Five things you need to know if you’re saving in a 401(k) for the first time

Five things you need to know if you’re saving in a 401(k) for the first time


Let’s be honest—401(k) plans are seriously underrated. And we don’t mean that in terms of how often they’re utilized, we mean it in terms of how exciting they are. While many people think of a 401(k) as just another retirement savings vehicle, in reality, 401(k) plans allow workers to save more for retirement than any other retirement savings vehicle—plain and simple. And the opportunity to reach maximum retirement readiness is exciting, no?

The inner workings of 401(k) plans and the retirement industry in general are complicated, and a little bit of guidance is always needed when so many rules and regulations are put in place. So without further ado, here are five things you need to know if you’re saving for retirement in a 401(k) plan for the first time.

Important things to know about your 401(k) plan

1. Why a 401(k) is so important to utilize

It’s no secret that preparing for the future is important, yet many workers still choose not to concern themselves with retirement savings until they’re close to their golden years. This procrastination causes rampant financial stress among today’s workforce, which can be more damaging than you think— leading to sleep deprivation, overeating, substance abuse, health problems, relationship issues, anxiety/depression, and the like. And the biggest cause of financial stress? For 58 percent of workers, it’s not saving enough for retirement [1].

Oh, what’s that? You don’t plan on ever retiring?

We’ve heard it all before. This unrealistic ambition is more common than you think, and while you may not be alone in having the “I’m never retiring” mindset, you’re going to need some serious luck to make it happen. Reality is: 75 percent of workers say they’ll be able to continue working until at least age 65, but less than one in four are actually able to do so. And the main causes of this disheartening statistic are beyond workers’ control; the majority of workers who retire earlier than they planned on did so because of their own ill health, newfound caregiving responsibilities, or their employer downsizing [2].

Reality is that you need a backup plan. Even if you plan on working for the rest of your life, you can’t rely on it—you need to have strategies in place to safeguard your future. You’ll almost certainly need to replace some portion of your income in retirement, and despite many workers planning to rely on Social Security to fund their retirement, this isn’t a safeguarded plan either. Experts say retirees, on average, need to replace between 72-82 percent of their annual income to fund a comfortable retirement, which Social Security benefits don’t even come close to. But here’s the real kicker: for the most part, the more you earn the more you’ll be responsible for replacing.

Wait, what?

Social Security benefits are designed to replace a smaller percentage of income for higher earners than for middle- or low-income earners, essentially to help keep lower-income seniors out of poverty in retirement. But it’s important to remember that Social Security benefits were never intended to be the sole source of income for retirees anyway—and it may be a moot point regardless because unless changes are made to the current Social Security system, the Social Security Administration is set to run out of money by 2034.

So why a 401(k)? The amount of workers who are confident in their retirement outcomes is very telling—76 percent of workers saving in a defined contribution plan, like a 401(k), say they are confident in their ability to live comfortably in retirement, while just 46 percent of workers who are not saving in a defined contribution plan can say the same [3]. And if you’re anything like most people, you probably don’t want to spend the later years of your life wondering how you’re going to get by day-to-day. Suddenly saving in a 401(k) becomes much more appealing.

2. What the benefits of 401(k) plans are 

Now that we’ve laid out why saving in a 401(k) plan is important, let’s get to the benefits. To start, traditional 401(k) contributions are pre-tax—meaning that you are reducing the amount of taxable income you receive when you contribute to a 401(k) plan through your employer. Further, this means that you’ll likely receive a bigger refund (or owe less back) at tax time than you would if you didn’t contribute to the plan.

But how?

Let’s break it down. Say your gross salary (before taxes and other deductions) is $50,000. For single filers in 2019, you would owe $4,543 in taxes for your tax bracket plus a 22 percent tax on the salary you make above the bottom line of the tax bracket ($39,475, in this example) [4]. That equates to an additional $2,315.50 in taxes. However, if you contribute 12 percent of your pay, for example, to your 401(k) plan, you would reduce your taxable income by $6,000 for the year.

How does that help? Well, it would decrease the portion of your salary subject to that additional 22 percent tax we mentioned earlier, ultimately lowering the additional taxes to $995.50 from $2,315.50.

Plus, when you save in a 401(k), you’re giving compounding interest a chance to do what it does best: grow your savings. Compounding interest happens when the interest you earn on your savings/investments begins accruing interest on itself, starting somewhat of a snowballing effect for your retirement savings. And the longer compounding interest has to do its thing, the better off you’re going to be because compounding interest can have major effects on account balances over the course of a career.

Let’s say three workers begin preparing for retirement at different times in their lives, but they all have three things in common: they contributed an initial $5,000 into their 401(k) plan and never contributed again beyond that initial $5,000, they earn an annual interest rate of 8 percent, and they plan on retiring once they reach age 67. The only real difference in this scenario is the amount of time compounding interest has to work its magic. Let’s take a look.

As you can see from the chart above, compounding interest can have a huge effect on a retirement nest egg when it has time to grow. Despite all three workers investing the exact same amount, the worker who saved at age 18 and gave compounding interest the most time to snowball came out almost $131,000 ahead of the worker who saved at age 30 and almost $190,000 ahead of the worker who saved at 40.

3. How to get started saving in your 401(k)

Before you start saving in your employer’s 401(k) plan, you’ll first want to learn about the plan and familiarize yourself with the basics. Talk to your HR director and see if there are informational packets or brochures available that detail the plan’s eligibility requirements, the enrollment process, and whether or not there’s an employer match. Some employers impose eligibility restrictions on young workers or new hires, so the first thing you’ll want to do is make sure you are eligible to contribute to the plan. Next, you’ll want to learn about the enrollment process to determine if you are automatically enrolled in the plan when you become eligible or if you will need to proactively enroll in the plan when you’d like to contribute. Finally, you’ll want to find out if your employer offers a matching contribution and if they do, understand what that match means.

Many workers don’t fully understand the terminology when talking about employer matching contributions, and things can get confusing pretty quickly—so let’s clear it up. When talking about an employer match on a 401(k) plan, you’ll often see the phrase “an employer match of X percent up to X percent.” Clear as mud, right?

The X’s can be filled with a wide variety of inputs, but for the sake of example, we’ll use an employer match of 50 percent up to six percent—a somewhat common matching agreement. This essentially means that the employer agrees to match 50 percent of the money you put into your 401(k), up to six percent of your total salary. We’ll make it simple—if you make $50,000 annually and contribute six percent of your salary to your 401(k), you’ll be contributing $3,000. Your employer will contribute $1,500 to your account, or 50 percent of your contribution up to that six percent of your annual pay.

If instead you elect to save, say, 10 percent of your total salary, you’d be contributing $5,000 into your 401(k), but your employer would still match only $1,500 because the 50 percent match only applies to the first 6 percent of your salary. This is referred to as the “full employer match.” You’ll often hear financial gurus say it’s advantageous to save enough to earn the full employer match or you’re “leaving free money on the table.” This essentially means you should contribute at least the amount of the second X, or six percent in this example, to max out the contributions your employer makes on your behalf.

4. How much to contribute to your 401(k)

Determining how much to contribute to your 401(k) plan is a deeply personal decision and should reflect your individual situation—but we’ll cover that part of it in more detail in a minute. Before getting into the nitty gritty of how much to contribute to your 401(k), you’ll first need to know that there are limits to how much you can put in each year. Every year, 401(k) maximum contribution limits are adjusted to reflect the current cost of living, so make sure you stay up-to-date on how much you can put in on an annual basis. For 2019, individuals can put in up to $19,000 in their 401(k) plan, unless you are age 50 or older. If you’re over the age of 50, you’re able to contribute $6,000 above and beyond normal 401(k) limits in “catch-up” contributions.

You might also be interested in: How to fully utilize catch-up contributions

The first step for determining how much you should contribute to your 401(k) plan is to determine how much you can afford to contribute to your 401(k) plan. Don’t feel discouraged if you can only afford to save a small percentage of your paycheck—there’s no shame in starting slow.

Experts suggest saving 10-15 percent of your annual income for retirement, but again, any money going towards retirement savings is better than no money at all. Every worker’s individual situation is unique, and we’re not here to pass judgement on how much you can afford to save. We are, however, here to make sure you’re retirement-ready when the time comes, so start small if you have to, but make sure you continue to increase your contribution percentage as time goes on so you meet your retirement goals.

Which leads us to our next point: think about how much you’ll need in retirement—but not in dollars. Instead, think about how many years you want to be retired, and go from there.

But how does that help?

Let’s say after taxes and other deductions, you take home $40,000 a year and are consistently able to save about $5,000 in personal savings annually. If you plan to continue your same standard of living in retirement, you can plan on spending roughly $35,000 per year. Now think about how long you’d like to be retired; if you want to retire at age 60, you’ll want to prepare to fund at least 19 years of retirement—as the average life expectancy in the U.S. is currently about 79 years old. Take a look at your own family history for a more accurate educated guess on your life expectancy; if your family has historically lived well into their late 80’s or 90’s, you’ll want to plan accordingly to live longer. Once you have an idea of how many years of retirement you’ll need to fund, multiply the number of years by the amount you determined you would need to keep the same standard of living in retirement. This simple calculation gives you a rough estimate of how much you should aim to save for retirement, but you can also utilize a 401(k) contribution calculator to get a more accurate view of how various contribution rates can affect your account balance at retirement time.

5. What to do with your 401(k) if you change jobs

Most workers change jobs at least once throughout their career, and it can be hard to know what to do with your 401(k) savings when you leave one employer’s plan to join another. Before doing anything with the funds in your old employer’s plan, make sure you check the 401(k) plan document to determine which actions are allowed. Under normal circumstances, you’ll likely have a few options for what you can do with the money in your old employer’s 401(k) plan:

  • Roll the assets into an IRA plan

  • Keep the assets in the old employer’s plan, if allowed in the plan document

  • Roll the funds over into the new employer’s plan, if permitted

  • Take a cash distribution

Read more: How to locate a 401(k) from a previous job

The last option should be seen as a last resort; while it may be nice to receive a boost in your wallet or personal savings account, you’ll be hit with some hefty penalties and taxes for your “early withdrawal.” In most instances, you have to wait until you reach age 59 ½ before accessing your 401(k) funds penalty-free, so distributions prior to reaching that age will be subject to a 10 percent penalty, for starters. Plus, the distribution you receive will be taxable as ordinary income—which could potentially put you in a higher tax bracket for the year. Rolling your assets over into a new retirement savings vehicle or keeping them where they are, if allowed, is perhaps the best option to reach maximum retirement readiness when the time comes.

And that’s the main goal, after all, right? You’re taking an important first step in getting there by saving in your employer’s 401(k) plan, but if you need help along the way, we’ve got you covered. We have a variety of retirement saving tips and educational information available on our website to walk with you through the savings journey and, ultimately, help guide you along the path to retirement readiness.


Sources:

[1] 2016 Financial Stress Research, Financial Finesse, 2016.

[2] 2018 Guide to Retirement, J.P. Morgan, 2018.

[3] 2018 Retirement Confidence Survey, Employee Benefit Research Institute, 2018.

[4] 2019 Tax Brackets, Tax Foundation Organization, 2019.