Workplace retirement plans, such as 401(k)s, are the vehicles many Americans use to become millionaires.1 But knowing how to leverage your 401(k) can be confusing, because each 401(k) plan can have different rules, costs and investment options. Understanding some basic things about your 401(k) can help you build your wealth effectively. In this article, we’ll look at four things you can do to take advantage of your workplace retirement plan as an employee.
1. Know the Rules and the Costs of Your 401(k)
The first thing you should do is ask your HR department for a copy of your 401(k)’s summary plan description (SPD) and 404(a)(5) notice. These are fancy terms to describe the rules and costs of your 401(k).
The SPD will tell you when you can start using the 401(k), how often you can change the amount you’re contributing from your paychecks, whether there’s an employer match or profit sharing, how long you must work at the company before you’re fully vested and other useful information, all in plain English. Take time and read through this document to understand your 401(k). Your company may even have a Plan Highlights document that will give you the basics in just one to two pages.
The 404(a)(5) will tell you which investments you have access to as well as how much you’re paying in administrative costs, recordkeeping costs, advisory costs and investment costs (called expense ratios). It will also showcase the historical performance of investment funds in your 401(k).
2. Get That Money and Work on a Plan to Save Enough for Your Retirement
If your 401(k) has a match, do your best to contribute enough from your paychecks to get the full match, and then work toward saving the amount you need to achieve your retirement goals. Be mindful of how often you can make contribution changes to your 401(k). According to a recent comprehensive study, most Americans should save 15% of their annual income to achieve their retirement goals.2 This 15% includes any employer contributions, such as matching or profit sharing. However, 15% is just a “quick and dirty” recommendation, because each of us has different wants and needs in retirement. Someone who starts saving for retirement at age 21 may not need to contribute as much as someone who starts saving at age 40. The amount you should work toward saving for retirement will require you to answer just three questions:
- At what age will I start taking distributions from my retirement accounts?
- How much money do I need each year in retirement?
- Am I invested in a portfolio that’s aligned with my goals?
You may not have definite answers to these three questions, so be sure to ask yourself these questions every so often and adjust your retirement savings and investment portfolio accordingly. Most Americans retire in their mid-60s3 and spend 55%-80% of the amount they were making just prior to retirement,4 but you might need to spend a different amount, and you may want to retire at a different age than what is “average.” Once you have an idea of what your retirement age and spending needs will be, use a financial calculator to run updated projections for your retirement.
You’ll also want to give serious consideration to how you’re invested in your portfolio. More on that below.
If you have access to a 401(k) advisor, set up a meeting and have them help you with the entire process. It’s very important to have a road map for retirement and update it as often as necessary; having a trusted guide to help you build and fine-tune your retirement road map is highly recommended. I like to update my own retirement projections with my advisor once per year or whenever I have any big life changes.
3. Invest in a Portfolio With the Right Level of Risk for You and Stick With It
Today’s investors often must take on more risk than investors of the past in order to get the investment performance they need to achieve their retirement goals. This is largely a function of today’s relatively low cost to borrow money (interest rates), which impacts how much you’re projected to make from some of your investments (namely bonds). Our central bank, the Federal Reserve, is currently raising interest rates, which will change the investment landscape. This alone is a good reason to update your retirement road map with your advisor as often as necessary! Over the long term, stocks tend to make more money than bonds, but stocks are a bigger rollercoaster than bonds. Bonds tend to isolate us better from the ups and downs of the stock market, but they also tend to not pay us as much as stocks do in the long run.
A good rule of thumb is that if you have ten or more years until you’re planning to retire, owning diversified stocks will put you in a better position to build your wealth than owning bonds. But once you get within a decade of retirement, you don’t have as much time to take those kinds of risks, and owning some bonds in your retirement portfolio is generally a good idea.
More importantly, you shouldn’t get on a rollercoaster if you might jump off when it’s going down! Always be diversified, and work with your advisor to figure out the appropriate mix of stocks and bonds for your stage of life and retirement needs. Then commit to staying the course through both good times and bad. Don’t freak out! If you stay on the ride, you’re going to have a lot more fun than if you jump off.
4. Don’t Let Money Burn a Hole in Your Pocket
Our brains are wired to survive, not save for retirement, which makes this whole thing tricky. Unfortunately, delayed gratification is not deeply embedded in our nature! As a result, my final recommendation is to save first and spend what’s left. Automate your retirement savings so that you never see that money land in your bank account. Challenge yourself to save a little bit more for retirement as often as you can, and understand that if you keep money in your pocket or at the bank, you’ll be more likely to spend it frivolously.
Here are some practical tips for saving and investing for retirement:
- If you have any high-interest debt, such as credit card debt, work on paying that off before you save significantly for retirement.
- If you can afford to contribute enough to your 401(k) to get some or all of your employer’s match AND pay down your debt, try to do that. If not, you may need to pay off debt before you save for retirement. Always remember: the power of compound interest can work for you or against you. With high-interest debt, it works against you.
- Try to save three to six months’ worth of your monthly spending needs in a bank account for emergencies.
- If you don’t have an emergency fund, make it a priority over retirement savings.
- If you can save for emergencies and get the employer match, try to do both.
- If you have a two-income household, three months is okay. If you have a single-income household, I’d recommend six months of spending needs for emergencies.
- Every time you get a raise, bump up your 401(k) contribution by 1%-2%. You probably won’t even notice it.
- If your 401(k) has both pre-tax and Roth options, speak to your tax professional or financial advisor to determine which contribution type is best for you.
- With a traditional account (pre-tax), you don’t pay taxes until you spend the money in retirement, and you may deduct any pre-tax contributions from your taxable income when you do your taxes. This may make things “easier” today.
- With a Roth account, you pay taxes when your contributions go into the 401(k), and if you follow some simple rules, all the growth on those dollars is tax exempt in retirement. This may make things “easier” in the long-term.
- Keep in mind any employer contributions (such as a match or profit sharing) will be taxable to you in retirement. You may be able to convert these dollars to Roth dollars, and pay the taxes when you convert, but that’s beyond the scope of this article.
Are you ready to start planning for your retirement? Creative Planning can help. As a nationally recognized wealth advisory firm, we deliver a team of credentialed, educated, experienced and action-oriented advisors, including Certified Financial PlannerTM professionals, attorneys, insurance specialists and other professionals dedicated to helping you achieve your goals. If you’re ready to speak to someone about your unique situation, please schedule a call.