For your grandparents, pensions were most likely the main way to save for retirement. In their day, it was relatively common to stay with a company for a long period of time, perhaps even for the entire length of a career. Eventually, companies realized that pension plans were curbing their bottom line. Most of them decided to eliminate pensions from their budget entirely. The alternative option emerged and employees started funding their retirement themselves, with the companies’ partial help – enter the 401(k).
Millions of US workers have a 401(k), but many of them may know very little about what they signed up for. They probably know that (1) “everyone” else is doing it, (2) it’s some type of retirement account, and (3) it takes money out of their paycheck each month that could probably be used towards something more immediate.
What are the facts behind this mysterious black box of money, and is the investment really worth it?
Before I get into the details, or if you simply want to stop reading now, know this– it’s dangerous not to take full advantage of a 401(k). This financial tool lets you save for retirement with your own money and, if you’re lucky, with a little from your employer as well. You save your pre-tax dollars (meaning that money is taken from your paycheck and invested before you ever pay taxes), and it’s managed by a separate investment company. The money you save can be withdrawn, penalty-free, after age 59 ½ (there are some exceptions to that rule, but I’ll save that for another conversation).
Here are three common thoughts among employees who mull over whether to invest in a 401(k):
“I won’t contribute to my 401(k) now, but I plan on doing it later when I have more money.”
I’ll hold off on discussing the time value of money and instead focus on contribution limits. For 2010, the maximum 401(k) contribution an individual can make is $16,500. This means that if you plan on catching up later on in life, you probably won’t be able to due to strict contribution restrictions. The only exception to this rule is the “catch-up.” After age 50, a person can contribute an additional $5,500. But even if you invest the full $22,000 a year once you’re 50, don’t expect that money to grow at lightning speed. If you can, try to max out your 401(k) contributions and start early.
“I won’t need that much when I retire because of Social Security.”
Unless you are retiring next week, this is probably untrue. The Social Security Administration has reported that after the year 2017, it will be paying out more money than it will be receiving. Unless the government finds more money under its mattress, don’t count on receiving your full benefit.
“My company gives me tons of options, but I don’t really understand what they are.”
You are not alone. Mutual funds, stocks, bonds, matching percentages, tax-implications… it’s all very confusing. To simplify the conversation, your company most likely provides you with two main options: (1) select your own funds, or (2) enroll in the company’s default plan. Here are a few nitty-gritty tips to keep in mind as you make your selection:
- Check to see if the default plan includes stock in your own company. This should not always be added in your 401(k) because it’s a double risk. If your company goes under, you’ll not only lose your job but some of your retirement income too.
- Do NOT add tax-exempt investments. A 401(k) provides tax-free growth until retirement. Only include taxable investments to take advantage of this.
- When picking funds for your 401(k), examine each fund at Morningstar.com. Morningstar is a great website that provides useful information on performance history, risk profile, and how the fund is projected to perform in the future.
Happy 401(k) hunting! I’ll enjoy seeing you on the beaches once our nest eggs have hatched.