Many of you have a 401k plan through your employer. We get a lot of 401k questions at CameronDowning. So here’s a post with some tips to make the most of this fantastic benefit.
401k plan basics
The technical name for the 401k plan is an employer-sponsored defined contribution plan with 401k provisions. Money goes into your account in different ways:
- You, the employee, defer (i.e. contribute) part of your salary on a pre-tax basis to invest for the future.
- Your employer makes profit-sharing contributions. These can vary year-by year. Employer contributions serve as an incentive for you, the employee, to work hard and make the company successful.
- Your employer may make matching contributions.
- You may receive forfeitures. Your plan has a vesting schedule, which tells you how much of the employer’s contribution you’ll be able to take with you should you go work elsewhere. If an account is not fully vested, typically the dollars that revert back are spread out to all the other participants.
Typically, you’ll be given various mutual fund options ranging in market risk from very conservative to moderately aggressive. You do not pay federal income tax on your deferrals into the plan, but you still pay FICA taxes on those deferrals.
The amount you can contribute is capped at 100% of pay up to $18,500 annually (2018). You get an additional $6000 in “catch up” contributions once you reach age 50. In other words, if you’re over 50 you can defer up to $24,500 into your 401k plan annually.
Keeping the above in mind, here are three rules of thumb when it comes to your 401k plan as a young investor:
1. Contribute up to the employer match in your 401k plan!
To encourage employees to defer into a 401k plan, employers often provide a company match as part of 401k plan benefits. For example, a company matches 50 cents on every dollar you defer from your salary into the 401k plan up to 5%. Your annual salary is 100k, so you defer $5,000 every year into your 401k and the company matches those dollars up to $2,500. Consequently, if you defer $7,000 the company will still match 50 cents on the dollar up to 5%. That is still $2,500. It’s free money up to the company match, so don’t leave it on the table.
2. Roth IRAs (or a 401k with Roth provisions) can be a very powerful supplement to a 401k plan.
Roth IRAs are also an important consideration worth exploring. That is, is it more important to get tax deductions today or tax-free distributions tomorrow in a Roth? This is a critical decision to make, especially if you think taxes will be higher in the future. Typically, a Roth IRA is appropriate for someone looking to invest in the market above and beyond the company match. It also makes more sense for someone with a long time-horizon until retirement.
Finally, to contribute to a Roth IRA you need to be below the IRS phaseout limit for contributions. It may make sense to contribute up to the company match and invest the rest into the Roth. In 2018, the phase-out is $120,000 for single filers and $189,000 for married couples filing jointly. If you make more than these numbers, you are phased out of eligibility to contribute to a Roth. More on this in my blog entry on Roth IRAs.
3. Start early, and contribute in a 401k plan up to the employer match!
Set up an automatic draft and let it rip! Most people wait much too long to begin disciplined savings. By starting early you have a much greater potential to be a successful investor. Start good habits, and pay yourself first before paying the bills. By putting away just $250 per month, after 40 years assuming an average return of 7%, you’ll have a little north of $650,000 in your account. Double it to $500/month, and you’re looking at $1.3 million! That doesn’t even include a company match or additional employer contributions.
Now, 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 plan into a personal IRA and continue your savings plan in that vehicle. We can help you with this too.
As a bonus, here’s a short video on 401ks which you may find helpful. If you have questions, please feel free to email us: [email protected] All the best to you as you save for the future! If you have any questions, by all means get in touch. Visit our website to learn more about our advice-based Registered Investment Advisory firm, CameronDowning. There you can follow the links to see all of our blog entries on various financial topics.