The 411 for Your 401(K)
If you haven’t yet enrolled in your 401(k) plan, do so as soon as possible, even if you’re not feeling flush. Then take the following steps to help achieve financial security during retirement.
Stuff your accounts.
By adding even a small amount– even just 1% or 2%–on a regular basis, you can build substantial wealth over the long-term. With a traditional 401(k), the money you contribute is tax-deferred, which means you don’t pay tax on the contributions or the earnings until you withdraw the funds, typically at retirement age. For example, if you are in the 28% tax bracket and you invest $5,000 a year, that’s $5,000 of your salary on which you are not paying taxes. This reduces your annual tax bill on that $5,000 by nearly one-third—$1,400 ($5,000 times 28%).
Leverage both pre-tax and post-tax contributions.
With traditional pre-tax contributions, you pay no tax on money as it goes into the plan, but you must pay tax on withdrawals. With a Roth, on the other hand, you pay tax on your contribution, but not when you withdraw the funds, so all the growth is tax-free. This is a valuable strategy if you expect your taxes will be higher when you retire, since you will pay taxes on the contributions now based on a lower tax bracket and pay no taxes on the earnings when you retire. Some plans allow you to make both types of contributions or some combination of the two.
Take advantage of a company match.
This is a valuable benefit if your employer offers it—where there’s a match, it’s typically capped at a percentage of your pay. For example, a company may offer a dollar-for-dollar match up to 3% of pay, or, a 50% match up to 6% of pay. Whatever the match, it’s free money and critically important to accumulating savings. Find out what your employer will match and, at the very least, contribute enough to be eligible for it.
Make catch-up contributions.
For 2013 you can contribute up to $17,500 to a 401(k) plan. If you are age 50 or older, you can put in an additional $5,500, for a total of $23,000. This “catch-up” provision, as it’s called, is especially useful for people in the 50+ group who haven’t started saving for retirement or haven’t saved enough. They can sock away as much as $225,000 over the next 10 years. With compound earnings, this can add up to significant savings.
Don’t crack the egg.
Even if the plan allows you to borrow from it, think twice before doing so. Dipping into the stash reduces the benefit of tax-free compounding that is key to building up savings. Other drawbacks:
- You will pay interest on the loan with after-tax dollars, thereby losing the tax advantage.
- You will pay taxes a second time when you eventually withdraw the money in retirement.
- Interest on the loan is not tax-deductible, even if funds are used for a home purchase.
- Most loans must be paid back within five years, but if you leave your job, the loan must be paid back in full immediately or the amount becomes a taxable withdrawal.
Invest for the long term.
Once you set your investment allocations, be patient. Predicting the market is not like predicting the weather. What’s important is time in the market, not timing the market. Discipline yourself to maintain your allocation through down markets as well as up markets. Having a properly diversified portfolio will help make any market swing easier to digest. Conduct an annual review of your plan to confirm your allocations still align with your finances and life stage.