Starting with what *is* a 401(k)?
When we first started working and earning real, adult salaries, or financial priorities more or less looked like this: rent, bills, student loans…shoes! Vacations! Shoes! Like many young adults, we were quite taken aback when we realized that, one, taxes *really* put a damper on those shoe and vacation budgets, and two, if we wanted to be responsible and make sound financial decisions, we’d need to start contributing to a 401(k). Given that most of us majored in English or journalism or art history, this left us with a lot of questions—namely, “What is a 401(k)?”
For the answer—and a lot of great financial advice—we turned to Allan Boomer, founder and managing partner of Momentum Advisors. Ahead, everything you need to know about your 401(k).
Thank you for chatting with us. First question: In the simplest terms, what is a 401(k)?
“Simply put, a 401(k) is a self-directed retirement plan for employees. When I say self-directed, it means that you, as the employee, make the decisions over how much gets contributed and how the money gets invested.”
So what’s the difference between a 401(k) and a pension?
“A pension basically goes like this: If you work for 30 years and you made $100,000 a year, when you retire, [the company] will pay you something like $70,000 or $80,000 a year. There really are no promises with a 401(k) plan the way there are promises with a pension plan. A pension plan is one of those things where you could rest assured that if you did your part by just working at the company for a certain number of years, you will be guaranteed to get a secured retirement.”
Well, that sounds good!
“Yes, but for the most part, pension plans have gone away. There are only a few employers today that have them. For example, if you work for the city or state, or are a teacher or firefighter or police officer, you might still qualify for a pension plan, but most corporations have done away with them because they’re very expensive to maintain. [Most companies] have moved towards the 401(k) route.”
Wait. What? What about social security?
“Unfortunately, social security is currently projected to run out of money in 25 years. So if you think about us as retirees, we’ve got no pension and social security is a question mark. The only thing we have now is the 401(k), so it’s super important for us to be putting money away for ourselves for retirement, and also really paying attention to how that money is managed.”
Noted! So when should you start contributing to your 401(k)?
“The moment you start earning wages and you’re allowed to contribute. A lot of people think, ‘Oh I’ll worry about that after I’ve been at the company for a few years,’ but the earlier you start, the better off you’re going to be.”
What if your employer doesn’t offer a 401(k) plan?
“In that case you can open up what’s called an IRA account. IRA stands for Individual Retirement Account, and it doesn’t need to be attached to an employer.”
How much should you be contributing to your 401(k) or IRA?
“I always advise people to max out. If you’re under the age of 50 you can put in a maximum of $18,000 a year. If you’re 50 or older that number jumps to $24,000. You don’t typically contribute through a fixed dollar amount, though; it’s usually a percentage of your salary. Some companies will cap you at, say, 15% of your salary, but whatever that cap is, you want to max out.”
How do taxes factor into this?
“If you’re putting money into a traditional 401(k), it’s pre-tax money. Say you’re making $100,000 a year and you put $10,000 in your 401(k); you’ll be taxed as if you made $90,000. Your tax liability goes down for every dollar you contribute, so if you’re contributing 10% of your salary, it won’t reduce your paycheck by 10%—it might only reduce it by 6–8%.”
What’s the deal with employer matching?
“Employers will often match your contribution up to a certain percent. At a bare minimum you want to contribute that amount, because it’s a 100% risk-free return on your money. But you’re not necessarily maxing out by contributing what the employer is willing to match. It’s up to you to go above and beyond that.”
How should you invest the money you’re contributing?
“Most 401(k) plans have 10–30 funds that you can invest in, versus an IRA, which will have a wider range of choices. You have to pick the investment, and there’s a default if you don’t. Many times the default is cash, which is essentially like putting it in your mattress; it’s not likely to grow. The key thing to keep in mind is that there are stock funds and bond funds. Stocks are a high-risk, high-reward investment, whereas bonds are a super safe way to invest. Everybody should own a blend of stocks and bonds. The way you blend them together depends on how much risk you want to take.”
Can you take money out of your 401(k) or IRA before you retire?
“Yes, but if you’re under the age of 59 and a half, you’ll have to pay penalties on the money you take out, in addition to taxes. The penalties can be in the 10 percent range, so if you take out $100,000, you’d be paying $10,000 in penalties on top of 20–30% in taxes. Note that with 401(k)s, you don’t have access to the money at all while you’re still employed by the company you set it up with; the above only applies if you leave.”
This is all so insightful. Any other tips? I feel like I may need a financial planner:
“I always give people the same three pieces of financial advice. Number one is to work towards saving three months to a year of expenses, in case of an emergency. Number two is to start saving for retirement through your 401(k) or IRA, and to invest that money; don’t just put it in there. And number three is to pay down your high-interest credit cards. You don’t need a financial planner for those three things. You can do them on your own for free.”
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