Brett Rice, CPFA | Sept 1, 2020
There is no way to overstate the importance of early investing. The longer your money is invested, the more time the magic that is compounding interest is able work in your favor. For many of us, our introduction to investing takes place at our first “adult” job through an employer-sponsored retirement plan.
If we do not have a lot or any investing experience, we might not understand exactly what we are getting into or even if it is a good idea. We will explain what these plans are and why they are almost always a good idea.
What is an Employer-Sponsored Retirement Plan?
An employer-sponsored retirement plan is a benefit some employers offer to employees. In most cases, it comes in the form of a 401(k). A 401(k) is a tax-advantaged retirement investment account that gives employees the option to invest a portion of their salary into a long-term investment.
Employees can usually choose between a few options, typically target date funds & mutual funds.
Why You Should Contribute
If your employer offers a 401(k), more than likely you should participate. These accounts have a lot of significant advantages.
You are Paying Yourself First
One of the most important aspects of personal finance is the practice of paying yourself first. This means setting aside money in your budget for your financial goals be they paying off debt, saving for a home or saving for retirement just as you would set aside money to pay a bill. Contributing to your 401(k) is one of the best ways to PYF because the money is deducted from your paycheck before your pay is deposited into your bank account. And what you do not see, you cannot spend!
You will Reduce Your Taxable Income
We all want a way to lower our tax bill and contributing to a 401(k) is one way to do it. Contributions go into the account pre-tax, so your taxable income for the year is reduced by the amount of your contribution.
There are contribution limits, and they are sometimes updated. For 2020, the limit is $19,500. Uncle Sam always gets his cut, though. When you withdraw the money from your 401(k) during retirement, the money is taxed then. But the advantage for many people is that they are in a lower tax bracket during retirement than during their working years.
You would not turn down free money, would you? That is exactly what you are doing when you do not contribute to a 401(k) with employer matching. Typically, the employer contribution is a percentage of your salary and employers who offer matching offer up to a certain percentage. Here is an example of how matching works. Your employer provides a matching contribution of up to 5% of your salary; you earn $1,000 per week. You contribute 5%, as does your employer. Your 401(k)’s principal balance increases by $100 a week, but you are only having $50 deducted from your paycheck. Even if you cannot afford to contribute the maximum, contribute at least the amount required to receive matching funds from your employer.
What to Do When You Change Jobs
People change jobs more often than you probably imagine. The average person will change jobs multiple times throughout their career. And that is not a bad thing. Changing jobs may boost your income more than the average raise.
But changing jobs frequently can leave a trail of 401(k)s behind you. What should you do with a 401(k) when you leave a job? You have several options, and not all of them are good options.
When you leave a job, you can take the money in your 401(k) as a lump-sum distribution. This is the least recommended option. It will mean you have less money saved for retirement, you’ll have to pay taxes on the money you cashed out, and you’ll have to pay the 10% early withdrawal penalty if you’re not 59 1/2 or older.
Leave it Behind
If you have more than $5,000 in your 401(k), many plans will allow you to leave the account where it is when you leave the company. If you choose this option, you may be charged higher fees as you are no longer an employee, and you will have to keep track of this account. Not ideal when it comes to simplifying your finances!
Move It Over
If your new employer offers a 401(k) and accepts rollovers, you can enroll in the new plan after a waiting period if there is one and roll over your old plan into the new one. A direct transfer means the old plan’s administrator will deposit the balance in your account into the new account. This will not result in owing taxes or a penalty.
You can also take the funds in your old account in the form of a check, but the money must be deposited into your new 401(k) within 60 days to avoid being taxed on the money. If you choose this option, be sure that your new 401(k) is completely set up and can receive the funds from your old account. This is a great option, so long as the investments offered by your new employer are good ones.
Roll it into an IRA
If your new employer does not offer a 401(k) or you do not like the investment options available, you can roll your 401(k) into an IRA (individual Retirement account). You can open an IRA yourself, and your options for investing are wide open. You can invest in whatever you choose, which gives you complete control over this money. An IRA is a tax-advantaged retirement investment account as well. This is a good option if you do not like the available fund choices offered by your new employer or prefer to have more of a direct hand in your investing decisions.
How to Prioritize 401(k) Investing
Retirement is not your only financial goal. You may want to save for a home, open a business, pay for your children’s education or do any number of other things. Where should 401(k) investing fall in your list of priorities? At the top! Your priority should be maxing out your 401(k) for all of the reasons I’ve listed above; it’s an easy way to pay yourself first, it reduces your taxable income, and if you’re lucky enough to work for an employer who offers to match your contribution, free money! In fact, a 401(k) with matching is such a great way to invest that I even tell my clients who have credit card debt, usually the priority, to contribute enough to get the match.
Investing in your 401(k) is one of the best financial decisions you can make.
This material was created for educational and informational purposes only and is not intended as ERISA, tax, legal, or investment advice. If you are seeking investment advice specific to your needs, such advice services must be obtained on your own separate from this educational material.