The 401(k) Explained
Written by Bobby Kaslander
Now that we have covered a brief overview of some of the basics and “defensive” aspects of financial planning (big law salary pay scale, understanding your paystub, income taxes, importance of an emergency fund), let’s move on to some of the “offensive” parts of financial planning, starting with investing in your employer’s 401k Plan.
In continuation of the Big-Law Associate’s Financial Playbook Series lets take a closer look at contributing to your companies 401(k), the pros/cons on maxing out your 401k, Traditional vs. ROTH, and how to choose the correct allocation or funds to invest in.
Starting with the basics…
“What is a 401(k) and does my employer offer it?”
A 401(k) is a tax-advantaged retirement plan that is set up and managed by an employer. It gives employees an option to contribute a portion of their paycheck into the 401(k) account where the funds can be invested and potentially grow tax free over time. In most cases, you choose how much money you want to contribute to your 401(k) based on a percentage of your income.
For 2024, the maximum annual contribution the IRS allows you to contribute is $23,000. For example, if you are making $250,000 per year you have the option to contribute up to 9.2% of your salary to your 401(k).
“Should I contribute to it?”
The first question you should ask yourself is “why should I contribute to a 401(k) in the first place?” Generally speaking, I believe the most important answers to that question are as follows:
- The Future. Retirement on average can last 25% of your entire life. You’ll need to fund it one way or another. Having an automated forced savings vehicle helps fund your future.
- Tax Advantages. Depending on if you choose traditional or ROTH (which we will cover later in this post), you may be able to reduce your adjusted gross income and have your contributions tax-deductible. Growth on the invested funds in the 401(k) are either tax-deferred or tax-free as well.
- Stock Market Returns. 401(k)s give you an easily accessible way into the stock market. The S&P 500, which is a broad index of the US Stock Market, has averaged approx. 10-11% each year over the last 100 years. This has historically been one of the best inflation hedges out there, hence why over 65% of US adults have money invested here.
- A Match. If your company provides it, most big-law firms do not unfortunately. Many employers match a portion of the employee’s own contributions up to a certain dollar amount or percentage. This is a powerful incentive for companies wanting to appeal and retain good employees. Financial professionals (myself included), will recommend contributing enough from each paycheck to take advantage of any match that your employer offers. Otherwise, you are losing out on part of your compensation and leaving FREE money on the table.
Beyond that, how much you should contribute depends on a variety of factors, including your age, your retirement plans, student loan debt, cash flow, real estate goals and more. And on this topic, advice varies. We recommend speaking with a licensed financial advisor to determine how much you should contribute to your 401(k) given your own personal financial goals.
To reiterate my point above, advice will vary depending on your own personal situation. Generally speaking, I believe it’s important to contribute some amount to a 401(k) each month (even if it’s 2-3% of your income). This can be used as a forced savings tool that is earmarked for future benefits. By building out a forced savings vehicle this creates good savings habits that carry over throughout your entire life. Whether or not you should max-out the 401(k) each year is case dependent, and I recommend speaking to a licensed financial professional if you have further questions.
"What's the difference between a Traditional & ROTH 401(k)?"
Let's tackle the difference between “traditional” vs. “ROTH”.
Traditional contributions are made with pre-tax dollars. The money therefore is tax-deductible and taken off gross income which lowers your adjusted gross income. The money in this account then grows tax free, however you’ll have to pay income taxes on the way out when withdrawing. The advantage of this approach is that you save the money immediately by reducing your current tax burden and lowering your AGI, which can be significant during your working years when you are paying a high marginal tax rate. The downside to this approach is that there is no certainty what tax rates will look like in the future. While conventional wisdom may tell you you’ll be in a lower tax rate come retirement since you are no longer in your peak earning years, while that may be true, other factors may bump you into a higher tax rate whether you like it or not (social security income, pensions, a working spouse, rental income from investment properties, etc.)… The individual income tax rate has varied significantly over time being as high as 90+% throughout the 1940s-1960s. My point here is that anything can happen with tax law. By choosing traditional route, there is some uncertainty on the future of our income tax system.
Roth contributions are made with after-tax dollars. The money grows tax free and then you never have to pay taxes on the money again. All qualified withdrawals are tax-free. The benefits of this approach is clear. All growth, gains, and distributions from the ROTH account are TAX-FREE. The downside to this approach is that is tax rates are lower in the future, and if you are in fact in a lower tax rate in retirement, then you essentially overpaid in taxes and lost out on liquidity during your working years. Personally speaking, I typically recommend (and take the same approach in my own situation) the ROTH route as I like the idea of having a tax-free asset later in retirement. I also firmly believe tax rates will likley go up in the future, so I’d prefer to lock in my tax rate today with the IRS vs. down the line.
The Takeaway:
Many advisors I’ve spoken with will give you different answers and different approaches to this topic. As with how much should you contribute to the 401k, I believe Traditional vs ROTH is also case dependent and can vary by each individual. Nonetheless, a safer more conservative route is splitting your contributions 50% (half traditional, half ROTH) as most 401k platforms now allow this. This way you are hedging yourself against lower/higher tax rates in the future!
“How should my 401(k) be allocated / What to invest in?”
To echo my previous points, there is no one-size fits all approach when it comes to your 401k allocation. Advice will vary depending on individual circumstances such as time horizon, financial goals and risk profile. It is always recommended to speak with a licensed financial advisor for direct investment advice. My goal of this section is to provide an overview of different investment strategies within the 401k and to provide a list of things to be aware of.
Do’s 401(k) Investing:
- Do consider investing in a target date fund – it can help simplify the investment management of your company retirement plan. Target date mutual funds let you invest in a single portfolio with an asset mix that becomes more conservative as the target date nears. These funds are often used as an investor's single portfolio when investing for retirement. The investor generally does not have to worry about rebalancing the portfolio as they age. They are suitable for investors who prefer a hands-off approach to their investing. They offer investors the benefit of diversification, the simplicity of one-stop shopping for a blend of equities and fixed income securities, and the convenience of automatic asset allocation rebalancing. The downside is they were designed to re-balance relative to your age, not relative to how the market is performing, so they're unlikely to optimize your returns and very likley to underperform the general market performance. Some TDFs can also carry hefty fees that cut into your retirement savings.
- Do invest according to your time horizon and risk tolerance – this can take the form of a target date fund or a certain ratio of stocks to bonds, but more on that in a later post. Generally speaking, the longer time horizon the more equity heavily weighted your portfolio should be.
- Do diversify properly – if you go the do-it-yourself route instead of a target date fund, then make sure you hold funds that provide proper diversification between a mixture of funds. Speak to your financial advisor on this.
Don’t of 401(k) Investing:
In my professional opinion these are more important!
- Don’t try to time the market – time in the market is better than timing the market. Remember, timing the market involves two decisions that you must time correctly: selling out of the market and buying back into the market. Even most professional asset managers don’t outperform the market!
- Don’t stay in cash or cash-like investments – your 401(k) is a retirement plan that should be invested stocks and bonds with an objective for growth, especially if you have a long time horizon. You need your account to grow beyond just your contributions to help fund your retirement and to help hedge against inflation.
Final Takeaway:
The 401(k) is a great retirement savings tool that offers many unique benefits such as easy access to the stock market, tax benefits, and a “forced” savings vehicle. If you have any additional questions on how much to contribute, traditional vs. roth, or how to properly allocate the 401k, we recommend reaching out and speaking to a member of our team here at Power Forward Group.
Sources:
https://www.investopedia.com/articles/retirement/082716/your-401k-whats-ideal-contribution.asp
https://www.allgenfinancial.com/401k-investment-strategy/
https://humaninterest.com/learn/articles/contribute-401k-even-theres-no-match/
https://www.irs.gov/retirement-plans/plan-sponsor/401k-plan-overview
Disclosure:
The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security. Past performance is not a reliable indicator of future results.
The principal value of Target Date Funds is not guaranteed at any time, including at or after the target date.
Diversification is a strategy designed to help manage investment risk. It does not guarantee a profit or protect against investment loss in declining markets.
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