into a personal IRA and continue your savings plan in that vehicle. We can help you with this too.
All the best to you as you save for the future!