How many times have you heard about the retirement crisis in America? Despite being all over the news, it can be hard to notice this issue in everyday life.
There are those moments, though, when you realize this crisis might not be a bunch of hot air. The 70-year-old man working at Home Depot – is he there because he enjoys this work or because he needs the money in retirement due to a lack of planning?
There are many reasons why you should plan for retirement, no matter your current age. Among these reasons is the fact that defined benefit plans, also known as pension plans, have been slowly disappearing in the past few decades and are now a very rare luxury most workers will not enjoy. The Bureau of Labor Statistics (BLS), estimates that the percentage of workers with access to a pension plan has fallen to 25%.
Saving a large and adequate amount of money for retirement is not difficult, but does require starting as early as possible and being consistent throughout one’s career.
The below chart from JP Morgan illustrates the immense power consistent savings can have over a long period of time. The earlier you start to save, the more time your money has to compound, resulting in substantially more wealth by retirement.
What is a 401(k)
A 401k is a tax advantage retirement account for employees of for-profit organizations or companies. This strange name is derived from the section of the tax code that outlines the provisions and rules of 401k plans.
401k plans are “tax advantaged” because they allow employees to contribute money to the account on a pre-tax basis. This is generally accomplished through automatic contributions from the employee’s paycheck as most plans do not allow contributions by additional means.
A great perk of a 401k plan is many employers match employee contributions up to a certain percentage or dollar amount. This “match” can represent a significant portion of an employee’s overall compensation package.
The tax advantages become obvious as employee contributions, employer contributions, or earnings from investments, such as interest or dividends, are not taxed until the funds are removed from the account. If these withdrawals happen after retirement age, or through other specific ways allowed by law, they are only subject to the normal income tax rate.
Types of 401(k) Investments
Most 401k plans are managed by a “provider,” which partners with your company to administer the plan. Providers are brokerage firms, investment banks, or other financial institutions. This firm will offer a variety of asset classes or products in which you can invest.
The most popular type of investment inside a 401k plan is a “mutual fund.” A mutual fund is a tool used by investors to group small amounts of capital together into a larger pool and use that larger amount to invest in productive assets such as stocks, bonds, or real estate. There are hundreds of thousands of mutual funds, of all different types with differing risk profiles. An important aspect of each fund on which to focus is the fund’s “expense ratio.”
The expense ratio of a mutual fund is the amount, or fee, the owners or investors in the fund pay to the fund manager and her team for work within the fund and for general administrative purposes within the fund. The lower this ratio, the better.
The investor does not pay this expense ratio fee directly – rather, returns on investor money will stealthily be reduced to satisfy this and other fees. Many financial experts advocate for “low fee funds” as this is one aspect of the investment process over which an investor has control.
The good news, though, for retirees is the average expense ratio has been trending downward for years, according to a Morning Star study conducted in 2015.
401(k) Contributions and Distributions
Within any 401k plan, an important number of which to be aware is the annual contribution limit. In 2016, this limit is set at $18,000. This limit does not include any employer match contribution. The limit, then, for the combined employee and employer contributions is around $51,000. It is not the end of the world if this limit is crossed, but doing so will make your taxes slightly more complicated.
401ks have strict limitations on when and how the money can be withdrawn from them, this action is also known as a “distribution.” Typically, assets from these plans can be withdrawn based on:
- Termination of the plan
- The employee experiences a “hardship” as defined by the plan
- The employee reaches the age 59 ½
- The employee dies, becomes disabled, retires, or separates from their employer
If an employee with a 401k plan leaves or is separated from their employer, they will usually hope to “roll over” their old 401k to a new account such as an Individual Retirement Arrangement, known commonly as an IRA. If this transition is done correctly, an IRA can keep the contributed money safe from taxes just as it would have been in the 401k. We will talk about the basics of an IRA below.
If the employee does not successfully transfer the retirement funds to an IRA and elects to extract the retirement money from the 401k plan without a qualifying reason, the additional money could be taxed as income with additional penalties that are associated with an early withdrawal.
Cashing out a 401k soon after a job switch can be extremely damaging to your retirement savings. Alarmingly, a recent Fidelity study showed the youngest savers are the most likely to make this mistake: almost 41 percent of workers studied between the ages of 20 to 39 cashed out their 401k early after leaving or switching jobs.
401(k) Required Minimum Distributions
A downside to most 401k plans is a limitation called Required Minimum Distributions (RMD). RMD forces the account owner to begin taking distributions from their 401k plan at age 70 1/2 unless still employed and the plan allows for the owner to avoid RMD while still employed.
This can lead to a higher tax bill as the account owner is forced to realize income they may not need or want to withdrawal at that moment.
Loans, High Income Limits, and Qualified Early Withdrawals
There are a variety of other features, rules, and options that accompany a 401k not appropriate for an introductory article such as this. These include limits on tax deductions for high income individuals who have access to a 401k at work, the option to take out loans from your 401k for certain expenses, like a home purchase, and various strategies to withdraw money from 401k plans before retirement age without penalty.
It is recommended to contact a professional to learn more about and receive assistance with these items.
Accounts Similar to 401(k)
There are many additional types of retirement plans or accounts usually lumped in with the 401k because of their close similarity.
An example would be the 403(b) retirement plans, a 401k type account but for employees of nonprofit companies. Employees of a nonprofit hospital or university may have access to such an account.
The Thrift Savings Plan, or TSP, is a similar account that is only available to government employees. This account has different contribution limits, rules, and investment choices than 401k plans, but are similar in that they are mainly used as retirement savings vehicles and offer tax advantages.
What is an IRA
Individual retirement arrangements, or IRAs, are one of many tools available for Americans to save for retirement. The two basic types are “Roth IRAs” and “Traditional IRAs.” These differ in their restrictions on contributions and the tax treatment of contributions, earnings, and withdrawals.
A traditional IRA is a retirement account in which the owner deposits money after tax. For example, Bob earns $2,000 per month, but only spends $1,300. He contributes $200 of this surplus, per month, into his traditional IRA. Unlike a 401k, the money contributed to a traditional IRA has already been subject to tax. An advantage of this plan, though, is that this money can be deducted on the owner’s tax return.
This deduction could be in addition to a deduction received through a workplace 401k, depending upon an individual’s income and their spouse’s access to a 401k.
Earnings within a traditional IRA are not taxed until taken out at retirement. At that point the earnings are taxed as regular income along with any contributions.
A traditional IRA essentially pushes all of the income tax burden to retirement when the owner is withdrawing from the account since there were no taxes while the funds grew along the way and the contributions were tax deductible when contributed initially.
Contributions to a Roth IRA are made in the same manner as a traditional IRA, but the difference between the two arrangements being that contributions to a Roth IRA are never tax deductible. Earnings, such as dividends or capital gains, from investments inside a Roth IRA are not taxed. Also, a key difference is that Roth IRA contributions can be withdrawn at any time, without penalty.
For example, let’s say I contribute $5,000 to my Roth IRA today. In 5 years, that amount has grown to $5,500. If I wanted, I could withdraw the original $5,000 I contributed without penalty whenever I wanted.
The additional $500, though, my investments earned inside the IRA cannot be withdrawn in the same manner. If I did withdraw this amount, it would be considered an early withdrawal and I would have to pay income tax and other penalties on that amount. That earned investment has to stay put until retirement age or upon the occurrence of another acceptable withdrawal method.
That being said, the greatest advantage of a Roth IRA, if one can follow all the rules and regulations, is that any contributions or earnings withdrawn after age 59 ½ are completely tax free.
The Roth IRA essentially lets an individual pay tax upfront, relieving the requirement to pay tax as the account grows and after the funds are tapped into during retirement.
A notable exception, of which there are others, is if you started contributing less than five years ago and try to withdraw earnings from the account because you are older than 59 ½, the funds would not count as a qualified withdrawal immune from taxation. This is known as the “five year rule”. Simply, earnings must be in the account for at least five years before being withdrawn tax free after 59 ½.
A Roth IRA is typically viewed as a way for individuals who expect to have a high tax burden in retirement to lessen it slightly whereas a traditional IRA provides tax savings up front since the tax is paid in retirement when withdrawing the funds.