Your company’s 401(k) plan is a powerful tool for helping you meet your retirement goals. If you aren’t currently contributing to your employer-sponsored plan, you probably should be, and the younger the better. If you are already making contributions, it is vital to take full advantage of your plan. Here are several guidelines to follow to ensure you are making the most out of your retirement plan.
How Much to Contribute and Utilizing Your Employer Match
First and foremost, start putting away money as soon as you possibly can; there is no such thing as starting too young. The beauty of investing is the eighth wonder of the world—compound interest. The younger you start saving, the more time your money has to grow and compound. For example, the below chart illustrates the difference between saving $5,000 a year beginning at age 22, and saving $5,000 a year beginning at age 32, using a 7% compound rate of return. As the below chart illustrates, beginning saving at age 22 rather than 32 would more than double the investment at age 70.
If possible, max out your contribution up to the legal limit each year, which is $18,000 plus a $6,000 catchup contribution for investors over age 50. This lowers your taxable income for the year, which is especially important for those in higher tax brackets. Additionally, your investments will continue to grow and compound tax-deferred. If you are unable to max out your contribution, you should certainly at least contribute up to your employer match, which is essentially free money from your employer to help your meet your retirement goals even faster. These factors are crucial to taking advantage of your 401(k). (For related reading, see: Your 401(k): What's the Idea Contribution?)
How to Invest
It is important to select the best investments for your individual goals, based on both age and risk tolerance. If you don’t want customized investment advice, a target date fund is a good place to begin. These funds automatically adjust the risk of your portfolio by your planned retirement date. If you do want customized advice tailored to your goals and risk tolerance, work with a certified financial planner (CFP) to properly align your retirement plan in conjunction with the rest of your retirement portfolio. A CFP will be able to help you evaluate your financial goals and select an asset allocation that fits your needs based on how much risk you can tolerate. A CFP will also be able to help you evaluate your investment options on a yearly basis and rebalance your account as necessary.
Penalties for Borrowing or Withdrawing From Your 401(k)
Borrowing or withdrawing from your 401(k) while employed should be done only as a last resort. Loans taken from your 401(k) must be repaid with after-tax money plus interest. Also, if you have a 401(k) loan outstanding and are terminated by your employer, you have to pay back the loan balance. Any unpaid loan balance is deemed a retirement distribution which is subject to income tax and could be subject to a 10% penalty if you are under age 59.5. (For related reading, see: 8 Reasons to Never Borrow From Your 401(k).)
If you are under 59.5 years old, you must also pay taxes in addition to a 10% penalty if you withdraw the funds. On top of that, withdrawing money means you’ve lost time for your money to compound and you are then set back a little further from retirement. To prevent this from happening, it is imperative to establish an emergency fund earmarked for unexpected life happenings to prevent you from needing to withdraw money from your retirement plan and potentially delaying retirement as a result. Don’t let an unexpected circumstance undo all of your hard work and diligence.
Take It With You When You Leave
If you’re in the process of changing jobs or have done so recently, take your retirement savings with you. The IRS allows you to roll the pre-tax portion of your 401(k) into a traditional IRA, which is not a taxable event. Rolling your 401(k) into an IRA will likely give you access to more investment options with lower expenses. No matter how small the balance, cashing out your 401(k) is not wise, because even small amounts of money can grow substantially with the power of compounding.
By following these few guidelines, you are sure to be on a faster track to retirement.
(For related reading, see: Understanding 401(k)s and All Their Benefits.)