Financial Advisors: Live Well in Retirement with a 401k

No matter your age, it's essential to consider saving for retirement early. Taking advantage of a 401(k) savings plan through your job can set you on the path to creating a comfortable financial cushion.

Whether you're a young professional embarking on your career journey or someone who is already maximizing 401(k) contributions (we'll discuss that shortly), it's beneficial to grasp the workings of these plans, acquaint yourself with the rules, and explore alternative options in case your employer doesn't provide a 401(k) program.

What is a 401k and how does it work?

A 401(k) is a retirement investment plan offered by employers that provides tax advantages for your retirement savings.

Here's how it works: As an employee, you have the option to allocate a portion of your paycheck directly into your 401(k) account before or after taxes are applied.

You have flexibility in deciding how much to contribute, with the contribution limit for 2023 set at $22,500 per year, an increase from the $20,500 limit in 2022.

Once you reach 50 years old, you become eligible for catch-up contributions, allowing you to add an extra $7,500 in 2023 (compared to $6,500 in 2022). These catch-up contributions enable you to boost your 401(k) savings as you approach retirement age.

What does 401k stand for?

The term "401(k)" doesn't hold any mysterious connotations. It simply refers to a section of the tax code that was established in 1978 with the intention of simplifying the process for employers to aid their employees in preparing financially for their retirement.

Interestingly, Ted Benna, the individual responsible for the 401(k) concept, revealed in an interview with Workforce that he had no inkling it would evolve into the primary method of retirement savings for countless individuals four decades later. Yet, that's precisely where we find ourselves today.

Benefits of a 401k

Although investing in a 401(k) entails risks, it undeniably represents a wise decision to contribute to one. Think of it to pay yourself for your retirement years. Here are some of the best perks.

Matching Contributions

One of the most advantageous aspects of a 401(k) is the potential for employers to match your contributions.

For example, let's say your employer offers a 100% match on your 401(k) contributions up to 6% of your income. If your annual income is $40,000 and you contribute the maximum to receive the employer match, you'd contribute $2,400, and your employer would contribute an additional $2,400.

Consider your employer's match as an integral part of your overall compensation package, providing you with valuable additional savings for your future.

Automate your savings

A 401(k) offers a convenient method of retirement savings, where you save without noticing it. The contributions are deducted automatically from each paycheck, making it seamless and painless.

Moreover, having your employer as the sponsor of your 401(k) plan often leads to lower fees compared to opening an individual retirement account. Just like group rates on health insurance, companies can negotiate reduced fees for services such as mutual fund management or financial advisory, providing additional cost advantages for the employees.

Upfront Tax Break

By contributing to a traditional 401(k), you are postponing a portion of your salary until your retirement years. This results in the money you currently contribute being excluded from taxable income, providing you with immediate tax benefits. However, when you withdraw the money during retirement, you'll be required to pay taxes on the accumulated amount.

401k Drawbacks

It's equally crucial to familiarize yourself with the limitations and regulations surrounding a 401(k), understanding both what you are not permitted to do with the account and the specific guidelines governing contributions and withdrawals.

Limited Investment Options

Compared to other retirement accounts, a 401(k) often offers more restricted investment choices. It does not allow you to individually select specific stocks and bonds for investment.

However, this limitation might not be a disadvantage, especially if you lack experience in investing and prefer to have professional guidance. Generally, 401(k) plans provide a variety of mutual funds to choose from, and some plans are expanding to offer exchange-traded funds (ETFs) as well. These options enable you to invest with knowledgeable financial managers, making the process more accessible and convenient.

A 401(k) is not intended for speculative stock market activities; rather, it serves as a tool for wealth-building over the long run, considering your risk tolerance and investment preferences.

Early Withdrawal Penalties

Because a 401(k) is designed to secure your income during retirement, withdrawing funds prematurely comes with penalties.

If you take money out of your 401(k) before reaching age 59 1/2, with a few exceptions like disability, you will face a 10% penalty and be required to pay income taxes on the withdrawn amount. However, if you leave your job at age 55 or older, you can avoid the 10% penalty on withdrawals from your current plan.

Certain 401(k) plans may allow hardship withdrawals for situations like medical expenses or preventing foreclosure, but they are generally limited to the contributed amount. You cannot withdraw the earnings, and the 10% penalty may still apply in most cases.

In specific circumstances, borrowing from your 401(k) is possible, but it operates like any other loan, requiring repayment with interest. If you leave your job, the full amount must be repaid when filing your tax return for the year. Otherwise, it will be considered an early distribution, incurring taxes and 10% penalty.

In summary, avoid treating your 401(k) like a savings account. Having a separate emergency fund is essential in addition to your retirement plan.

Vesting

When enrolling in your 401(k), you may encounter the concept of "vesting," which pertains to the duration you must work for your company to gain full ownership of the funds in the account.

Suppose your company has a two-year vesting schedule. If you leave before completing the two years, you would forfeit the employer-contributed funds in the account, while the contributions you made would remain yours. This serves as an encouragement to remain with the company until you become fully vested.

How do Taxes work with a 401k 

Taxes for your 401(k) can be managed in two ways. In a traditional 401(k), you make contributions before taxes are deducted. Consequently, taxes are paid upon withdrawal of funds during retirement.

Alternatively, you have the option of a Roth 401(k), where contributions are taxed upfront. As a result, you can withdraw the money tax-free once you reach retirement age.

Traditional or Roth

When deciding between a traditional and a Roth 401(k), it's essential to consider both your current tax bracket and the one you anticipate being in during retirement.

Typically, retirees find themselves in a lower tax bracket as their retirement income is lower than their working salary. In such cases, opting for a traditional 401(k) might be preferable.

However, some individuals might have the option to invest in a Roth 401(k), allowing them to contribute money they've already paid taxes on in exchange for tax-free withdrawals during retirement. It's important to note that employer contributions are usually pre-tax, meaning taxes will be applicable upon withdrawal. You should inquire with your employer to see if this option is available.

Ultimately, the choice lies with you, but seeking advice from a financial adviser can be beneficial in determining which option suits your circumstances best.

What happens to your 401k when you quit?

When you have a 401(k) through your employer, you might wonder what happens to the money in the account if you leave your job.

Even though your employer sponsors the account, it doesn't have ownership of it. The account is yours, and typically, a third-party administrator manages it. If you quit or get fired, your money remains in the account, continuing to grow and earn returns. However, you won't be able to contribute more to it unless you decide to roll over your 401(k) into a new employer's plan or an individual retirement account (IRA).

Rolling over your old 401(k) into a new one is a smooth way to maintain your retirement savings.

"For many people, the automated setup of their employer's 401(k) plan is the primary reason they consistently save every month," said Paul Ruedi Jr., a certified financial planner specializing in retirement planning in Plano, Texas.

If you choose to roll over into an IRA, you'll be responsible for making contributions independently. However, if your new employer offers a 401(k) plan with a matching contribution, it's highly advisable to enroll and contribute at least up to the matching percentage to take full advantage of the benefit.

401k Investment Categories 

A 401(k) plays a vital role in building your retirement savings through strategic investments. You have the option to exercise full control over where your money is invested, or you can opt to select general investment categories and entrust the decision-making to your broker.

In general, most 401(k) plans offer four main investment categories to choose from.

Stocks

Your company's 401(k) plan may offer options for investing in different assets. If available, you can choose to invest in individual company stock, though individual stocks may only be accessible if your plan includes a broker.

Stock Mutual Funds

A more prevalent option is investing in stock mutual funds, where your money goes into a diversified pool of stocks, reducing individual risk.

Bond Mutual Funds

Another option is bond mutual funds, which function similarly to stock mutual funds but involve investing in a collection of bonds, offering lower risk compared to individual bond investments.

Variable Annuities

An alternative to stocks and bonds is variable annuities, which provide regular payments after an initial upfront investment.

Your age plays a vital role in deciding the investment mix for your 401(k). When young, you can tolerate more risk in your investments. As retirement nears, riskier investments might lead to potential losses that could affect your retirement funds.

The allocation of your investments is your decision, but considering factors like age is essential. Generally, a 401(k) portfolio will have a higher proportion of stock investments for younger individuals and gradually shift towards more bond investments as retirement approaches.

Bottom Line

Starting with a 401(k) is an excellent initial move towards saving for retirement. If your employer provides this benefit, explore the option of maximizing the amount they match, and contemplate contributing additional funds each month or even opening an Individual Retirement Account (IRA).

Your future retired self will undoubtedly be grateful for the sound financial decisions you make today.

Sources:

https://www.thepennyhoarder.com/retirement/401k-plan-guide/

Disclosures:

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This material is provided as a courtesy and for educational purposes only.  Please consult your investment professional, legal or tax advisor for specific information pertaining to your situation.

These are the views of the author, not the named Representative or Advisory Services Network, LLC, and should not be construed as investment advice. Neither the named Representative nor Advisory Services Network, LLC gives tax or legal advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. Please consult your Financial Advisor for further information.

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Variable Annuity (*if IAR is also a registered rep with a Broker/Dealer, variable annuity advertising may need to be filed with FINRA through their Broker/Dealer)

Variable annuities are offered only by prospectus.  Carefully consider the investment objectives, risks, charges, and expenses of variable annuities before investing.  This and other information is contained in each fund’s prospectus, which can be obtained from your investment professional and should be read carefully before investing.  Guarantees are based upon the claims paying ability of the issuer.

Variable annuities are long-term, tax-deferred investments designed for retirement, involve investment risks, and may lose value. Earnings are taxable as ordinary income when distributed. Individuals may be subject to a 10% additional tax for withdrawals before age 59† unless an exception to the tax is met.

Add-on benefits are available for an extra charge in addition to the ongoing fees and expenses of the annuity and may be subject to conditions and limitations. There is no guarantee that an annuity with an add-on living benefit will provide sufficient supplemental retirement income.