MoneyMonday: Basics of a 401(k)

What is the best way to save for your long-term future?

This session will provide an overview of your employer-sponsored retirement plan and the benefits that come with it, along with the investment strategies and resources available to help you reach your retirement goals.

Some Questions We Answer:

• How does my retirement plan work?
• Am I on track to meet my retirement income needs?
• What is diversification? How should I invest my retirement savings?
• What tools are available to help me manage my retirement savings?

Video Transcript: 

If you’ve attended other sessions, you’ve been introduced to the three stages of financial wellness. If this is not familiar, check out the Money Milestones course which takes a deep dive into each stage. Basics of 401k is a core course that is appropriate for anyone at any stage.

Let’s start with the basics. Where will your retirement paycheck come from? Your paycheck currently comes from one source, your employer, and is based on your wage and how much you work. But, in retirement, it isn’t so cut and dry. There may be a variety of sources that contribute to your retirement income including…

• Social Security – usually about 40% of what you’ll need.
• Pension – you may or may not have an old-fashioned pension benefit. If you do, this piece is about 10% of a typical retiree’s paycheck.
• Some folks will work part-time or have other sources of income.

But the size of your retirement paycheck will be largely influenced by the savings you accumulate over your working career.

We gather and grow those savings in a variety of account types including IRAs, 401ks, brokerage accounts, bank savings, and even dollars in your Health Savings Account can be considered retirement investments.

Here are some of the main differences between the various account types:  

• First, most investment accounts are personally owned. Your 401k, however, is a group arrangement where your account is within the company-sponsored plan.
• Depending on your personal situation, there may be tax benefits when you save in a 401k that is not available when saving in personally owned accounts
• And 401ks, unlike personally-owned accounts, can accept contributions from your employer

As you can imagine, there’s a lot to know about a 401k. The good news is, you don’t have to know it all because you have us. 

Every plan has an eligibility period you must satisfy before you can participate. It can range from your first day to your one-year anniversary.

Once eligible, you enter at the next entry date. Entry dates range from daily to twice annually. Let’s say your plan has 30-day eligibility and monthly entry. If you are hired on September 4th, you become eligible 30 days later on October 4th, and join the plan on the first day of the next month, or November 1st.

Enrolling in your plan can be confusing. This might make it easy to set decision-making aside. But life moves at the speed of light and before you know it, years of savings opportunities might pass you by. This is why many plans have automatic savings features. In an automated plan, you are automatically enrolled unless you opt-out. If the plan has automatic escalation, your savings rate will increase each year. For example, you might automatically enroll at 3% in your first year and then your savings rate will increase by 1% annually until you reach 10%. Each plan’s auto features are different so consult your plan documents… or reach out to us!

Some employers make contributions to your retirement savings too. A matching contribution is a “match” of your savings, in other words, “you save, they add” but if you aren’t contributing, there will be no match. Alternatively, your employer might make a profit-sharing or non-elective contribution which is put in your account even if you are not contributing. Be sure you understand what type of contribution your employer makes and try to make the most of it. We call that getting all the “Free Money.”

If your employer contributes, you will need to understand the vesting schedule. Vesting ranges from immediate to six years. If your plan has a 6-year vesting schedule, for example, you “vest” in 20% of the employer dollars each year. If you leave your job after one year but before your second anniversary, you’ll only take 20% of the employer’s contribution with you. If you leave after your 6th anniversary, all the employer dollars are yours. Here again, be sure you understand your plan’s vesting. Note, however, that vesting does NOT apply to your contributions which are always fully vested.

Finally, we know picking investments can be confusing. That’s why most plans offer a default investment. Like the auto features, the default investment is the “do nothing” option. If you do not pick your own, you will be invested in the default option – most commonly a target date fund. We’ll talk more about that in a minute.

Now that you know how a 401k works, you might wonder how much you should be saving. To answer that question, you’ll need to estimate how much you will need.   While every situation is different, most folks need to replace about 70-80% of their income in order to maintain a similar lifestyle in retirement

Once you complete your financial wellness assessment and establish your personalized MyMoneyNav dashboard, you will be able to access the retirement income calculator to help determine how much you should be saving. 

But there are other demands for your financial resources, and it can be hard to save as much as you should. Here’s a rule of thumb for basic savings goals.

• If you start saving in your 20s, you should aim to save at least 7% of your paycheck.
• If you start in your 30s, aim for 10%
• If you are getting started in your 40s, you’re shooting for 15%
• And if you in your 50s, you are targeting 20%

You can see the longer you wait to start, the higher the goal. So, the most important thing is to START.

That brings us to the concept of compound interest. Simply put, compound interest is piling up earnings on top of earnings on top of earnings. The name of the game in investing is to let your investments grow over time. The longer the dollars stay in your 401k, the bigger they can grow. In this example, getting started at age 25 versus 35 left this person with almost twice as much! Again, the most important thing is to START. Even if it’s only 2 or 3%, get started today. And try to add 1% each year with a goal to reach the savings rate required for the full employer match as soon as you can.

Let’s see how powerful it can be to add 1% to your saving rate each year. Spoiler alert:   committing to steady, incremental changes is a huge wealth creator.

One of the best 401k habits is to increase your savings by 1% each year. For a person earning $50,000, 1% reduces your take-home pay by about $16. And – if you’re being honest – you’re probably spending at least that much on something less important than a healthy financial future.

But that $16 per pay really adds up. Meet Smart John and Smarter John. John earns $50,000 per year and starts saving 2% in his 401k - SMART. But Smarter John adds 1% each year until he reaches 10%.

That $16/pay leaves Smarter John with four times as much! For $16/pay, Smarter John bought himself an extra $167,000 of retirement possibility! So, every year make a habit of increasing your savings rate by 1%, a change you probably won’t even notice along the way that will make a mountain of difference in your future.

Regardless of your investing experience, you probably know that markets go up and down. In fact, they bounce around so much that being an investor can feel like riding a roller coaster. Now, there are those among us who stick with the kiddie coaster and others who have zero reservations about signing a safety waiver before climbing aboard the triple loop upside down, inside-out coaster. In investing, it’s just as important to assess your “stomach” for risk so that you can build an investment portfolio that you can stick with for the entire ride.

When it comes to investing, your “stomach” is called your risk tolerance. To get on the right investment ride, you’ll need to consider:

• Time horizon: How many years until you retire?
• How do ups and downs make you feel: Investing is equal parts emotional and financial. Be honest about how you’re likely to react when the market goes down as it inevitably will. Does a “sky is falling” headline make you hide under the covers, or do you keep going about your daily routine confident that downturns are temporary?
• Your current financial status: How solid is your personal financial situation?
• Your financial needs: What are your short- and long-term financial needs? Do you have adequate emergency savings outside of your 401k?
• Your overall financial picture: What other sources of income, aside from your retirement plan, will you have available when you reach retirement?

While it seems complicated to consider all of these things, there are risk tolerance assessments that can help. Researching and monitoring investments regularly may not be at the top of your list. If so, you might consider investing in a target date fund.

A target-date fund is a portfolio of investments managed by a team of professionals. They select and manage investments to ensure the mix gets less aggressive as the target retirement date approaches.  

Let’s consider two savers to understand how TDFs work.

Kate is 30 years old and expects to retire in 2058 when she will be 67.

Kim is 58 and also expects to retire at age 67 in 2030.

For Kate, retirement is further away which means she has a higher risk tolerance.

Kate’s target date fund manager will design a portfolio that earns more over time but also goes up and down more in the short term since her retirement (the bullseye) is still a long way off. Since Kim is closer to retirement and has less time to recover from market downturns, her portfolio manager will design a lower-risk portfolio since the bullseye is closer.

Target-date funds take the guesswork out of investing by letting investors “set it and forget it.” In fact, in most 401k plans, if you do nothing, you will be automatically invested in a target date fund based on your date of birth.

But if researching and monitoring investments IS at the top of your list of fun things to do on a Friday night… you might want to build your own portfolio from the list of funds available in the plan. There are options offered in each of the major asset classes. But – to make sure you don’t bite off more than you chew – it’s still a good idea to complete a risk assessment to figure out what type of portfolio you should build.

Portfolio risk reflects the size of the slices in the pie. The more aggressive you are, the larger the aggressive investment slices and the smaller the low-risk slices will be.

A DIY investor should…

• Have clearly defined goals
• Diversify their investments
• Be able to make decisions even when the exact outcome is not known
• Possess solid judgment and knowledge about investing
• Be composed and patient
• Avoid allowing fear and emotion to rule their decisions

There are a variety of ways to build your own portfolio. You can tackle it yourself using the resources available on your plan’s website. Or you can work with an advisor.

No matter what kind of investor you are, it’s important to maintain your portfolio. Be sure you have a plan to…

Rebalance: although target date funds will do this for you.

Over time, some slices grow bigger and faster than others. Without maintenance, the mix you originally selected changes resulting in a portfolio that is different than you intended. Rebalancing resets the slices, so your portfolio stays in balance.

Diversify: although target date funds will do this for you. Just like your grandmother told you… don’t put all your eggs in one basket

This can be a complex topic but that’s beyond the scope of today’s session. So, here, we’ll just point out that pre-tax investors take their tax benefit today because they contribute dollars BEFORE Uncle Sam takes his bite out of your paycheck. Pre-tax savers agree to pay their taxes later when they make withdrawals. This is often best for savers in high-income tax brackets who expect to be in a lower tax bracket when they retire.

Alternatively, Roth savers agree to pay their taxes now by contributing to their 401k AFTER Uncle Same takes his bite out of your paycheck. This “pre-payment” of retirement taxes means that withdrawals of both contributions and earnings are TAX-FREE at retirement.

While every situation is unique, here are some general situations where the Roth 401k might be best…

• Employees who expect to be in a higher tax bracket in retirement. These folks tend to also be
• Younger employees who have more time until retirement and more time to build tax-free earnings
• In order to contribute to a Roth IRA, your income must be below IRS limits. But Roth 401k has no such limit. In other words, any saver can be a Roth 401k saver. So employees who aren’t eligible for a Roth IRA might opt to use the Roth 401k
• Finally, Roth 401ks are inherited tax-free so if you are saving money you intend to leave to your beneficiaries, the Roth option might be best.

Okay, we are on the home stretch. In an emergency, it’s important to know what happens to your 401k.

Let’s first talk about what happens if you die. Your 401k has beneficiaries. If you don’t pick one, there is a default set by your plan. Most often the default is your spouse, then your children. But this isn’t something you should leave to default.

When it comes to managing your beneficiaries,

• Don’t leave the form blank! Failing to name a beneficiary is a big mistake. So take time to go online or fill out the form.
• Don’t designate your estate or “your will” as the beneficiary. This could lead to involving a court which can delay the distribution to your heirs for months or even years.
• Keep your info current: Many people fail to update designations after major life events like marriage, divorce, or the birth of children or grandchildren
• Lastly, consult an expert if you aren’t sure who to name as your beneficiary. Experts would include an estate attorney or a tax professional.

But there are other emergencies too and you might find you need to access your 401k to deal with them. Each plan designates how and when employees can access their savings. So, for this topic, consult your specific plan information or contact us.

In general, 401k savings are “off limits” until you reach age 59.5. If your plan allows it, however, you might be able to take a loan or a hardship distribution. A loan is repaid through payroll with after-tax dollars and includes an interest payment. Financial hardship is a taxable withdrawal. If you’re under age 59.5, you’ll pay taxes plus a 10% early distribution penalty. But consider these distributions from your retirement savings as an absolute last resort. While your current hardship is no doubt real, retirement is probably the only financial need you can’t take a loan out to cover.

Wow! We covered a lot of ground. Remember, your 401k is a key part of a secure financial future, but you don’t have to make these decisions all alone. There are lots of resources in MoneyNav for this and many other financial topics. Schedule right from your MyMoneyNav dashboard or email yourfinancialcoach@moneynav.com. If you haven’t already done so, a great next step is to complete the MoneyNav assessment. Your responses will be used to build a personalised set of best next steps or MoneyMoves to get you on track and moving forward. Email yourfinancialcoach@moneynav.com for a link to your company’s assessment.