Do you have access to a 401(k) at work? If so, you could use it to build a considerable sum to help finance your retirement.
These popular investment accounts have many benefits that will help you make the most of your hard-earned dollars. Here are four ways you can better leverage yours.
1. Take maximum advantage of your company match
As a way to give people an incentive to plan for retirement, many companies offer to match a portion of their employees' 401(k) contributions. If yours is one of them, that's essentially free money for you — so take it.
The company match will usually have conditions though. The first is that your company will only match what you contribute up to a certain percentage of your wages. So if, for example, you make $60,000 and your employer caps its match at 5%, if you put $3,000 — or more –into your 401(k) this year, they will add another $3,000 to the account.
But if you only contribute $2,000, your company will match just that $2,000. And if you don't contribute at all, you won't receive any of that extra cash.
Some 401(k) programs are also subject to a vesting schedule. Although your account balance will increase immediately by the amount of the company match, that part of the account won't be yours free and clear. To fully claim those funds, you have to remain with your employer for a period of time. In some cases, for each year of your tenure at the company, a set percentage of those matching funds officially becomes yours to keep. In other cases, the employee vests all at once upon reaching a certain length of service. Either way, if you leave for a new job before you're fully vested, you'll be giving up some of your matching funds.
2. Figure out your maximum contribution amount
In 2021, the government's annual contribution limit for 401(k)s is $19,500. It may not be feasible within your budget to set aside quite that much for retirement — but you may be able to afford a bigger contribution to your 401(k) than you think.
One of the main benefits of this type of plan is that taxes on your contributions are deferred until you take the money out of your accounts — usually, in retirement.
Because your contributions are made with pre-tax dollars, your paycheck won't shrink by the actual size of your 401(k) contribution. The table below illustrates what the difference would be between the amount that you contribute and the reduction in your paycheck if your top marginal tax bracket is 22%. (That bracket tops out this year at $85,525.)
Decrease in Take-Home Pay
Calculations by author.
This will allow you to save more each year in this type of tax-advantaged investment vehicle than you'd be able to otherwise. So figuring out the maximum contribution you can afford may involve calculating your optimal tax savings.
3. Make a plan
You can simply invest money into your 401(k), and it will grow over time. But it's better to optimize and personalize your account so that it does exactly what you want it to do to meet your retirement needs. Making a plan will start with looking at where you see yourself in the future. At what age do you plan to retire? What other income sources will you have once you do? And what do you expect will your expenses be?
Assuming that your expenses in retirement exceed what you get from Social Security (and, if you're lucky, a pension or similar defined-benefit plan), retirement vehicles like your 401(k) will most likely be the first sources you tap to cover the difference.
Figuring out how much money you'll want to be able to withdraw will inform your decisions about things like your asset allocation model.
The table below shows what different contribution amounts at different annualized rates of return could grow into over 30 years. Between 1926 and 2020, an investor could've earned an average annualized rate of return of 7% with a portfolio made up of 20% stocks and 80% bonds, 8% with 40% stocks and 60% bonds, 9% with 60% stocks, and 40% bonds, and 10% with 100% stocks.
Annual Contributions of…
…At a 7% Annualized Growth Rate Become
…At an 8% Annualized Growth Rate Become
…At a 9% Annualized Growth Rate Become
…At a 10% Annualized Growth Rate Become
If you find that the amount you're contributing isn't going to be enough to get you to the total you'll need, you'll want to tweak your plan.
You may need to work a few more years so you can save and invest over a longer time period. You could increase your contributions if possible. You could also invest with a strategy that targets more rapid growth, by making higher stock allocations or putting your money into more aggressive funds. But it's vital to note that allocations and assets that offer greater potential returns also increase your risk of losses.
Over time, the stock market and the various equities in it will rise and fall, and as that occurs, your asset allocation can get out of whack. For example, consider a year like 2008, when large-cap stocks lost 37% percent of their value. A portfolio that was made up of 70% stocks and 30% bonds at the start of that year would've had (on average) 58% of its value in stocks and 42% in bonds at the end.
The following year, the stock market rebounded. A portfolio with 70% stocks would've grown by 20.3% in 2009. But a portfolio that began with 58% of its value in stocks would've only grown by 17.8%.
When you rebalance, you sell a portion of those investments that did well, and buy more of the types of investments that didn't, boosting their percentage back up to meet the asset allocation model you've chosen. This helps keep your portfolio balanced. It also helps you profit from changes in trends that you otherwise might not anticipate. For example, in 2006, U.S. investment-grade bonds were the worst-performing asset class and real estate was the best. The following year, this reversed. Rebalancing your portfolio ahead of that shift would've helped an investor get the exposure to those trends that they wanted.
A 401(k) can be an invaluable tool for preparing financially for retirement. How well you take advantage of it could determine whether or not your lifestyle in your golden years is everything you hope it will be.
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