The Undeniable Benefit of the 401(k)

As you enter the workforce or begin a new job, you are often overwhelmed with a barrage of paperwork initiating the benefits package. In one sitting an employee is asked to choose a healthcare option, a beneficiary for insurance policies and decide if they would like to participate in the employer’s defined- contribution plan, most commonly known as a 401(k) plan. When it comes to signing up for retirement plans, a new employee can be tempted to opt-out of participation due to lack of understanding of the plan, fear of a smaller paycheck or thinking that retirement is a lifetime away. This decision could impact the quality and feasibility of retiring. Before striking the opt-out box, here is what you need to know about the undeniable benefits of a 401(k) plan

What is a Defined-Contribution Plan

The first step to successfully maneuvering your company’s retirement plan is having an understanding of what it is. A defined-contribution plan is a plan in which an employee’s retirement benefit depends on the contributions made by the employee himself. Depending on whether you are employed in public, private, non-profit or the federal business sector, your defined-contribution plan is referred to by its correlating section of the tax code, like 401(k), 403(b), 457, or Thrift Savings Plans for federal employees. The success of the plan depends not only on the employee’s contribution, but the performance of the assets in the portfolio. The employee has the ability to choose how the money is invested and is given number of investment options, such as stocks or company stocks, bonds, or mutual funds to select from. The investment choices are not locked, and can be changed throughout the course of the plan.

How Defined-Contribution Plans Work

Most defined-contribution plans work in a similar fashion. You decide how much you would like to contribute into the selected investments of the plan through payroll deduction of pretax dollars. Many employers offer matching contributions where they fully or partially match the amount you invest. For example, if your employer agrees to match 50% of every dollar you contribute, up to 6% of your salary, if you make $30,000 a year and contribute 6%, you will have $1800 invested each year. Include the employer match and your contribution becomes $2700. This is like getting a 50% return on your investment before adding the accrued interest from the investment itself.

Determining How Much to Contribute

Given the undeniable benefit of long-term investing, compounding interest, and the tax advantages of defined-contribution plans, anyone who can contribute the maximum should be encouraged to do so. If you are not able to do this at first, at least shoot for the percentage your employer will match and aim to increase this contribution by at least one percent each year, or as your salary increases. Even the smallest contribution adds up over time. To illustrate this point, if you were to save $100 a month from your very first job and did not receive an employer match or increase this amount over the course of your career, after 45 years you will accrue over a half million dollars assuming an averaged investment rate of 8 percent. What this shows is small and consistent long term investing matters! If you didn’t start saving until 20 years before your retirement, you would have to contribute 9 times the monthly installment to end up with the same savings. The lesson is no amount is too small as long as you start investing as soon as you are able.

How to Choose your Defined-Contribution Investments

After deciding how much to contribute, the next step is choosing which investments you would like in your plan. This can be very intimidating, but it is potentially the most important step. Being too conservative at a young age can significantly alter the amount you have by retirement. Conversely, being too aggressively invested at the end of your career can put years of savings at risk. How you invest needs to be fluid and adjusted as you age. If you do not have a financial adviser to help navigate the choices, use an asset allocation calculator that takes into consideration age, risk tolerance, and years until retirement. This should help show the blend of stocks, bonds, etc. that are recommended to have in a portfolio for your needs. A great calculator for determining asset allocation can be found at CNN Money.

The Power of the 401(k)

There are two things that make a defined-investment plan a powerhouse for retirement savings; the tax advantages and the potential impact of matching contributions. The tax savings benefits are undeniable. Money used to fund your retirement plan is taken from pre-tax earnings. This lowers the amount of earnings that you are taxed on. For example, if you earn $30,000 a year and contribute $3000 into your defined contribution plan, your taxable income will then become $27,000. With the help of a tax adviser, you could potentially maneuver into a lower tax bracket depending on how much you contribute. And your money grows tax free! Tax is not paid until you start to withdraw it after retirement, and you only pay on what is taken. Second, because the money is tax free, you have already gained more than you would from the same money deposited into a non retirement investment. Assuming you are in a 28 percent tax bracket, it actually costs 1.28 for each dollar invested into a non-qualified account due to the tax withheld from your paycheck. In addition, if the money is placed into a taxable account, you are also responsible for tax on any earnings accrued each year. This makes placing money earmarked for retirement in non-retirement accounts less advantageous. Along with the tax benefits, employer contributions are the other way your defined contribution plan is a powerhouse for saving. These contributions provide the gift of free money. With time and compounding interest, this match will significantly increase how much you will have in your plan at retirement age. An investor would be foolhardy not to take advantage of this gift.

The only mistake made when it comes to a 401(k), or defined contribution plan, is not participating. Regardless of how much you initially choose to invest or whether you guess at the investment options, you must always opt-in as soon as possible. The percentage contributed can be increased, and your investment choices can be changed, but you can never gain back the lost time needed for compounding interest to weave its magic. The earlier you start, the more securely you will retire later.