A 401(k) plan is one of the most common types of employer-sponsored non-pension plans in the US. According to stats from various institutions, there are about fifty million Americans, if not more, who contribute to a 401(k) plan at work. It’s one of the best tools for building wealth. However, people are prone to making mistakes with their 401k plan.
What’s a 401k, and Why is it Useful for Retirement?
A 401k refers to a qualified retirement plan, allowing employees of a particular company to save and invest for their own future retirement on a tax-deferred basis. The employer is the only one who is eligible to sponsor a 401k plan for the employees, who decide how much money should be deducted from their paycheck. The deducted money is deposited to the plan based on limits imposed by various rules.
You should always read the summary plan description provided to you by the plan sponsor. But you have to remember that it’s a retirement plan and not a savings account. It provides various investment vehicles for you to choose from, including your company’s own stock, stock mutual funds, bond mutual funds, and Stable value accounts, including guaranteed investment contracts and money market funds.
4 Best Things to Do With Your 401k
Your company’s retirement plan is a very powerful tool as you prepare for retirement. Here are four of the best things you can do with your 401k plan.
Join as soon as possible
The first point is pretty obvious but is often overlooked by many individuals. The sooner one begins contributing to retirement, the better the chances are for accumulating more money. If your employer is making a matching contribution, do not delay participating, as you are basically missing out on free money.
Look to increase your contribution rate every year
To elucidate this point, let’s take an example.
- Suppose an individual earns $20,000 and makes a 3% contribution, which amounts to a total of $600 annual contribution.
- Based on the same salary, if the individual increases his/her contribution by just 1% each year for a decade, he/she will be adding $200 a year. This is less than $8 every two weeks.
- In ten years, the total contribution would reach 13% of the salary.
- If the salary of the individual grows by 3% per year, after ten years, it grows to $26878. A 13% contribution would thus amount to $3494.
- Compared to this, if the individual continues contributing 3% without changing, he/she would only be deferring $896 a year.
- The difference the additional $2598 per year would make is immense. For instance, thirty years down the line, the additional money, compounding at 8% per year (hypothetical), would give you a total amount of $317,855.
Look to contribute enough to get the full employer match
Individuals should make sure that they qualify for their employer’s maximum matching contribution.
- Let’s assume that the employer is kicking in 50 cents for every dollar that the individual contributes.
- If this is up to 6% of the individual’s $20,000 salary, they can receive a $600 annual bonus.
- This boosts the individual’s $1,200 a year deferral increases to $1,800. This amount grows tax-deferred until you choose to take the amount out.
Look to rollover your money when you leave
One of the main aims an individual should have for wealth building is to let their money grow tax-deferred for as long as it’s feasible. They should not regard the money as a lump sum when switching jobs or retiring. The individual may face an early withdrawal penalty, or they will have to pay taxes. It’s a better option to do a direct rollover to a completely new 401(k) plan if they are changing jobs, or opt for a rollover IRA when they retire.
4 of the worst things you can do with your 401k
In spite of the number of ways individuals can use 401(k) for wealth building, there are some mistakes many others make in regards to this contribution plan, mainly due to a lack of knowledge or understanding.
Joining late or not entering altogether
Waiting even some years before joining can be a costly mistake. Let’s take an example:
- An individual aged 25 wait for five years before making a $1000 per year contribution for 35 years.
- Assuming he/she earns 8% on that money, the individual would accumulate a total of $93,000 less than someone of his/her age who began contributing right at 25 and did so steadily for the next 40 years.
Being too aggressive or conservative with the investments
Individuals have to find the right balance between a conservative approach and a more aggressive approach and not lean in any particular direction. If an individual invests too aggressively, they might be exposed to too much risk.
If an individual invests too safely, such as investing in a low-yielding money market fund, he/she might lose out on significant savings over the years.
Your contribution rate is too low
An individual may be placed at a default contribution rate when joining the plan. An employee should never assume that the existing rate is enough to meet his/her retirement income needs. They have to plan to eventually double or triple the contribution at some point.
Chasing stocks which are “hot”
It’s pretty easy for an individual to get fixated on hot performing stocks. But investment performance often follows cycles. A top-performing fund can often underperform in the next year. Thus, one needs to seek the right mix and maintain it.
In a 401(k) plan, the employee is the only one who has the vested interest fully at heart. Educating oneself about the plan will prevent any kind of unnecessary mistakes, which could end up affecting the quality of life after retirement. There are numerous educational resources online where anyone can read about 401(k) plans in detail.