As of 2019 the maximum contribution you can make to your 401(k) is $19,000, $25,000 if you are over 50. That amount will increase to $19,500, $25,500 if you are over 50 in 2020. If you are planning on leaving your current job or already have and your 401(k) is still sitting there you have a few options. You could move it into your new employer’s plan or leave it where it is and pay higher fees. You could also withdraw the funds but then you would be subject to an early withdrawal penalty if you are under 59.5 plus tax. What I recommend is to roll that 401(k) into an IRA account. By doing this you can not only reduce the amount of fees you are paying buy you also vastly increase the investment options available to you. Most employer plans only have about 20-30 investment options and those typically are target fund accounts and company stock. By rolling into an IRA you can now invest in everything from mutual funds, ETF’s, index funds and individual stocks like Apple and Amazon.
There are many different 401(k) products available to you today that all the information out there may seem a little confusing. There is the Solo 401(k), SIMPLE 401(k), Small Business 401(k) but the most common and the one we are going to be discussing today is your everyday employer or company sponsored 401(k). In 1978 Congress passed the Revenue Act of 1978 which included a provision that was added to the Internal Revenue Code – Section 401(k)- that allowed employees to avoid being taxed on deferred compensation. New rules and regulations have since been put into place, but the basic principles remain the same today. The biggest hurdle for most people is just getting started. It may be that you are just putting it off for another day or you feel you can afford to make contributions right now, but the truth is only 44% of eligible participants are contributing to a 401(k) plan and those are the ones who will be fighting an uphill battle down the road and will not be able to build real wealth.
When setting up your 401(k) with your employer there are several questions you should ask yourself before starting. First and the most straightforward is, does your employer offer a company match? If the answer to that question is yes, then make sure to contribute at least the minimum amount needed to take advantage of the full match. If you are not doing this then it is like saying no to free money. That extra 1 or 2 percent out of your pay is not going to make or break your break you, but an extra 1 or 2 percent over 20 or 30 years with compound interest can equal hundreds of thousands of dollars. The average match today is 4.2% and 25% of 401(k0 participants do not take advantage of their full employer match. Here is a quick example of this. Let’s assume you earn $50,000 per year and your employer will match 3% of your pay dollar for dollar. That’s $3000 a year and at an 8% average annual return you would have $372,589.86. Using this same example but you only put away 2% and earned the matching 2% for a total of 4% your total value would be $248,383.31. That’s a difference of $124,206 for only 1% more each pay. If you are paid biweekly that is only $19.23. That is the beauty of compound interest and the difference even 1% can make. Imagine if you increase your contributions by 2% or even 3%, what kind of a difference it could make.
The next step will be to determine if you will make your contributions pretax or after tax, which would be a Roth 401(k) contribution. The difference between to the two is in the traditional 401(k) your contributions are made pretax, thus reducing the amount of taxes you would owe in that year. The Roth option makes contributions after tax but all the interest you earn grows tax free and when it comes time to withdraw those funds you would not be subject to any taxes on you gains no matter how big they are. There are a lot of factors to consider when determining if the Roth 401(k) option is best for you, such as do you plan on working during retirement, how likely is your income to increase between now and retirement. While we can not predict the future if you believe your income will be higher in the future or at retirement then the Roth choice may be best for you to avoid having to pay a higher tax. When you are first starting with your career chances are you may not be realizing you biggest earning potential yet, and this is a great time to make contributions to a Roth 401(k). If you are already in the 10% or 12% tax bracket the advantage to saving tax now may not outweigh the savings down the road when your income has increased, and you are in the 24% or 32% tax bracket.
Lastly, you will need to pick what your contributions will be invested in. As I stated early most employers offer a small group of investment options, typically being target date funds. A target-date fund is a fund offered by an investment company that seeks to grow assets over a specific period of time for a targeted goal, which would be retirement in this case. The best way to determine which target date is best for you is to estimate what you will retire and choose the fund that most closely matches that year. The longer the target date is in the future the more tolerance there is for risk. As the years go by and the date gets closer the mix of assets becomes more and more conservative to preserve that which was earned in previous years. Occasionally your employer will offer some other investment options or the opportunity to purchase company stock with your contributions. Make sure to understand what you are investing in and to keep an eye on the fees you are charged as well to preserves as much wealth as you can.
Joe Pietrzak is the writer of this article. Feel free to email me at joepietrzakproperties@gmail.com with any questions or comments.
Disclaimer: I’m not a lawyer or accountant, and this is not legal or accounting advice. This information is based solely on my own personal opinions.
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