It’s been projected for years that the Social Security trust funds will run out by 2034. In its 2019 annual report, the Social Security Administration’s Board of Trustees pushed that projection back a year. This means that by 2035 there won’t be funds to draw on to make up the difference between what workers pay in Social Security taxes and what Social Security pays out. This will likely mean reduced benefits. So having another source of income in retirement, such as a 401k, is imperative.
What Is a 401k and How Does It Work?
One common vehicle for building up retirement savings is a 401k. A 401k is a tax-deferred savings plan offered through employers. A tax-deferred contribution reduces the amount you are taxed on in each paycheck, so the tax savings will partially offset the amount you deduct. If you contribute, say, $100 from each paycheck, your paycheck will be less than $100 lower than if you didn’t contribute (because you won’t be paying taxes on the $100 dollars you contribute to the 401k).
Basically, you don’t pay taxes on money you invest in a 401k, or the interest it earns, until you withdraw it. By then, you will likely be in a lower tax bracket due to retirement.
How Does a 401k Earn Money?
Your 401k will be invested in stocks and bonds, generally through a managed fund, with several to choose from. Look for a fund with low fees. Index funds usually have lower fees than mutual funds. But, depending on your employer, you may not have low fee funds available. Nerdwallet has a fee analyzer, and you can check a fund’s expense ratio on Morningstar (you have to have a membership, though).
The expense ratio is the amount the fund will deduct in fees. For example, a 1% ratio means they’ll charge 1% of your funds each year. That is, you’ll pay $10 in fees for every $1,000 you have invested. Many index funds will charge 0.1%, $1 per $1,000, or less.
The Compounding Effect
Over time, your investments into your 401k will earn interest. Your earned interest is added to the total amount, and so it begins to earn interest, too. Earning interest on your interest has been called “the magic of compounding,” and it will keep compounding even after you retire.
You don’t need to start withdrawing until April 1 of the calendar year after you reach 70½ years of age, or April 1 of the calendar year after you retire, whichever is later. And you don’t need to withdraw it all at once. You only need to meet the required minimum distribution (RMD).
How Much to Contribute to a 401k in Your 20s
To understand why you should start contributing in your 20s, it’s useful to know the Rule of 72. The rule of 72 is a quick way to figure how long it will take your money to double at a particular interest rate. Divide the interest rate into 72, so if your earnings average a 7% return, your investments will double about every 10 years. The sooner you start investing, the more times your investment can double before you have to start taking your RMDs.
One common illustration of the power of compounding makes investing early seem like a no-brainer. It shows that if you contribute a certain amount between ages 25-35 and then stop, you’ll have as much or much more saved by age 65 than someone who contributes the same amount per year from ages 35-65. (For a sample graph, check out this article from news site Vox.com.)
But how much should you contribute? One guide is whether your employer matches your contributions up to a certain amount. You should, at the very least, contribute enough to get the maximum contribution from your employer. However, there is a maximum amount you can contribute—the most you can contribute yearly to your 401k is $18,000.
What to Invest In
The higher the risk, the greater the return. Riskier investments, like stocks, pay more than safer investments, like bonds. You want to have a mix of both, with more risky investments when you are younger, and safer investments as you age.
Financial planners often recommend investors under 40 put about 75-90% in stocks and the rest in bonds. In your 40s and 50s start shifting the balance so that when you reach your 60s you’ll have about 60% in bonds and 40% in stocks.
Is a 401k Worth It Anymore?
A 401k is a great vehicle for building a retirement nest egg, so why are people asking, “Is a 401k worth it anymore?”
There are some drawbacks, the main one being that you can’t set up a 401k on your own. A 401k has to be offered through an employer. In a gig economy, you may be working as a contractor rather than an employee. Other drawbacks include:
- Employers may not offer a 401k until you’ve worked for 6 months or some other trial period.
- Employer contributions may not fully vest for 5 years, vesting at 20%/year. In this case, if you leave the company before that period you’ll lose some of the employer contribution.
- Fees can be significant.
- Most funds require you to cash out or rollover if the balance drops below $5,000 and you’re no longer contributing. It can take years to build up to $5,000, so if you leave your employer before then, you may have to take a distribution and pay a penalty, or roll it over into a low-paying IRA. If you’re lucky, you may be able to roll it over into your new 401k.
With all this hassle, no wonder many people are asking if a 401k is even worth it. If you find that a 401k is not worth it for you, consider a Roth IRA.
What Is a Roth IRA and How Does It Work?
An individual retirement account (IRA) is an account you can contribute to by yourself, no employer required. The annual contribution limits are lower than for a 401K—$6,000 ($7,000 if you’re 50 or older by year’s end)—but you can contribute the same amount to both a traditional IRA and a Roth IRA. A traditional IRA has the same tax-deferred advantages as a 401k, but there are differences. You have to start withdrawing at age 70½ even if you’re still working.
A Roth IRA, however, doesn’t require a distribution during the owner’s lifetime. It is not tax-deferred, but you don’t pay taxes on your earnings, so all that compound interest compounds tax-free.
You’ll likely earn a lot less with an IRA through a bank, so do some shopping around to find a Roth IRA with investments.
Whether you choose a 401k, a Roth or traditional IRA, or a mix of strategies, it is vital to start saving as soon as you can. And if you find that you need a loan along the way, check out the installment loans that Lift Credit provides.