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How to Make the Most of Your 401k

What’s a 401K?

A 401K is a work sponsored retirement account, where an employer sets it up for the employees to participate and contribute money, directly from their paycheck, towards their retirement. Depending on the type of company you work for, you may also find a 403B being a similar type of account, but mainly for non-profits, schools and hospitals’ employees. Not too long ago, the landscape of investing for retirement was different when companies provided a pension and workers ‘committed’ to working all their life for the same company. Now, with the companies not being able or wanting to provide pensions, together with the employees’ much faster turnover and moving from one company to another, the 401K has become the most common employer provided retirement account. Sure, some pensions still exist, but those tend to be rare and either legacy or government type of setups.


Company match / ‘Free Money’

Since the companies removed the investment risks from their books by removing pensions and offering 401Ks, there had to be some additional compensation provided in the form of a match to an employee’s 401K. Some call it ‘free money’, some call it ‘part of compensation’, the 401K match is definitely a perk that should not be left out. If the company (and most do) offers a 401K match please check what it is, or what the formula is and try to maximize and put all that’s needed from your side in order to get all of the match allowed. Very often companies match from 3-6% of salary and occasionally much higher. For many that put just the minimum to get the match (say 3%) and if the company matches 3% too, that is technically a 100% return of your money, and no investment can give you that. Learn your company’s matching formula and don’t let your ‘part of compensation’ or ‘free money’ go to waste.


Roth or Traditional

The Traditional 401K used to be the most common one, given the name too. The money is put in the account and it is tax-deductible from your income in the year of contribution, one of the major benefits of a 401K, say versus a taxable account. For high income people getting the benefit to deduct their 401K contributions is a big factor for having a 401K in addition to (of course) saving for retirement. Lately, most of the new 401K programs are also offering a ROTH option, where you don’t get a tax deduction, but you get to enjoy income from the ROTH in retirement completely tax-free. On the other hand, the Traditional 401K, while it gives you tax-deductibility on contributions, does get taxed as income in retirement when you take it out. 

Should you max it if possible?

A 401K, since it is a tax-advantaged account, gets the above-mentioned benefits as allowed by law, but it’s not uncapped. In 2021 the maximum one can contribute is $19,500 (plus an additional $6,500 if 50+ years old) not counting if the employer matches which could bring the total higher. For many, the conversation is how much to contribute there and if possible, would it be wise to max it. Every decision depends on the unique circumstances of each person, but there are certain factors to consider. First, yes, if you have a high income and thus get taxed at a high tax bracket, it would make sense to reduce income in the ‘now’ and pay those taxes later in retirement if you believe you’ll be at a lower tax bracket. On the other hand, if you’re just starting out, your income and thus your tax bracket may not be too high and you may not have the means to max it i.e. other bills to pay. But the rule of thumb is that if you start in your 20s or early 30s to invest for your retirement you’ll need to save & invest at least 10-15% of your salary for retirement – and it does often become your largest savings goal. If you can’t do that much from the start, at least put enough to get the maximum company match and then slowly, each year, try to increase your contribution if possible. Lastly, there are other options that you could also utilize, if your 401K investment options are not the best. An IRA or even a taxable account have benefits too, including flexibility and portability. 


Behavioral benefits of long-term investing

One of the major benefits of a 401K is unspoken, hidden and lies right next to you like an invisible elephant. This ‘elephant in the room’ is that a 401K gives you potentially decades of investing and dollar-cost averaging into the investments you have. Also, many have the mindset (rightly so) that this account is for later and they don’t invade it for spending or other short-term needs. This behavior benefit adds significantly, as it has been noticed that people behave better (stay the course) in their 401Ks compared to other investment accounts they may have. That’s a reason why we also promote assigning specific goals to your money or investment accounts, and even having a separate investment account for each goal – it creates the mindset of what the money is for, the time it has to be there as well as what it’s NOT for.


What funds to invest into and how to watch your fees

Now, putting money into a 401K doesn’t automatically get invested, you have to choose the investments inside the 401K that you want to purchase periodically. Most 401Ks provide participants a short list (15-20) of funds that they can invest into at a percentage that they desire. This process, as important as it is, has been left in the hands of participants alone, unless you hire an advisor provided by the custodian/investment company where the money is held. Nevertheless, many now have certain defaults that aligns the portfolios with the age of the employee and then utilizes a Target Date Fund to make that alignment. A target date fund is a simplified version, but a decent choice nevertheless, to provide some asset allocation and appropriate risk-adjusted investing for most. If you don’t know what to do, a Target Date Fund could be very good for you. Make sure the funds you pick or your advisor picks are also low cost or index funds, as cost has been known to be a factor in performance – the less you pay, the more you keep.


What if you don’t have access to one or have an old 401K

But many small companies cannot afford or don’t want to offer a 401K for their employees, what then? Well, if you have income you can still have a retirement tax-advantaged account just like a 401K, known as the IRA (Individual Retirement Account). This account has lower maximum limits (in 2021 you can contribute up to $6,000/year plus $1,000 more if 50+ years old) than a 401K, but still for many starting out provides a decent amount that could be set aside for retirement. If you want to do more, either find a job with benefits and a 401K or start a business where you have more choice and much larger limits to invest for your retirement. 


Lastly, if you leave a job you may want to think about what you want to do with that 401K. Sometimes the job may allow you to keep the account there, even though you cannot contribute further as no longer employed there, but imagine leaving several jobs and having several 401Ks hanging around. Another option is to roll over the 401K to the new job’s 401K if they allow for such, or roll it over to your IRA which stays with you and doesn’t matter how many jobs you change. The worst you could do is get a distribution from that 401K if you’re not of retirement age (59.5 years old according to the IRS) as you’ll have to pay taxes as well as penalties for early withdrawal from the account designated for retirement. Also, you want to check the vesting schedules of when the employer’s match becomes yours to take if you leave the job, as many 401Ks have a vesting schedule.


A 401K is a great tool to save for retirement, but also should be seen in totality with the other accounts and goals that you may have. A comprehensive financial plan, which is key to have first, will address how much to contribute and what other goals or investments to also think and consider. After all, you’re more than just your retirement.