Five Tips To Master Your 401(k)
Manage and invest your workplace 401(k) like a pro
|Written by Tom Yeung, CFA | CDFA
Investment Advisor & Fund Manager, Jurnex Financial Advisors
You probably know that American’s aren’t known as great savers. According to the US Federal Reserve, the average American is currently on track to save just 8% of their salary. That’s not nearly enough to ensure a comfortable retirement. But your 401(k) plan can help make saving far easier. So in this article, I’d like to share my five tips on how YOU can master your 401(k).
And as always, I suggest you reach out to an investment pro before making the final decision on your 401(k) plan. That’s because financial pitfalls today might remain hidden for decades. But to get you started, here’s my advice on how you can master your 401(k).
What is a 401(k) Plan?
Before we begin, we should examine what 401(k) is.
In short, a 401(k) plan is a tax-deferred employer-sponsored savings plan. In other words, it’s an investment plan that employers set up for the benefit of their employees. Contributions are automatically deducted from your wages and invested in a pre-defined set of funds and stocks of your choosing. Once you’ve set up your plan, your plan sponsor will take care of investing your savings on your behalf. Government and non-profit workers have an equivalent plan called the 403(b) plan.
Why master your 401(k) plan?
401(k) plans allow you to defer taxes, lets your investment grow tax-free, and runs without any effort on your part.
For example, imagine you earn $100,000 per year. If your tax rate is 30%, you would pay $100,000 * 30% = $30,000 in taxes per year. However, imagine your company offers a 401(k) plan that automatically deducts $10,000 of your salary. Rather than pay $30,000 in taxes, you will only be liable for $90,000 * 30% = $27,000. That’s $3,000 of tax savings!
Many employers also offer 401(k) matching, meaning that every $1 you save gets matched by an extra $1 from your employer. These funds often have vesting schedules, but any contribution YOU make will always belong to you, even if you decide to leave your employer.
401(k) plans have zero capital gains taxes
As a bonus, you’ll never have to pay any capital gains on your 401(k) plan. That means your investments can grow virtually tax-free since they won’t trigger short or long-term capital gains. Short-term capital gains can be as high as 37%, and long-term at 20%.
Downside: 401(k) plans penalize early withdrawals
What’s the downside to 401(k) plans then? Surely there has to be a catch.
The most significant downside to your 401(k) is that any early withdrawal will trigger a 10% penalty. That means if you choose to withdraw your 401(k) balance before you reach age 55, you will have to pay both income tax AND the 10% penalty.
The good news is you can always borrow against your 401(k) funds if you need it for an emergency. You can also withdraw money from your 401(k) and replace it within 60 days to avoid the penalty.
Does your company offer a 401(k) plan?
The vast majority of companies offer 401(k) plans. At Jurnex, we estimate that close to 75% of working Americans have access to either a 401(k) plan or a 403(b) plan.
And even if you don’t qualify for a 401(k) plan, you can always contribute to an IRA. From a taxation perspective, these work in a similar way to 401(k) plans. The only significant difference is that you have to open and fund an IRA yourself, rather than rely on your workplace to do it for you. The contribution limits for IRAs are also lower than for 401(k)s.
To find out if your company offers a 401(k) plan, contact your HR department. Generally, most companies tell you about their 401(k) program upon employment and allow immediate participation.
Some companies, however, require plan participants to work at the company before they qualify. But according to Safe Harbor laws, no company can deny eligibility to any worker over the age of 21 and has at least one year of service.
How much to contribute to your 401(k)?
The decision on how much you should save depends significantly on three things.
Consideration 1: How much do you currently have saved? If you’re on track to reaching your investing goals, then saving 15% of your income should keep you in good shape. However, if your nest egg is lagging, you should consider using catch-up contributions to your 401(k) if you’re 50 years or older. Catch-up clauses increase your contribution limit by $6,000.
Consideration 2: How much will you need in retirement? Most advisors recommend having at least 8-10 times your annual salary saved by the time they retire. But if your family has a history of medical needs or long life expectancy, you might need to keep more aside to cover additional living expenses
Consideration 3: How consistent are your career prospects? Most financial advisors assume your salary will be relatively constant. However, those with lumpy salaries or who want to leave the workforce to raise children will have to save more today.
Why master your 401(k) plan?
401(k) plans are one of the most powerful savings tools you have to achieve the retirement you deserve. That’s because, besides their tax advantages, 401(k) plans have several benefits over other tax-advantaged accounts.
Advantage 1: Automatic withdrawals. We all know that saving money can be difficult. But because 401(k) contributions are dealt with by your employer, it makes it far easier to save money. A study by Vanguard showed that 91% of people participated in the workplace 401(k)s when they were automatically enrolled.
Advantage 2: Employer matching. Many employers also offer 401(k) matching, where for every dollar you contribute, your employer will add that amount (or percentage of it) to the account. The additional contributions will help your savings to grow even faster.
Advantage 3: Flexible withdrawal options. Unlike IRAs, 401(k) plans allow you to withdraw money as early as age 55. Early withdrawal can make an enormous difference for people looking to diversify their retirement savings. You could use the savings towards a down payment for a real estate investment, for example.
Advantage 4: Ability to borrow. In emergencies, you can often tap into your 401(k) assets through a loan. The IRS caps maximum loan sizes at 50% or $50,000 (whichever is lower). You should also only borrow with the intent of replacing funds as soon as possible.
What about other savings plans?
Besides investing in your 401(k), there are other savings plans you can also consider.
- Emergency fund. You should keep at least 3-6 months of savings as cash for emergencies.
- IRAs. These operate in a similar way to 401(k) plans, except withdrawal can only happen at age 59.5 without penalty. The IRS caps contribution limits to $6,000 per individual per year.
- College Savings. The 529 College Savings Plan allows you to save for children’s education. The beneficiary can also be changed to ANY family member if your kid doesn’t use all of the savings.
- Low-cost brokerage account. A regular investment account can help your savings grow too. Having money in these accounts will allow you to withdraw your savings at any time when you need the cash.
- Real estate. Buying property is one of the most potent ways of investor money. Not only can you deduct mortgage payments, but you may also qualify for many first or second time home buyer benefits.
Diversifying your holdings can help you fund medium-term goals that would otherwise trigger early-withdrawal taxes on your 401(k)
When should you master your 401(k)?
The answer is: as soon as possible!
However, you should consider two things before that.
Consideration 1: Do you have 3-6 months of emergency cash? While it’s tempting to start investing in your 401(k) immediately, I recommend all my clients have at least 3 to 6 months of emergency cash. That’s because you want to protect yourself in case any medical or family emergency comes up, without having to worry about liquidating any long-term savings.
Consideration 2: Have you paid off high-interest debt (above 8% APR)? Before you start investing in your 401(k), you SHOULD pay off any high-interest debt as fast as you can. These debts can include both student debt and credit card debt that have interest rates above 8%. Paying off these debts today will let you set aside even more money in the future.
Five tips to master your 401(k)
Now that we’ve covered the basics, here are my five tips that will help you master your 401(k)
1. Max out employer contributions
Around half of all 401(k) plans offer some form of matching employer contributions. Matching means that for every dollar you contribute to your 401(k), your employer would add an extra dollar to your 401(k). The average plan matches up to 3% of your salary. And some will match 6% or more!
If your employer offers matching contributions, I highly recommend you take full advantage. For every $1 you save in your 20s, you’ll have around $7 (in today’s money) by the time you retire. With matching employer contributions, that seven dollars doubles to $14. Even if you’re not in your 20s, every dollar saved in your 50s will still turn to four dollars by the time you retire.
2. Use target-date funds
Target date funds are funds offered by investment companies that aim for a particular retirement date. A target retirement of 2065, for example, might start invested mostly in stocks. As time passes, the fund would switch its holdings to favor bonds. By the time you retire in 2065, the majority of the fund’s holdings would be in more conservative investments.
Target date funds are excellent 401(k)s because the majority of people forget to rebalance their portfolio. Target date fund overcomes these issues by automatically rebalancing your portfolio for you every year.
3. Rebalance as needed
If you’re a more active investor, you should monitor your 401(k) holdings periodically. I recommend revisiting your holdings at least once every year.
That’s because your portfolio might require rebalancing from time to time. Some of your stocks might do incredibly well and grow by hundreds of times over. While that’s good in the short run, you can spell trouble in the long term once it makes up too much of your portfolio. That’s because a decline in the stock’s value can have a massive impact on your nest egg.
For example, imagine investing 1% of your portfolio in a stock that goes up 100 times. All else equal that stock will now make up around 50% of your portfolio! You can read my article on diversification to learn more
4. Diversify your savings
It’s tempting to let your 401(k) run on autopilot. But before you do that, I suggest you pick a diversified basket of holdings that you would be comfortable holding for the long run.
The Rip Van Winkle test
When people ask me what stocks to buy for the long run, I use the analogy of Rip Van Winkle, the famous villager who fell asleep for 20 years. The Rip Van Winkle test is simple: imagine you bought shares in a company, and couldn’t touch it for twenty years. Would you be able to sleep, or would you have nightmares thinking about the value of the investment?
There’s no need to think too hard about this. It’s the difference between buying a high-returning company in a fantastic industry (Google) versus buying a low-returning company in a shrinking sector (Sears).
How to diversify?
In general, I recommend clients put 1/2 their savings into 8-12 phenomenal handpicked stocks, and the remainder in low-cost factor ETFs. Diversifying between ETFs and stock gives you the benefit of owning shares as well as the diversification benefits of ETFs. I write about this more in my article on investment diversification.
5. Rollover your 401k instead of withdrawing early
What does that mean for employer-sponsored 401(k)s? When you leave your current job, what should you do with your 401(k)?
It’s often tempting to withdraw your 401(k) early. But that generates two problems. Not only do you have to pay ordinary income taxes on it, but early withdrawals are subject to a 10% penalty.
To avoid the additional charges, you can do what’s known as a 401(k) rollover. In essence, this means opening an IRA at a brokerage account and depositing your 401(k) investments there. Rollovers do NOT trigger any taxes because the assets are transferred directly from your current 401(k) plan into the new one.
What if you miss the deadline for rolling over your 401(k)?
If you don’t instruct the plan sponsor, they may reserve the right to close your 401(k) account and deposit your assets in a bank account. That’s bad because this will trigger taxes. Fortunately, you have a 60-day window to redeposit the holdings in a rollover IRA account. Keep in mind the plan would have withheld 20% for withholding taxes, so you may need to dig through your savings to replenish the IRA in full. But don’t worry, as long as you replace everything within 60 days, you’ll receive a tax credit when you go to file your taxes that year.
Are YOU ready to master your 401(k)?
If this seems like a lot of information, don’t worry. The great news is that help is available. Consider talking to a qualified investment pro about your 401(k) today.
Where to find more resources
If you’re looking for even more investment tips, you’ve come to the right place.
That’s because I’ve helped invest client money for over a decade in the same old-fashioned way. And that’s to seek out great companies in great industries that can you can buy at a discount to their fair value. Sounds too simple to be true? Give me a call today, and I’ll show you that it’s still possible after all these years.
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