401(K)’s are the leading retirement account offered in the U.S., you can usually get involved via your employment as many workplaces offer 401(K)’s as an employment benefit. But I think even if you want to start one on your own, these 11 reasons should convince you it’s the right thing to do.
With the 401(K) being 42 years old this year, only 14% of employers in the U.S. offer 401(K) to employees. Of the 79% of Americans that have access to 401(K)’s, only 32% are investing through a 401(K). With the benefits associated with 401(K)’s I think we need to be encouraging the workforce to start saving for retirement.
People with the most time on their hands are going to be the most likely to reach their retirement goals. Saving from an early age will put you ahead of your peers, start as early as you can, today is better than tomorrow. Just look at this graph showing two investments of $1,000 at an average compounded market return of 5% in a 401(K).
The saver who started at 30 years old has 62% less retirement savings than the person who started saving at 20 years old.
This all leads onto our 11 reasons why you should not only invest through a 401(K), but start while your young.
11 Reasons Why You Should Invest in a 401(K) Now!
#1. 401(K) Contributions Lower your Tax Bill
Contributions to your 401(K) are taken from your salary before tax is paid, this makes them a tax write-off. Your contributions mean you can take advantage of a lower tax bracket, meaning you will not only be saving for retirement, you’ll also save money on tax.
For most of us, our working years are when we are in the highest tax bracket of our lives. Then once retired, our tax bracket dramatically changes.
If you are a 24% taxpayer during your work life, then when you retire you go to a 22% taxpayer there is a potential to make a saving:
- Contribute to a 401(K), which could bring you down to a 22% taxpayer during your work life.
- You will still be a 22% taxpayer when you retire.
- You make a 2% annual saving on tax!
You should be aware that the limits on contributions could be a fault in your plan. This level of tax saving only applies to those close to lower bracket limits. Talk to a tax professional to iron out the details.
#2. Your Employer Might Kick in Some Cash
Many employers offer what is called an employer contribution pension or a ‘Matching Contribution’ plan.
That means they will your employer will match whatever you contribute into your 401(K), up to a certain amount. For example, if you contribute 4% of your salary into your pension, your employer will match that 4%, doubling your contribution.
You may contribute more if you would like, but most companies will cap their top-up to 4-5%.
This has to be one of the only legal ways to get free money from your workplace, and only a mere 32% of Americans take advantage of it.
#3. Your Earnings are Tax Deferred
Not only do your contributions into your 401(K) count against your income, lowing your tax in the current year. All you earnings from the investment are deferred until you withdraw them.
Normally if you were to save money in a regular bank account or investment account, you would have a pay tax on your earnings and interest. With a 401(K) that tax is deferred, so you don’t have to list your earnings as income on your tax return.
This allows your savings to grow quicker, and because you only pay tax on what you withdraw, you can plan your earnings accordingly with your needs.
#4. Compound Interest Leads to Higher Payouts
Compound interest can be a difficult subject to wrap your head around but it is how people like Warren Buffett, Ben Graham, and other Wall Street legends have built their wealth.
By saving $1,000 per year, at an interest rate of 5%, that means after 1 year, you would have… $1,050. So now you do it again, $1,050 at 5% interest… $1,102.50. And so on and so on.
Now with a 401(K), you are likely to continue to save each year. So if, each year you save $1,000, not only will you take advantage of your savings, you’ll compound your interest exponentially. Just look at this graph as an example:
Your savings in a regular bank account might yield a small amount of interest, maybe 0.01% per year. But in a 401(K) returns are determined by the market. Most 401(K) providers have an estimated growth rate of 5% per year.
#5. It’s Painless to Setup
It’s really easy to setup a 401(K), so easy, you might just need to apply with your employer.
When you open an account your employer will automatically deduct your selected amount each month from your payslip and deposit it with the pension provider. Most people don’t even miss the money as it can be from as little as 1% of your salary.
You can give consistent dollar amounts each month, but I would recommend selecting a percentage of your wage. That way, if you were get a pay rise, you are giving yourself a pension rise.
#6. It’s a Cheap Way to Invest Money Passively
If you contribute through an employment it is slightly cheaper if you go it alone. Normal 401(K) plans have small management fees ranging from 0.37% to 1.42% of account balance per year.
So if your account balance was $100,000 you would pay somewhere between $400 to $1,000 per year. But this money would just come out of your investment profit for the year.
Realistically, 401(K) fees only become an issue if you don’t gain any interest in the year. This is very unlikely.
If you go for it alone, you can find similar plans for the same price, but it might cost you a one-off setup fee with a financial broker. However, with M1 Finance, they don’t charge any upfront fees, and have a zero-commission fee structure.
With brokerage fees, management fees, and commissions. They work really simply, if the broker makes money, you make money.
#7. You Can Have as Much Control as You Want
You might be a financial novice looking for an easy ride to retirement, and that’s fine. But if you want to take a little bit of control and work on your goals, you can.
This pairs well with the point above. Basically, the more involved you are with your investment, the less it will cost you.
Most brokers these days will have 4 or 5 basic plan arrangements which will offer you a certain amount of reward, but with a corresponding amount of risk. They can range from saying things like ‘Adventurous’ or ‘Bold’ all the way down to ‘Cautious’ and ‘Safe’.
If you want a balanced portfolio that is low risk, I suggest following your providers guidance. But for some people, they want a say on where their money goes.
For these people, you can open a self-managed 401(K) where you can choose from all stocks, bonds, ETF’s, and RIET’s on the market. But this is at your own risk.
You can also have a mid-sized impact on your investment by asking your provider to invest in a certain type of company or industry, as well as keeping your investment ‘green’ or socially friendly.
One last thing about choosing your own investment… You don’t want to mess this up, so ask lots of questions and trust your advisor because at the end of the day they’ve done this before and… If you make money… They make money.
#8. 401(K)’s Have Higher Contribution Limits Than IRAs
The contribution limit for IRA holders per year is $6,000 which goes up to $7,000 for over 50s.
The contribution limit for 401(K) holders per year is $19,500 which goes up to $26,000 for over 50s.
Not only that, as we’ve mentioned before your employer can contribute towards your 401(K). Your employers contributions are not capped, so you can essentially put more than $19,500 into your 401(K) per year.
There are a few more differences I would like to point out between IRA’s and 401(K)’s, so I have compiled a small table to show the main points.
|Taxation of Contribution||Contributions are tax deductible, however you can’t contribute as much.||Pre-tax income used as contribution, reducing taxable income.|
|Eligibility to Participate||– Individual must be under age of 70.|
– A single person much have annual income of less than $139,000
– A person with annual income between $124,000 – $139,000 will have reduced contribution limits.
– Married couple filing jointly must have combined annual income of less than $206,000.
|An employer might set age limits, or length of service requirements for participation in workplace 401(K). However anyone who has employed income & Social Security Number can open a 401(K).|
|Withdrawal Rules||IRA holders can withdraw income at any time, but if no withdrawals are made before the age of 71, the IRS will start to withdraw tax amounts.||Participants must reach the age of 59 before withdrawing from a 401(K). Unless personal circumstance leads to hardships, then a loan can be put in place while still employed.|
|Taxation on Withdrawal||Income tax is chargeable on eligible withdrawals.||Same applies. Income tax is chargeable on eligible withdrawals.|
|Early Withdrawal Penalties||10% early distribution tax is chargeable if the holder is 59 years or younger, unless there is a penalty exemption.||10% early distribution tax is chargeable, unless a penalty exemption is in place or a loan is established.|
This is the rub. You have more freedom with an IRA or Roth IRA, but you can save more through a 401(K). You also have more chance of being accepted into a 401(K) scheme than an IRA scheme. If it was up to me, I’d have both.
#9. Changing Jobs Doesn’t Affect You Contributions
When you change job you might think your 401(K) savings just rollover with you to your new plan. This is not always the case.
Most of the time they will stay in the original account held by your previous employer, until you come to withdraw it. This can be arranged, but you have a similar way which keeps your money under your control.
You can apply the free technique of rolling-over your 401(K) into a Traditional IRA, which keeps al of your contributions & earnings tax deferred.
By doing this you keep your tax sheltered retirement fund, but now it is detached from your 401(K) contributions, so you effectively have two retirement savings accounts. You can continue to contribute to both or just your new 401(K) with your new employer, either way, your money will continue to grow until you reach your retirement.
Another positive of doing this, is the fact you can now diversify your accounts. What you have previously done is follow your providers advice and stuck with their investment strategy. With two accounts, you can brach out and invest in a wider market, hopefully yielding more earnings.
#10. Social Security Won’t be Enough
It has long been understood that social security is only supposed to make up a small percentage of your retirement earnings. The median house hold income of retired people in the U.S. is $43,696. Of this amount only a third is Social Security income.
Many financial advisors agree that the average person will need between 70% and 90% of their pre-retirement income to live comfortably throughout retirement. With Social Security only supporting 30% at best, you need to be thinking about the rest.
To find out how much your monthly income will be on your current pension plan check out this Lifetime Pension Calculator.
#11. Take Advantage of Dollar Cost Averaging
Dollar Cost Averaging is the process of buying more shares at a low price, and fewer shares at a high price.
Because the majority of people will contribute to a 401(K) after every paycheque, this is the default strategy used by pension providers.
It works like this:
- You contribute $500 per month no matter what the market conditions.
- At low market prices, your $500 can buy 10 shares in the S&P 500 ETF.
- At high market prices, your $500 can buy 5 shares in the S&P 500 ETF.
Using this strategy you will, over time, lower you average cost per share by acquiring shares at the ‘market average’.
So… $500 = 10 shares = $50 per share
And… $500 = 5 shares = $100 per share
Then… $1000 = 15 shares = $66 per share, which will be the market average for that time period.
Rather than investing a lump sum of savings at the ‘wrong’ time, you can hedge your bets by lowering your average purchase price so you can maximise your sale value.
Why Your 401(K) is so Important
If you are late to the party and need to save more aggressively for retirement, this is where the 401(K) becomes vital to your future. With the boosted yearly contribution limits, 401(K)’s are much more desirable that IRA’s, also not to mention that your employer can match your contributions.
If you and your co-worker have the same salary but one of you doesn’t contribute to the workplace 401(K), that person is not only missing out on the tax benefit, they are also potentially losing free money from your employer.
As I have mentioned, Social Security will not be enough to support you and your family through your retirement years. You need to start thinking now about your retirement.
Even if you contribute the minimum amount of money you can into a 401(K) it will be worth it.
Contributing as low as $500 per year, matched by your employer from the age of 20 can give you a final retirement pot of $128,000. Meaning your monthly income from the 401(K) savings would be $544.
I think we can all agree, $500 a year is not a massive amount. So do something useful with it and get it in a 401(K).