5 things to consider when investing in a 401(k) plan
As you begin your career, it’s important to consider all of your compensation benefits—not just your salary. Employer-sponsored retirement plans are an important yet sometimes overlooked benefit and allow even the smallest contributions to accumulate quickly. Many companies even offer matching and other incentive programs to boost your retirement savings. Depending on the plan’s features, an employer-sponsored retirement plan can meaningfully increase your overall compensation and future savings, especially when considered over a 30- or 40-year time horizon.
If you have access to an employer-sponsored 401(k) plan, the following considerations can help you make sure that you maximize its potential benefits.
Time Value of Money
The time value of money is one of the most basic principles of financial planning. The idea is that money available today is worth more than the identical sum in the future because of its potential earning capacity. In other words, saving a little today is often better than trying to save a lot later.
Participating in a 401(k) plan gives you a head start on your long-term financial security. An employer 401(k) plan allows your money—plus any income or capital gains it earns from your investments—to compound on a tax-deferred basis. So even small contributions, especially if matched by your employer, have the potential to grow to a substantial nest egg over time. The earlier you start participating, the greater chance you’ll have of amassing the savings you need to retire comfortably.
Traditional vs. Roth
Many employers give you the option of contributing to a traditional 401(k), a Roth 401(k), or both. When you participate in a traditional 401(k) plan, contributions are made before taxes, meaning income taxes are deferred until distributions are made in retirement. The contributions you make to a traditional 401(k) plan reduces your taxable income for the current tax year.
On the other hand, if you participate in a Roth 401(k), the amount you contribute doesn’t reduce your current taxable income or income tax bill. However, distributions in retirement are generally tax-free, subject to certain restrictions and considerations. Age, income and your expectations for your future tax bracket can all play into whether a traditional or Roth 401(k) is more appropriate.
The federal government limits the amount you can contribute to an employer-sponsored 401(k) plan annually. In 2018, participant contributions have been capped at $18,500 and rise to $19,000 for 2019. If you are age 50 or older, you may contribute an extra $6,000 in both 2018 and 2019 as a “catch-up” contribution. Because the limit often changes from year to year, it’s important to review your contributions at least annually to ensure you are maximizing your savings.
If you’re able, maxing out the contribution limit is advantageous given the tax-deferred nature of 401(k) accounts. Of course, make sure you can afford to withhold whatever amount of money you designate each paycheck. Early withdrawals typically come with tax penalties and can be expensive.
Participation Options and Incentives
Some companies will automatically enroll their employees in a retirement plan and choose a default contribution amount and investment option. However, it’s up to you to determine what contribution rate and investment approach is right for you. It’s also your responsibility to manage your account on an ongoing basis.
Additionally, many employers incentivize employees to save by offering matching provisions. If your employer matches, a good goal is to try and contribute at least the minimum amount to receive the full match.
Although any money you contribute to a 401(k) plan (and the earnings on those contributions) always belongs to you, any money your employer contributes on your behalf belongs to your employer until you are vested. Vesting gives you full legal rights to your account and is usually determined by your length of time on the job. Your employer determines the vesting schedule, which is typically immediate, gradual, or all at once after a designated period.
While a vesting schedule shouldn’t be the only reason you stay at a job, it’s important to be aware of its restrictions so that you don’t unintentionally lose out on a substantial amount of money. If a new job offer would cause you to leave money on the table with your current employer, you may consider negotiating any lost benefits with the new employer.
As you evaluate your career opportunities, always consider all potential compensation benefits. An employer-sponsored retirement plan is a valuable savings tool and can significantly increase your total compensation if your employer also contributes on your behalf. Because you have several decisions to make when enrolling and participating in a 401(k)—from how much to contribute to how to invest your contributions—be sure to reach out to a trusted financial advisor with any questions.