Do you have enough saved for retirement?
Since 1985, the average cost of living has increased by nearly 140%. In an expensive metro area like San Diego, CA costs more than tripled. More than 70% of all employees in the U.S. can access a retirement plan. However, only about a third of them participate in their employer's programs. Beyond that, most people severely under-fund their savings.
If you have $200,000 in savings and retire at 65, you only have $8,000 per year to live on until you are 90. You need to start saving early. Let the 401k limits be your guide.
What Is A 401k Plan?
A 401(k) plan is an employer-sponsored retirement plan. It's called a 401K because of the IRS code that defines it.
It helps people save for their eventual retirement. The biggest advantage is that contributions to a 401k are tax-deferred. This means that they are not subject to the IRS until they are withdrawn.
The IRS places an annual limit on the amount of money that may be tax-deferred. Presumably, an employee is in the highest income tax bracket while employed and in a lower tax bracket when retired and drawing on savings.
How Does A 401k Plan Work?
Employers manage 401k plans. They decide the type of 401k plans offered, the types of investments and the investment management firm. Employees have lots of flexibility within that structure. Employees need to opt-in to the plan (usually at hire or soon after), then select their contribution level and which type of investment portfolio they want.
The employee may contribute as much as they would like, up to the annual limit. In 2020, the IRS increased this annual limit to $19,500. An employer may match the contribution or offer other incentives for the employee to save a portion of their salary. Some plans require an employee to work for a number of years to receive the employer contribution.
The IRS limit for employee and employer contributions combined is $57,000 per year! Remember to note these contributions for future reference with your paystub creator.
Encouragement To Max 401k Limits Early
Anyone can start saving for retirement at any time. It's easier to start saving with small contributions that compound interest in your 20s than it is to put away large amounts in your 50s. Make sure you take these steps to make contributions count.
Employees Should Always Take The Match
Many employers offer a favorable match to employee contributions, subject to a minimum contribution. For example, one employer offers a 100% match on the first $5,000 of employee savings and a 50% match on the remaining employee contribution, up to the max contribution limits.
For a person in their 20s who makes $33,000 a year, a $5,000 contribution works out to just over $200 saved per bi-weekly paycheck. Matched 100% by their employer, it adds up to $10,000 compounding and growing tax-free until retirement. If a person can afford to save even more, the employer matches even more money.
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Compound, Compound, Compound
The earlier a saver starts, the longer the savings have to compound interest. In other words, earn interest on interest previously earned. If the employee above saves $5,000 a year for 10 years, they have $50,000. Then they quit saving. They just let their 401k sit there earning 7% interest until they retire at age 65. They will have around $600,000.
A late bloomer doesn't start saving until age 35. They manage to save $5,000 per year for 30 years until retiring at 65. Their money also earns 7% interest. At age 65, the late bloomer has around $540,000.
Give Savings A Raise!
Savers should increase savings amounts regularly. One of the easiest ways is to give the savings amount a boost at every wage increase.
Pick Appropriate Investments
401k plans give the employee lots of options for investment. Here are some considerations.
Age and Number Of Years To Retirement
The longer the time to retirement (the younger the worker), the more risk they can withstand. If an investment performs poorly, there is more time to recover. On the opposite side of the spectrum, people looking at retirement within a few years need to look at preserving their capital.
Factor in lifestyle and approximate retirement age. For example, if an employee is age 20 and plans to retire to an island in the Pacific at age 50, they're going to need plenty of money. They would choose a 401k investment portfolio with more-aggressive risks and rewards.
Not everyone can stomach aggressive risk. For employees that are anxious about the rollercoaster of stocks, many plans offer mutual funds, annuities, and other less risky instruments that run counter to the stock market.
Tax-Deferred Does Not Mean Tax-Free
The money in a 401k belongs to the employee. However, if they needed it before age 59 1/2, they pay a penalty plus the regular income tax on the withdrawal. Exceptions to the rule are total and permanent disability, loss of employment at age 55 or older, or a qualified domestic relations order after a divorce.
After age 59 1/2, withdrawals from the account are without penalty. Only ordinary income tax is payable. The portion remaining continues to earn interest until withdrawn.
Invest in the Future Right Now
Investing the 401k limits every year is an essential part of smart financial planning for many adults. The IRS limit for 2020 is $19,500 for employee contributions. For companies offering a match, the max contribution limit of $57,000 per year combined is a very nice nest egg. Inflation and uncertainty affect retirement quality.
The amount of money required for comfort is difficult to predict, but inflation rates indicate that costs double or more every decade. Begin saving as early as possible to avoid falling short. Any amount, no matter how small, can grow with compounding and plenty of time. A 401k is the perfect vehicle because of its tax-deferred status. Instead of paying taxes when earned, taxes are paid at disbursement.
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