Does your company offer an employer sponsored retirement savings plan or 401K? If so, is it a given to invest? In short, YES, YES, YES!
Chances are, you will have an opportunity to participate in a 401K plan and while the specifics can vary between employers, the fundamentals will generally include:
- Pre-tax (tax deferred) contributions – You can invest money pre-tax which can reduce your taxable income (today). Don’t be fooled though, most things are not free and that is especially true when it comes to taxes and let’s face it, the government wants its cut. If you are investing pre-tax dollars, you will pay taxes when you draw from your 401K later. Further, your money grows “tax free”. Hence the reference “tax deferred”.
- Limit on what you can contribute – you cannot put all your income into a 401K. This is regulated by the IRS who places maximum limits each year. Currently (2017), the maximum you can contribute to a 401K is $18,000 (unless you are older than 50, then you can contribute an additional $6,000)
- Company match – Many employers offer a company match which basically means your employer will match some portion of the money that you contribute. For instance, your employer may match your first 3%, dollar-for-dollar or maybe match your first 6% at .5% of each dollar you invest (Basically, when you invest 6%, your company will match it with 3%). In some cases, there is a vesting period of the company match which means you need to stay with the company for some period before you get your employer’s contribution. However, the portion contributed vests immediately.
- Penalty for early withdraw – One of the rules associated with these plans is you cannot withdraw funds prior to retirement (Hence the name “Employer Sponsored Retirement Savings Fund”) without suffering a penalty. The earliest you can draw on your 401K penalty-free is 59 ½. There is also a requirement that you must start drawing on your 401K by the time you reach 70 ½ . In the event you withdraw money from your 401K prior to 59 ½ you will pay a 10% penalty and taxes based on your current tax bracket. Some plans allow you to borrow against your 401K balance to avoid such penalties (I will detail the in’s and out’s of borrowing against your retirement savings another time).
Knowing the basics, should you take advantage of this savings plan? In nearly all cases I recommend that you do. Here are the five main reasons:
- Tax deferred savings – Reduces the amount of taxes to pay today. You want as much of your money working for you as possible, especially earlier in career. If you can pay fewer tax dollars today, this means more of your income can grow and start to compound “tax-free” unlike a savings account or brokerage account that incur taxes for interest and dividends (due at the end of each year).
- Nearly free money – An employer’s match is as close to free money as you can get. Sure, you will pay taxes when you draw on a 401K during retirement, but if an employer is going to match some portion of your contributions, why not take advantage of it!
- Forced savings plan – Since contributions general happen automatically, you will not have a chance to spend the money. It is virtually painless to participate in a 401K.
- Professionally managed account – In nearly all cases, an employer sponsored plan will be professionally managed and thus will allow you to take advantage of a relatively low cost, diversified portfolio. You won’t be saddled with minimum investment amounts to take advantage of certain funds and your employer [should] do the work in identifying reasonably appropriate investments.
- Higher limits than IRAs – Both Traditional and Roth IRAs have maximum contribution limits of $5,500 ($6,500 if you are older than 50). Also, for high earners you become ineligible to contribute to a Roth IRA when your income reaches $133,000 (single filers – $196,000 for Joint filers).
So again, I say, YES, get started with your employer’s 401K and let your money start growing sooner than later!