401ks were never supposed to be the default plan for retirement—but that’s what we’re working with, Grownups. Here are some tips from our CFP(R) team.
Have you ever heard your parents or grandparents talk about their pension? In prior generations, pensions were a big part of retirement planning. But why don’t you hear much about them anymore? It’s because they were recently added to the endangered species list. Just like Giant Pandas, the number of companies offering pension plans has significantly declined over the years.
Over the past 20 years, a new retirement planning species has become much more popular: the 401(k) plan. In fact, the “fathers” of the plan, Ted Benna and Herbert Whitehouse, hatched the idea in the early 1980s to supplement company pension plans.
And today, they’re saying it was never intended to be so pervasive, nor become the pillar of retirement income planning. In a recent On Point story, Big Worries for Your 401(k) Retirement Plan, Benna and Whitehouse admit that they may have “created a monster.”
So, how did 401(k)s go from being supplemental to the main savings vehicle? And short of the government establishing a national retirement saving plan for all citizens, what should you do to save for your own retirement?
So, What Actually is a 401k?
The name comes from the IRS tax code on which the program is based (we know—so creative, right?), which allows employees to avoid taxation on a certain amount of their income now by contributing to an employer-sponsored retirement plan. The IRS, of course, will never give you a freebie, so they’ll tax whatever you take out of the account come retirement. 401k plans were originally meant to help highly paid executives save more for retirement in a way that would let them delay paying taxes as well. Because the plans proved to be less expensive and don’t require employers to contribute, they began to replace the pension plans they were only meant to supplement.
How Did 401ks Become So Popular (and Problematic)?
Originally, 401(k) plans were designed to be simple and reasonably priced. As they’ve evolved into the primary vehicle for retirement savings, they’ve become more complicated and expensive—both administratively and for employees. This has happened partly because of the involvement of investment managers, who can charge high fees.
If a company offers a pension plan, it’s required to contribute to it on the employee’s behalf. There’s usually a formula the employer follows, often based on age and years of service, to determine how much goes into each employee’s account.
401(k) plans, however, are not mandatory. An employer is not required to offer them and if they do, they don’t have to contribute to them. (Many do, though, as an employee benefit and must do so for all eligible employees.) Even if 401(k)s are offered, employees don’t have to contribute. So unlike a pension plan, participation in the 401(k) is voluntary for employees. The voluntary nature of 401k plans is a big reason why people don’t seem to be taking full advantage of them.
Compared to pensions, another drawback to 401(k) plans is the value of your savings and investment is not guaranteed. 401(k) plans are typically invested in mutual funds (and sometimes company stocks), which are subject to swings in the stock market. It’s tough to see the money that you’ve invested in and are counting on for retirement lose value (sometimes drastically, as the stock market most recently did between late 2007 and early 2009).
It’s unfortunate that many people don’t take advantage of their employer’s retirement plans, but it’s best to use what’s available to you. It would be wonderful to have an automatically guaranteed retirement benefit to bank on, but many of us just don’t have access to pension plans anymore. So while some folks such as Benna and Whitehouse suggest that the system should be overhauled and we should all be able to pay into a national retirement savings plan, the reality is you’ll probably need to “self-insure” for retirement with your employer’s plan if offered.
What’s a Grownup to Do?
For better or worse, 401(k)s are popular and (likely) here to stay. With pensions increasingly endangered and Grownups need to be proactive when it comes to retirement—and the earlier, the better.
Here are some tips and tricks to hopefully get yourself to a comfortable retirement with help from your employer-sponsored plan (such as your 401k, 403b, 457, SEP, or SIMPLE plan):
Start saving early into your employer’s retirement plan. Most young Grownups don’t think of retirement savings as a priority. (We get it: It’s hard to when retirement is 40 years away!) If your employer doesn’t offer a pension plan, it’s important to start saving as early as you can into your employer’s or an individual retirement account (IRA) in order to help put you in a better situation once you get to retirement. Compounding interest can turn even a small investment into a significant amount of money over the course of many years. Compounding interest is how your money makes money, and the effect is like a snowball. It’s always better late than never, though! If you didn’t start early, consider starting now, though you may want to prioritize your retirement savings and contribute as much as possible.
- If your employer offers a matching contribution, begin saving at least enough to get that match. Many employers will match contributions up to a certain percentage of your salary. For instance, if your employer offers a 5 percent match, that means they will match your contribution up to 5 percent of your salary. If you contribute 3 percent, they will do the same, so unless you contribute enough to get the full match, you’re basically leaving money on the table.
- Some financial advisors think of retirement savings as a race to achieve a particular number. In the On Point story, saving eight times your salary was one target amount discussed. When you’re younger, it’s hard to know what number you should shoot for; to be honest, those lofty numbers are often pretty intimidating. That’s why we recommend Grownups consider trying to save 15 to 20 percent of their salaries on a regular basis until the maximum allowable contribution is reached (for 2018, that number is $18,500 a year and an extra $6,000 if you’re older than 50). It can be really hard to think about starting at that level, so start where you can—ideally with enough to get that match—and increase by 1 to 2 percent whenever you get a raise. If you feel like you want more guidance, consider meeting with a financial planner to discuss an appropriate level of savings to put yourself on a good path toward a comfortable retirement.
- Most employer plans offer target date retirement funds which will invest your money in a diverse mix of stocks and bonds all in one fund. Choose one based on your estimated retirement date. (It’s right in the title of the fund!) These types of funds start out more aggressive and automatically rebalance periodically to become more conservative as you get closer to retirement. This is a great alternative for many Grownups who don’t have the investment knowledge to pick funds themselves. Target date funds will frequently have lower fees (though not all do), so more of your earnings can be realized. This is really important because one drawback of 401k plans is that fees can be charged at two levels. Not only does the mutual fund company charge fees to cover their expenses, but your employer needs to cover their administrative costs, too. You can check your 401k webpage, the mutual fund company’s page, or Morningstar for a list of fund-level fees. (Stay tuned for an upcoming post where we’ll help you figure out how much you’re paying in fees.) Your Human Resources department should also provide your company’s summary plan document and annual plan fee disclosures.
- If your employer doesn’t offer a plan, or you’re self-employed, don’t panic! Opening an IRA or Roth IRA is a great alternative option. Contribution limits are lower than with a 401k. (For 2018, the total limit is $5,500 or $6,500 if you’re older than 50.) In some cases, you may even be able to open an individual account in addition to your 401(k). Check out the IRS website for contribution and withdrawal rules.
- Learn more about retirement planning. Many folks who aren’t taking advantage of their employer retirement plans aren’t lazy—they just don’t understand how not saving now may impact them later in life. Knowledge is power, and getting a better understanding of retirement savings could lead you down a path where you feel more comfortable and confident in your future.
- Try to consider your retirement account untouchable. It may be tempting to dip into this money if you need some cash, but doing so comes with consequences. Remember: This money is intended for retirement, so you could find yourself on the hook for IRS penalties and income tax payments depending on your age, reasons for distribution, and type of account. Your plan administrator can provide you with specific restrictions around withdrawals and loans from your employer’s retirement plan. When you leave your job, you have choices about what to do with your account. While taking a “lump sum distribution” or cashing it all out is an option, remember you will still have to pay income tax and, if you are under age 59½, you may be liable for a 10 percent IRS penalty. Consider rolling the account over to an IRA or to your new employer’s plan. There are no tax penalties for doing so, and it can make sense to have all of your retirement savings under one or two umbrellas. Avoiding penalties and taxes isn’t the only reason to hang on to your retirement savings. Remember that compounding interest is a powerful tool in your ability to save enough for a comfortable retirement. Dipping into retirement savings makes it harder to reach your long-term savings goals because your money’s ability to make money gets interrupted.
Any third-party resources or websites referenced above are not under Society of Grownups control. Society of Grownups cannot guarantee and are not responsible for the accuracy of the resources, websites, or any products or services available through such resources or websites.
While Society of Grownups hopes the information is useful, it’s only intended to provide general education. It’s not legal, tax, or investment advice, and may not apply or be useful to your specific financial situation. All investing has a risk, including the possible loss of assets. If you need recommendations geared to your personal financial situation, schedule time with a financial planner.