Saving for retirement can be a confusing and daunting proposition but becomes exponentially more beneficial the younger you begin. If you’re a young professional, you’ve probably had this preached to you countless times with the message of “SAVE YOUR MONEY” barely escaping the otherwise static noise as to why you should save. If you are someone that needs another refresher as to why you’re best off starting retirement savings in your 20s, I suggest reading this past blog I wrote. For the purposes of this blog however, we’ll direct our focus towards a specific retirement plan: the commonly used and commonly confused 401(k) plan. If you have been hesitant to make investment decisions in your 401(k) plan or are concerned that you’re making the wrong decisions, trust me when I say you are not alone. The options to a 401(k) plan can be like trying to read and order from a menu in a foreign language. It’s a jumbled mix of companies you’ve vaguely heard of with letter combinations that looks like you fell asleep on your keyboard, and future retirement dates that some of us might be living on Mars for. Now while specific investment recommendations are too individualized to clarify in a blog, I can and will clarify some of the broad decisions you should make on your 401(k) which will put you in a better position to make your own investment decisions.
Is a 401(k) Right for You?
Before deciding on what to invest in, there are a few choices you may have to make. First and most importantly, is placing your money in a 401(k) even the right choice for you? For some, a Traditional IRA or Roth IRA might actually be the more beneficial path to take. An IRA has the main pro in that it gives you an extremely wide diversity of investment options to make, whereas most 401(k) plans offer a fairly limited selection. However, IRAs are restricted by a $6,000 annual contribution limit. A 401(k) on the other hand has a $20,500 annual limit. So, if you’re able to contribute over $6,000 a year towards retirement, you’ll probably want to at least partially contribute to your company’s 401(k) plan.
Even if you plan to contribute under $6,000, a 401(k) might still be the better choice than an IRA. The main consideration in this circumstance is whether your employer will match your 401(k) contribution and to what extent. Missing out on a 401(k) match is essentially like missing out on part of your salary, and generally should be taken advantage of to the full extent that your budget calls for. Some employers cap the employer contribution as a percentage of salary, in which case the most beneficial move could be to contribute up to that cap and invest the rest of your savings into an IRA. Your employer’s vesting schedule will also factor into the possible benefits of matching. Your vesting amount is the amount of the employer match that you own. By terminating your employment, you would forfeit whatever amount of the match is not yet vested. Vesting schedules vary in length and can take various forms but for visualization purposes let’s say you are not fully vested until after 3 years of service, however plan on leaving the company after 1-2 years. In a case like this, the employer match likely won’t have an impact on your decision between a 401(k) or IRA. There is also the possibility that your employer offers graded vesting, in which the vested percentage of your employer match increases the longer you stay at the company. Therefore, the decision might become complex if you’re uncertain about your near-term future and/or depending on your employer’s vesting strategy.
Given that you have made the decision to invest in a 401(k), you may get the option between multiple 401(k) types: Traditional 401(k) or Roth 401(k). Like Traditional and Roth IRAs, the 401(k) versions differ because of the timing in which your funds are taxed. One choice isn’t necessarily better than the other but there might be a clear favorite depending on your individual circumstances.
Traditional 401(k)
Your 401(k) contributions are not taxed up front, giving you a tax deduction for the current year as your contribution amount is deducted from your taxable income. Once you withdraw (over the age of 59 ½) the withdrawal amount will be taxed as ordinary income at your future respective tax rate, including gains from investing.
Considerations
- Are you currently in a higher tax bracket than you will be when you withdraw? If so, you may want to be taxed on the lower rate in the future and choose a Traditional.
- Do you live in a state with a high state income tax but plan to move to a state with low or no state income tax in the future? Those who plan to move in retirement can set themselves up to take advantage of one state’s low-income tax rate while living in another state by investing in a Traditional 401(k).
- Are you on the border of tax brackets? Reducing your taxable income now may bump you down to a lower tax rate. Conversely, your Traditional IRA withdrawals later in life may bump you up to a higher tax bracket later in life, including higher social security and Medicare B costs.
Roth 401(k)
Your 401(k) contributions are taxed up front, giving you a tax deduction later in life. For the current year, any amount contributed to your Roth 401(k) will be reflected as taxable income. Once you withdraw (over the age of 59 ½), your contribution and any gains from investing will be withdrawn tax-free.
Considerations
- The younger you are, the more compelling a Roth 401(k) will be. Investing decades before retirement gives plenty of time for the power of compound growth to blossom your contributions made early in life. Let’s demonstrate this with a $100 contribution taxed at 20%. If that investment grows for 40 years, returning an average of 8% annually, it will grow to about $2,172. The only tax you paid was $20 on the contribution when you first contributed, and all the rest can be withdrawn tax-free in retirement.
- Young professionals are also more likely to be in a lower tax bracket now than they will be later in life. If you expect your income to increase as your career progresses, then investing now in a Roth will help you optimize your current lower tax rate before it rises.
- Have you considered estate planning implications? If your 401(k) is inherited, your heirs would avoid having to pay income tax on an inherited Roth unlike its Traditional counterpart. Not only will this cut into their future inheritance, but a large Traditional 401(k) inheritance is likely going to bump your heirs into a higher tax bracket as well.
All these considerations must be hedged by the fact that we can’t confidently predict future tax rates. Not to mention, if you’re still decades away from retirement then there are a countless number of variables that will impact your financial future, for better or worse. Because of uncertainty, it’s wise to split your 401(k) between a Roth and Traditional over time. Perhaps for a young investor though, you will want to be heaviest or completely invested in a Roth and increase your Traditional 401(k) exposure overtime. Also, employer match contributions are automatically invested in a Traditional 401(k) so this could provide a natural hedge for your investments. Diversifying investments across multiple accounts can reduce risk like diversifying securities, so splitting retirement savings between 401(k)s and IRAs could be a smart move to take.
Target Date Funds
If your employer offers a 401(k) plan, then you’ll probably recognize the most common 401(k) default investment option: Target Date Funds (TDFs). The simple idea for these funds is that they are exposed to several types of investments to represent a diversified portfolio, and most actually invest in various mutual funds instead of individual securities. The funds are set with a target retirement date so an investor can choose the fund that most accurately represents their expected retirement. As the target date nears, the fund becomes increasingly more conservative by rebalancing its portfolio with a heavier income allocation.
Considerations before investing
- The biggest argument for using a TDF is that it is a convenient way to invest your money and have it automatically rebalanced overtime without having to make any changes or further investment decisions.
- TDFs tend to be a cheaper option than paying a financial advisor or robo advisor. Although fees vary across different TDFs and you should be aware of the fees associated in yours before investing.
- A TDF doesn’t take your individual needs and risk tolerance into consideration. Just because an investor is in the same age group, doesn’t mean that they have the same income needs and risk tolerance.
- An investment strategy cannot be properly diversified if it’s completely placed in one fund. A TDF should be just part of your investing strategy.
- TDFs don’t account for the allocation of your entire portfolio. In making the decision to include a TDF as part of your investment strategy, you should examine how the TDF’s allocation fits with your overall portfolio and readjust the portfolio accordingly.
The links to find the asset allocations/holdings of the top four most commonly used 2060 retirement target date funds are listed below. If you hold another company’s TDF, you can find its asset allocation listed in a similar manner on that company’s website. For those with a different retirement date, you can simply search the name of the fund or ticker on the company website to find its asset allocation and other information. Like I mentioned earlier, most TDFs are funds of funds, so in order to get a sense of the specific securities held, you may have to further search each mutual/index fund held in the TDF to see the actual percentage of each individual security that comprises the fund.
While retirement plans can be confusing and consequently tempting to neglect, the early moves you make can have a significant impact on your future lifestyle and the age in which you’re able to retire. Hopefully this blog gave you some further insight into what you should be considering with regards to your 401(k) options. In making investment decisions, always take the time to diligently research the funds you are investing in beforehand or hire an advisor to give you a professional recommendation. No matter what investment strategy you take on, the most important and basic step you can take is to diversify your investments.
