1978 brought about a change in legislation that forever changed the landscape of American retirement planning. That was the year that saw the creation of the 401(k). Up to that point, retirement plans offered by employers were primarily defined benefit pension plans. As the name would indicate, you earned a defined monthly benefit at retirement based on age, salary, years with the company, etc. The details of these plans were handled by the employer. They made the contributions, picked the investments and also bore the risk of being able to pay out that benefit for their employees.
401(k) plans were designed to allow employees to have the ability to contribute to their own retirement plan on a pre-tax basis. An unexpected side-effect was that it allowed employers to scale back the pension benefits they provided for employees and push the responsibility to save and the investment risk onto their employees. In short, everyone who has a 401(k) now has the responsibility of funding their own retirement and in choosing suitable investments. If you mess up the management of your 401(k), nobody is going to be there to bail you out. For this reason, anyone dependent on a retirement plan they are responsible for funding better understand how to manage it because your retirement is dependent on you doing it right.
For more on what a Christian retirement looks like, you can read that article here. I reference it so you know that I’m not talking about ways to get rich or avoid work as the basis for this type of planning.
As always, let’s get some basics out of the way before we get to the real meat. Following are some basic details about 401(k), 403(b), or other workplace plans that allow you to make contributions.
Ease of contribution – There is probably no easier plan to contribute to than your 401(k). The money is taken directly from your paycheck before you get it, so it’s the closest thing to an out of sight, out of mind savings plan that you’ll find. Most people that start contributing to a 401(k) plan soon realize they don’t even miss that money since they’ve never had it in their hands to spend anyway.
Pre-tax Contributions – Contributions to a traditional retirement plan can be made on a pre-tax basis. This benefit allows you to contribute a larger dollar amount because each dollar you contribute only costs you 60 to 80 cents from your net pay, depending on your tax rate. In recent years, the invention of the Roth plan allows you to get other tax benefits in exchange for contributing after-tax dollars, but that’s a discussion for another time.
Tax Deferral – Unlike investments made outside of a retirement plan, the earnings inside a retirement plan are not taxed until they are withdrawn from the account. This allows your money to grow faster since the amount that would have otherwise gone to pay taxes on earnings can continue to stay in the account and compound until you reach retirement. In traditional plans where the contributions were made pre-tax and the earnings have also not been taxed, every dollar you withdraw during retirement will be considered taxable income.
Company Match (Free Money) – It’s pretty common for employers to offer a company match in addition to the amount you contribute. This provides a way for employers to contribute to the retirement of their employees and also give an incentive for employees to contribute. Employers have flexibility in the amount they choose to match, if any. The company match is probably the closest thing to free money most of us will ever see. Our initial goal should be to contribute enough to get the full company match as soon as we can. If you can’t afford that today, start where you’re comfortable and continue to increase it until you get the full company match.
Example: Your employer-sponsored plan offers a match of 50% of every dollar that you contribute up to 6% of your income. In order to get the full company match, you need to contribute 6% of your income. By doing that, your employer will put in an additional 3% bringing your total contribution to 9% of your income. You only get the match on the amount you contribute though. If you put in 2%, the company match will only be an additional 1% of your income.
Vesting on Company Match – You will probably find there is a vesting schedule on the company’s matching contributions. That means that it doesn’t officially become your money until you’ve been employed by the company for a specific amount of time. The money has been contributed to your account and can be invested right away. However, if you quit your job before being vested, you are only entitled to take the portion of the company match in which you are vested. Vesting schedules will vary from company to company, but do have limits on how long they can withhold ownership.
Restricted Access to Your Funds – The IRS came up with retirement plans as a way to get individuals to contribute money toward their retirement years. They provided us with tax benefits as an incentive to save. However, since they understand the nature of man will be to use that money for other near-term purposes, they also restricted our access to these funds. Since this is money intended for retirement, the IRS will charge you a 10% penalty plus income taxes for withdrawing funds before you reach age 59 ½ (with a few exceptions). For this reason, cashing out a retirement plan to pay off credit cards or to use for other expenses is not usually a good idea.
Another restriction specifically for workplace plans is that you are not allowed to transfer your money to another retirement plan as long as you are working for your employer. Once you sever employment, you are free to move that money into a similar retirement plan, either with a new employer or into an IRA (Individual Retirement Account) without taxes or penalties since these other plans follow the same rules.
Loans – Some company plans do allow you to borrow against the balance of your plan, but that’s not without danger. A loan from your retirement plan will avoid taxes and penalties because you are promising to pay it back under a structured repayment plan. However, if you are unable to pay the loan back, it will be considered an early distribution and taxes plus a 10% early withdrawal penalty will be charged on the remaining loan balance. If you decide to change jobs while you have an outstanding loan, you will likely be given a short amount of time (60 or 90 days) to pay back the entire loan amount or be charged the penalty and taxes. Paying back a loan when you just lost your job may not be an easy thing to do, so be very cautious when taking a loan from your retirement account.
Investments – Most company plans will offer you a limited number of investment options. Since employers are responsible for offering you a variety of investment options to meet your goals, you will likely have a diversified selection to choose from.
Mutual funds are the most common form of investment vehicle in a workplace retirement plan. In recent years, low-cost index funds and target date retirement funds have started to become more common.
Index funds allow you to invest in a fund that is intended to mirror the performance of a specific market index. For example, one of the most well-known index funds is the S&P 500 index fund. This fund is a representation of 500 large, American corporations. Since it simply invests in a pre-designed list of companies, the fees for managing index funds are very low, which bodes well for an employer responsible for choosing low-cost investment options.
Target date retirement funds offer an easy way for you to pick a fund that matches your goals. Since these funds have a retirement date in the name, you simply pick the fund with a date close to the year you plan to retire. For example, if you want to retire in 2025, you could pick the Target Retirement 2025 Fund. That Fund will hold a diversified group of investments that match the standard risk profile of someone in your situation. As you get closer to retirement, it will continue to adjust the investment allocation to reduce investment risk and match the shorter time to retirement.
Note: While I believe that some active mutual fund managers are worth their fees, since 401(k) plans offer such a limited selection of investment options, I find that most people are better served choosing index funds or target date retirement funds as long as they are low-cost as well. In recent years, some target date funds have been criticized for their fees, so make sure you look at that before investing in them.
Employers also need to be aware of the risks they are taking as the fiduciary of their company plan. In recent years, there has been a rise in the number of lawsuits and penalties against employers for not offering good enough retirement plan investment options or fees being too high. Just a few years ago, Fidelity was even sued by its employees for the funds they offered in their own retirement plan. For more on this topic, you can read this article.
Employer Stock – Some employers will give you an option to invest in their company stock or provide the company match in the form of stock. While I’ve seen some individuals do quite well for themselves by investing heavily in their company stock, I have also seen the opposite happen. For example, my wife’s former employer offered a company match in the form of stock and despite its solid performance over the years, we would periodically sell it to make sure we kept it to a minimum. My philosophy is that if your job is already dependent on the company, your retirement account shouldn’t be. She left the company while things were still good. However, it wasn’t long before the stock of the company went from $40/share to just over $2/share in a very short period of time. We knew of individuals that had the majority of their account invested in the company stock. Those individuals not only had their job security shaken, but also saw their retirement plans lose 95% of its value. My suggestion is to be very careful when investing in your company’s stock.
In Part II of this article, we’ll explore funding your retirement plan and why most people are falling well short of their needed retirement savings.
Brad Graber, CFP® has been working with clients on personal financial planning and investment issues since 1996. He invests his time mentoring and educating individuals on ways to be better stewards of the resources God has entrusted to them.
***Disclaimers: The information contained in this article is general in nature, is provided for informational purposes only, and should not be construed as investment advice. I cannot guarantee that all information is accurate, complete, or timely. The information in this article should not be construed as investment advice or a recommendation of any particular investment. Please seek out professional investment advice before investing.