Here's How to Make Sense of Your 401(k) and Other Retirement Savings Options
So you don’t feel completely lost talking to Carol from HR about your contribution percentage.
Does the above image fill you with an existential dread that questions your competency as an adult? Don't worry, that's perfectly normal.
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When you’re just getting in on the ground floor of this whole “adulthood” thing, planning for retirement can very easily seem like an alien concept. You just accepted your first position with a salary that doesn’t end in a decimal point and “per hour.” “401(k)” might as well read like a Bingo card.
Unfortunately, because we tend to feel self-conscious regarding our own lack of knowledge — or because we just don’t feel like we have the ‘extra’ money to squirrel away — many young people do not take full advantage of the investment options available to them. Even more terrifying is the prospect of switching careers or becoming self-employed later in life and realizing you are suddenly and solely responsible for planning your own retirement savings.
So, all that being said, open up a couple of extra browser windows and important-looking spreadsheets as camouflage in case your boss walks by, and enjoy this brief crash course in gifting money to your future self.
In a 401(k) your employer takes a percentage of your salary — before taxes are deducted — and puts it into an investment account for you. The money compounds and accrues interest over time, and can usually be transferred or kept as-is if you switch jobs to a new employer.
- You do not have to pay tax on this money until you withdraw it, hopefully decades from now when you are in a different tax bracket and financial situation. (Typically not before age 59.5; any time before then is likely to incur penalties unless under incredibly specific circumstances which you can read more about here.)
- Because the money is withdrawn pre-tax, it may even help to drop you into a lower tax bracket now, saving you even more in taxes.
- Many companies offer “matching” programs, wherein they will actually match your contribution with one of their own, essentially rewarding you with “free money” for saving more. This match might be 1:4 or even 1:1 dollar for dollar, and may or may not have a maximum cap. In general, it is in your best interests to contribute at least as much as your employer is willing to match.
- Most savings plans say they will allow you to contribute up to 100% of your salary to your 401(k), but in reality the maximum federal limit in 2018 $18,500 (and that’s cumulative between all 401k accounts, so if you have one from an old employer and one from your current job you can’t double-dip). Employees aged 50 or older may contribute and up to and additional $6,000 as a “catch-up” contribution.
- If you work for a school, hospital, tax-exempt organization, or certain other groups you might have something called a 403(b) instead of a 401(k), though they function essentially the same.
What if you’re self-employed, a freelancer, a contract employee, or anyone else who simply doesn’t receive 401k benefits? Well, then you might want to consider an IRA.
An Individual Retirement Account is exactly what it sounds like: basically a 401(k) set up by an individual. Your money goes in pre-tax as before, and you again pay taxes only when you withdraw it.
- The maximum yearly contribution to an IRA is $5,500, though those 50 and older can contribute catch-up contribution of an extra $1,000.
A newer type of IRA, a Roth IRA adds features that make it particularly attractive for the self-employed, but can benefit many people.
- Contributions are made after your pay is taxed, so whatever you put in your Roth account can be withdrawn tax-free.
- You can withdraw and reinvest your contributions (just not their earnings) at any time, tax and penalty free. This allows your retirement account to double as a safety net in the event you have a sudden and unexpected expense.
- The maximum yearly contributions are the same as a traditional IRA: $5,500 and $6,500. These maximums are shared between however many accounts a person has, same as the limits on multiple 401(k) accounts (and should you withdraw a contribution, you still can’t reinvest more of that until the next year, so be careful).
- Some employers — in lieu of a traditional 401(k) — will offer a Roth 401(k), effectively the same thing as a Roth IRA but with the higher contribution limits of a 401(k).
Knowing the different kinds of retirement savings accounts and their key features will help you decide which one is most closely suited to your employment situation, but even then there are plenty of choices when it comes to the specifics of an available plan. To help break that mountain down into a molehill, we’ve once again brought in local Katherine McGinn, Certified Financial Analyst with Rye Brook’s Pell Wealth Partners.
What is the current general rule of thumb for salary percentage one is advised to save?
If your company will match your 401(k)/403b contributions, a great goal is to take advantage of their offer. Otherwise, you could be leaving money on the table. It’s also critical to establish an emergency cash reserve.
After you have an emergency cash reserve squared away, you can work toward maximizing your retirement savings. A typical rule of thumb for mid-career savers is 10 percent of your annual salary. If you make less than $55,000 a year, that is likely a bit aggressive. For those earning $30,000, you may want to consider starting at 3 percent a year. At $40,000, consider trying 4 percent and so on. Keep in mind that these are general guidelines and can vary based on the specific financial goals you’re working to accomplish.
Why would I want to contribute more than the maximum percentage my employer would match?
If you feel comfortable with your emergency cash reserve and with your progress towards saving for other nearer-term goals (i.e., paying down loans or buying your first home), then you may want to consider saving more into your retirement accounts. Starting these savings now can give you more options as you’re nearing retirement. Of course, there’s no one-size-fits-all approach to saving for retirement — but as you’re starting out with retirement plans through work, there are often resources available from your employer to help get you up to speed.
Investment accounts will tend to list any investment option in general terms of “aggressive” vs. “conservative,” meaning higher risk and reward vs. lower risk investments. Can you explain target date plans for our readers?
Target date funds use your projected retirement date as a guideline for building a diversified investment portfolio. They’re considered a “set it and forget it” solution, since they’re designed to take a relatively small amount of money and invest it across stocks, bonds and other types of investments. They start out as more aggressive the further away from retirement you are and dynamically adjust to be more conservative as you get closer, so you don’t need to worry about changing them every few years. While they may be convenient, target date funds don’t account any circumstances in your life changing — so it’s important to make sure they are a good fit with your overall goals.
If a person really has to choose between paying off their loans and saving for retirement, why is it generally better to pay off the loans first?
In most cases, your priority should be to establish an emergency cash reserve (reoccurring theme here!). Once that’s set, review your loans and 401k match. Often it can be more worthwhile to get the match money first (basically free money!) and the loans second, but it depends on several factors including the interest rate on your loan and the amount of debt you have outstanding.
Would it ever make sense to set up an IRA separate from my employer’s 401(k)/403(b)?
Once you get to the point where you’re comfortable with your cash reserve and near-term goals, you may want to explore contributing to a ROTH IRA too.
At what point am I just investing enough money as to merit opening a managed brokerage account? (I.e., getting a stockbroker or say a Financial Advisor *hint*hint* to manage my investments more closely.) When am I earning enough to say, “Time to level up”?
Typically, people feel ready to invest their money if they have extra cash sitting in their checking accounts. Keep in mind the emergency cash reserve goal, and any near-term goals. For example, saving to buy a house in the next two years? You may want to keep your down-payment money safe in an FDIC insured savings account or certificate of deposit. If you’re good with these and have cash set aside for any longer-term goals (three-plus years out), then it might be time to consider opening a non-retirement investment account. In addition to helping you pick appropriate investments, a financial advisor can help you map out and prioritize your various goals and set up a plan for balancing increased retirement savings and savings for everything that comes in between.
Whenever you invest, it’s important to remember that markets and your investments move up and down. Nobody can say with certainty what will happen to stocks over the next week, month or even over the next year. It’s super important to assess your willingness to accept investment risk in conjunction with the goals you are trying to achieve.
How can you go about trying to find a financial advisor who is right for you?
Find someone who cares about your goals for the future and will act as a partner in your success. Your financial advisor should ask all kinds of questions about your personal values, future goals and concerns. Look for an advisor who not only discusses important financial topics, but also listens and understands your needs. You’ll want to select an advisor and a firm with a solid reputation. As you interview advisors, you can ask for references and specific examples that show how they helped clients like you reach their goals or weather difficult financial times. Also, check the advisor’s educational background and note any professional designations or industry accolades they have earned.
Finally, you should have a clear understanding of what you’re paying for. Advisors should provide information to help you evaluate the benefits, risks and costs of the investments and services they offer, and those they’re recommending for you. If anything is unclear, be sure to ask questions.