Investing at Work – Understanding your 401(k) Options

401(k) Introduction:

The most frequent questions coming from young professionals are in regards to their 401(k) retirement savings accounts at work. Most major employers are transitioning their retirement benefits from the traditional defined benefit programs (like a pension plan where workers get a specified dollar benefit paid monthly in retirement) to a defined contribution plan like a 401(k) plan where employers agree to give you a defined amount of money now and let you invest it. This is a much less risky format for companies since they pass the investment risk to the employees and they don’t have to agree to pay someone for the rest of their life (whose longevity is undetermined and thus risky). But savvy investors will likely be able to receive much better returns in the long-term through investing the money themselves instead of having the company invest for them and then pay out a pension.

401(k) plans are offered by most large private sector employers. Similar offerings by non-profit and public education organizations include “403(b)” plans, and “457” plans for government employees. Since all three of these are very similar we will lump them together and refer to them collectively going forward as your “401(k)” plan (since it is the most frequently used). If your employer doesn’t offer a retirement savings plan then fast-forward to the next section to learn how to open an IRA (individual retirement account) to begin saving for your retirement.

The term 401(k) itself means nothing – it is just referring to an IRS tax code created in 1980 that allows for special tax treatment for these types of retirement savings plans. Every person who has access to these types of plans should absolutely take advantage of them. Most companies offer to match some portion of your contributions to your accounts, and those who delay setting up their contributions are essentially refusing to take free money. Get focused and set up your 401(k) account the first week you start your job.

These retirement savings plans are critical vehicles for young professional investors to use to save and invest for retirement. Saving for retirement, even though it may be 40 years away, allows investors to begin compounding their investment. Refer to the charts and descriptions in the “Stocks over the long run” section under the “Why equity investing” page to see how returns over extremely long periods build upon themselves exponentially to create a huge nest egg for you to live off of in retirement. In 2018 401(k) accounts allow for up to $18,500 in annual employee contributions so you have the ability to put a large chunk of funds away for retirement each year into these tax-advantaged accounts.

Monies contributed to these accounts are strictly for your retirement savings – the majority of withdraws before you turn 59.5 years old are subject to your regular income tax levels plus a 10 percent penalty (unless you face rare extreme hardships like a permanent disability) which is critical to avoid (referring to the penalty … but also please avoid permanent disabilities if you can). Therefore, we are going to set up a nice retirement savings account here and in the next section, we will take you through how to use your additional savings to begin investing for your personal account (which you can withdraw from at any time for emergencies or major purchases).

Generally, most employers offer only one type of 401(k), but a recent rule change has allowed for another 401(k) account type. You will need to decide which one is the best fit for you. Here’s a breakdown of your two options:

1) Traditional 401(k):

This is the most frequently used 401(k) account type. This account allows you to automatically send money into the account from your paycheck at a set percentage or dollar amount every pay period (which nicely follows one of our investing principles “make it automatic”). Whatever money goes into this account is not subject to income tax withdraws in your pay cycle, and you will not pay income tax on this money when you file your annual tax return. These are “pre-tax” contributions.

For example, you currently make $50,000 a year. You set a 5 percent allocation to your 401(k) and you get a match up to 5 percent of your contributions from your employer. So over the course of every paycheck that year you have contributed a total $2,500 to your account, and your employer also chipped in $2,500 … so you have $5,000 in your account. At the end of the year, you will only have to pay income taxes on $47,500 since you sent $2,500 of it to your retirement plan “pre-tax”. If your overall income levels put you in the 25 percent marginal tax bracket you will have avoided paying 25 percent in taxes on $2,500 (keeping $625 in your retirement savings instead of giving it to Uncle Sam).

But, you won’t avoid paying taxes forever. When you begin withdrawing money from this account in retirement in 30-40 years you will have to pay income taxes on all funds distributed at that time. What will the tax rate be then? Who knows! It will depend on your tax bracket in 30-40 years and what the marginal income rates are within each bracket at that point. Note that you will pay your marginal income tax rate on all of the money you take out, which includes the sizable gains that have built up over the decades (you will not pay the favorable capital gains rate which is currently 15 percent).

This point is at least 30, maybe upwards of 40 years away for many of us. Since our timelines for this money is extremely long, if you have the risk tolerance for it, 100 percent of this money could be allocated to stocks and none of it is left to lower performing long-term assets like cash and bonds. Please refer to the material on “Why Equity Investing” if you want to understand more about the risk and reward associated with a high equities allocation.

2) Roth 401(k):

The difference with this 401(k) account type is that you contribute money to the account “after-tax”, so you pay income taxes on everything and then send a percentage of your after-tax income to the account. “Roth” is the name of Senator William Roth of Delaware who sponsored the legislation to create this type of account in the late 1990s.

So in our previous example remodeled: You make $50,000 and are in the 25 percent marginal federal tax bracket. You elect to send 5 percent of your salary which after 25 percent in taxes paid is $1,875 to your Roth 401(k). Your employer’s match can’t be made after-tax due to silly tax rules so it is made as a 5 percent pre-tax contribution to a separate account, so only your contributions will receive the after-tax treatment. So, your employer kicks in 5 percent pre-tax of $2,500, and your ending year balance is $4,375 (spread across a pre-tax and an after-tax account).

So this is less than the $5,000 in the Traditional example, so it’s obviously a crappy deal right? Not exactly. All of the money you contributed to your after-tax account is now free and clear of all taxes forever. So all of the sizable gains that you will build up in the portfolio of your contributions over many decades are all yours. No kickbacks to the man required in 30-40 years. The money from your employer match, however, acts like a Traditional 401(k) where any withdraws in retirement from that account will be taxed at your marginal income tax rate.

Which account type is right for you? Essentially if you choose a Roth 401(k) you are betting that you will have a higher income and thus be in a higher income tax bracket when you distribute fund from the account after age 60 (even if you are retired … say through income off a business you own or sizable income from your non-retirement investments) compared to your income levels now, and/or that income tax rates within each bracket will be higher when you retire. This is ideal for a person currently in an entry level job that will be pursuing graduate degrees. The assumption is that you will make much more money later in life compared to where you are now, so you want to pay taxes now instead of paying them later.

For users of a Traditional 401(k) you are betting that you will have lower income levels in retirement (thus you will be in a lower income tax bracket then) and you wish to defer paying income taxes until this point. This would be best for persons in a career path that have high salaries now but limited income growth potential. You are also betting that the percentage rates within each bracket will be lower in the future.

Still can’t decide? The good thing is that as long as you are contributing to either type of account then you are on the right path. As we age we will finally have enough loots to where it makes sense to get a professional to help with this. It may also be strategic to diversify your tax bases…or in other words to have both types of accounts. That way you don’t have to imagine what the tax brackets will look like in 30-40 years since who knows, maybe the feds will shift to a sales tax strategy and radically lower income tax brackets? Or maybe you will stumble upon a lot of money later in your career and your original plan of paying taxes later in your life would then look unattractive!

Generally, young professionals are best off that if they are in a 25 percent marginal tax bracket then to use the Traditional 401(k) option (and then perhaps you can also fund a Roth IRA as explained in our following sections so you have money in both tax “buckets”). If you are within a 15 percent marginal tax bracket then a Roth 401(k) contribution could be attractive. As long as you start contributing now and you contribute enough to get the full match by your employer (if you have a 5 percent match available but only contribute 4 percent then you are avoiding free money) then you will be fine either way.

The Costs of Waiting:

Anyone can find an excuse to put off pushing money aside for retirement: It’s too complex and I’m busy, I need money now since I just got out of school, I’ll do it later …

But the problems with delaying setting up your 401(k) are magnified even more if you are passing up the option to get an employer match. If you get a 5 percent match then the first 5 percent of your income that you set aside for your 401(k) essentially automatically receives a 100 percent return on investment. No investment option will ever offer an immediate and guaranteed return like the matching money offer by your employer.

The main issue facing young professionals is they are heavily indebted from school and thus can’t pay down loans like they want to and still save for retirement. The rates on your student loans are probably less than 7 percent, and your credit card is at most 20 percent. If this is your excuse for not contributing to your 401(k) and you miss matching money then your gap is still an 80 percent return between interest building up on your credit card and the missed investment opportunity in your 401(k). Continue to pay down debt; just don’t miss this opportunity … so pay your debt down slower in this case.

If things are just “tight” and you aren’t able to save 5 percent of your income, then the hard truth is you are simply living beyond your means. Even if you aren’t offered a 401(k) match by your employer you should still set aside 5 percent of your income into an IRA or Roth IRA with the goal of building your overall retirement savings rates towards 15 percent of your income. If you are unable to meet these savings targets then set a goal to adjust your lifestyle since your current spending levels are simply not sustainable, and you are not setting yourself up to build wealth.

To hit this point home I want to give an example of someone who begins contributing to their 401(k) at 25 compared to someone who starts at 30. Let’s start with a few assumptions:

      • You will retire when you are 60.
      • Current income at age 25 is $50,000.
      • You contribute 10 percent and receive a 5 percent match from your employer.
      • Your income grows annually at 4 percent (this is going to vary greatly among us).
      • The compounded annual return on your 100 percent allocation to equity investments is 10 percent (large U.S. stocks have returned 10.1 percent as a compound annual return according to the Ibbotson 2015 Yearbook).

In this scenario, the champion who got focused and set up their Traditional 401(k) at age 25 will have almost $945,000 more in their retirement account than the slacker who waited five years to get contributions rolling. Here is this scenario presented graphically (Remember, this assumes a steady compounded investment return rate. Your investment returns will be volatile but over the long-run, if these averages hold then your ending balances should approach those represented below):

  • The ending balance in a traditional 401(k) based on the above assumptions is $3,351,093 for an investor starting contributions at age 25 compared to $2,406,115 for an investor starting contributions at age 30.
  • This massive difference is even larger when we account for those who also began additional savings outside of their 401(k) at age 25 compared to 30.

These numbers are not inflation adjusted – meaning that these balances will be worth relatively less in 40 years compared to now since prices for all goods will be higher due to inflation. However, the difference in your account balance seen through investing early is still sizable and will result in a much more favorable retirement for those who got started early.

Setting Contribution Levels:

When selecting a salary deferral percentage in your 401(k) there are several things you should consider. The end goal of retirement savings is to put yourself in the position to build a portfolio of investments that you can spend from in retirement so that you can walk away from your job and forgo your paycheck. This is known as independent wealth – where you have the ability to rely on your own investments for income instead of a job or a pension or any outside income source. The illustration below shows that a significant level of ongoing savings over a long period of time is required to reach independent wealth:

Assumptions:

  • Save 15 percent of your pre-tax income for 36 years.
  • Do as much as possible in tax-favored accounts such as Roth IRAs and 401K/Profit Sharing Plans.
  • This is based on a beginning $30,000 income, rising 4 percent per year. Adjust your situation, up or down, from the $30,000 example.
  • Total stock market results are estimated at 10 percent annually in the future.
  • With 11 percent returns, it would take about 34 years to achieve these results. 9 percent returns would take 39 years and 8 percent returns would take 42 years.
  • Begin spending 5 percent annually in retirement.
Year Income 15 Percent Annual Savings Portfolio
 1  $30,000 $4,500 $4,706
 5 $35,096 $5,264 $30,811
 9 $41,057 $6,158 $73,188
 13 $48,031 $7,205 $131,087
 17 $56,190 $8,429 $230,351
 21 $65,735 $9,860 $382,210
 25 $76,901 $11,536 $612,186
 30 $93,562 $14,034 $1,068,283
 36 $118,385 $17,758 $2,021,305
 -17,758  ——–        x 5 percent
 $100,627  $101,065

Note how it took almost over three and a half decades of diligent ongoing savings that are invested correctly in order to fully replace the lost income in retirement with a reasonable 5 percent portfolio spending rate. If one were to save 20 percent annually in this illustration there would be about 33 percent more in the portfolio after 36 years. With 7.5 percent annual savings there would be 50 percent less. And if the funds were invested more conservatively with a 50 percent equities and 50 percent bonds allocation you could expect about 35-40 percent less money left at year 36. Invest early, invest strategically focusing on equity investment for growth over long time frames, and invest on an ongoing basis to get yourself towards independent wealth!

It is understandably difficult to reach the 15 percent savings rate for retirement so use that as an end goal to work towards. But by all means, strive to set your contribution percentage amount at least to the employer match level. If you don’t have an employer match or you need to wait several years to “vest” the matching money (which means you must earn the matching money through tenure or you don’t begin to receive matching money for several years), still contribute at least 5 percent so you can begin building a balance and get used to the money leaving your paycheck and living on what is left.

You should also consider how much you are able to save outside of your retirement account. You want to have additional money saved that isn’t subject to withdraw penalties (like your 401(k) assets are) so you can have money at some point for major purchases like a down payment on a home. Setting your percentage contribution so high that you aren’t able to save money outside of your retirement accounts can lead you to not achieve your non-retirement financial goals. If you can save 5 percent in your 401(k) and have plenty of money left over after-taxes to spend and save in a personal investment account (that section is next), then maybe you can ratchet up your percentage past the employer match. Eventually, you will run into contribution limits which for 2018 dictate that you can’t contribute more than $18,500 per year to your 401(k) account. So, regardless of your employer match, contribute at least 5 percent. Then, increase this amount over time to work towards the 15 percent target retirement savings rate and beyond to even maximize the annual funding if you are able to.

Selecting Funds Within Your 401(k) Plan:

Now you’ve got an account type figured out and picked a percentage of money that will flow into the account each pay period. So, where does that money go? Here we will go through the funds available in your 401(k) plan. Each employer selects various types of professionally managed mutual funds so this menu will vary from employer to employer. You aren’t able to select individual stocks or bonds, but rather you can choose from a limited number of mutual funds – or funds that will spread your money across many different individual investments. The chart below will try to give a generic description to match the fund that is likely available to you, describe what it is, and provide comments as to what general allocations to these funds would be ideal to an investor with a very long time horizon to retirement (20-30+ years). Remember your fund names and types will likely sound different but they should resemble the fund description provided below.

At the highest level – remember this money is strictly for investing for our retirement. This point is at least 30, maybe upwards of 40 years away for many of us. Since our timelines for this money is extremely long, it is best that 100 percent of this money is allocated to stocks and none of it is left to lower performing long-term assets like cash and bonds. Please refer to the material under the page “Why Equity Investing” if you still don’t agree or need more clarification on the importance of this item.

Please do your own research on funds in your plan before selecting your investments so that you understand the investment’s risks and expenses.

Fund type: Fund Description: Allocations:
Cash-like options: 0 percent
Stable Value Fund These “cash-like” funds are only available in 401(k) plans, and have historically offered higher yields than regular money market funds due to their ability to invest in more riskier and complex short-term debt. 0 percent
Short-Term Treasury These funds tend to invest in only short-term government debt. Since the yield curve is so low as seen in our Investment Classes page these funds are yielding less than 1 percent. 0 percent
High Income Money Market Money market funds primarily invest in short-term government and company debt, but due to the low rate environment, they also continue to yield next to nothing. 0 percent
Fixed-Income options: 0 percent
Short-term bond Short-term funds invest in debt that is due in generally less than 3-5 years. These funds can invest in a variety of bonds including government and company debt. 0 percent
Medium-term bond These funds will take on more risk than short-term bonds by buying longer-term debt, but long-term returns still are unfavorable to stock/equity investments 0 percent
High-yield/Foreign bond A fund that advertises “high-yield” debt means they are investing in “junk” bonds, or those that have low credit quality and thus offer higher yields. They may also invest in bonds outside of the U.S. 0 percent
Equity fund options: 100 percent
Large Cap Growth Big companies that have growth prospects. These funds generally have a high concentration of companies with higher “P/E” ratios which signifies that they are expected to grow their earnings. 25 – 30 percent
Large Cap Value Big companies that have lower valuations relative to growth companies. These funds will look for stocks that may pay a dividend and have a P/E ratio that is below the overall market. 25 – 30 percent
Small/Medium Cap Growth These funds look for smaller sized companies that fit the “growth” criteria mentioned above. It is good to have diversification among different sized

companies as well as different industry types.

5 – 10 percent
Small/Medium Cap Value Smaller companies that may pay a dividend and have below-market valuation ratios. 5 – 10 percent
International – Europe/Pacific So far we have diversified among different types of companies in different industries and different sized companies. Now we are going to add further diversity to lower overall risk by investing in companies outside of the U.S. This fund will invest in larger, more established economies like countries within Western Europe and developed Asian countries like Japan. 15 – 20 percent
International – Emerging Markets Emerging economies also offer attractive growth opportunities as their economies are rapidly expanding, but stock investments in these countries are normally more volatile than U.S. companies. These funds will buy stock in companies from countries such as Brazil, Russia, India, China, and many other smaller nations with above-average economic growth rates. 5 – 10 percent
 

 

Index Funds

These funds are designed to mirror movement in major indices like the S&P 500. These funds are attractive in many cases due to their low fees and broad diversification. If the majority of your fund options have high expense ratios then you will likely be better served to pursue an index fund if they are available. Then also obtain some international exposure on top of your US equity-based index option. 0 – 80 percent
 

 

Company Stock

Employers sometimes provide some of your matching money in the form of company stock, and they also give you the option to buy more shares in your plan. Be sure that this allocation doesn’t exceed 5-10 percent at any time as you don’t want to have a large chunk of your retirement savings reliant on one investment. There are examples of employees in firms like Enron who had 50 percent+ allocations to company stock that unfortunately got half of their retirement account wiped out when the firm unexpectedly declared bankruptcy. 0 – 5 percent
Target date funds: 0 percent
Retirement funds 2015, 2020, 2025 … These funds are relatively new investment vehicles that offer investors automatic rebalancing of their investments from riskier investments (stocks) into safer investments (bonds, cash) as they approach retirement. But, we are so far away from retirement, and funds for our generation in certain cases inappropriately allocate up to 20 percent to cash and bonds…money that could be earning higher returns over the long-term in stocks. 0 percent