If you’re not investing into your IRA today, you are ROBBING from your future self! DO NOT steal from this person that you love, and instead giving them the gift of having your SHIT together to benefit you BOTH!
A 401 (k) plan is a terrific employer-sponsored benefit. Over half of US workers have access to a defined contribution plan, and another 12 percent have both a defined contribution AND a defined benefit plan. The difference is significant. A defined benefit plan is what most of us think of as a traditional pension, in which the amount a retiree receives each month is fixed and determined by their length of service and compensation while employed. For many public sector employees, this is still the standard. However, private industry has moved away from these plans, mainly because of the long-term cost and obligation.
A 401(k) or similar plan offers the employer a way to support employee retirement savings without the long-term responsibility. Employees contribute part of their salary to the account, and the employer often matches a portion of the employee contribution. The employee benefits from making retirement savings with pre-tax income and receiving a return due to the employer contribution. Since all contributions and earnings are untaxed until retirement, the fund can grow positively, especially if the worker starts early and leaves the funds untouched.
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Start contributing early for maximum impact.
The best approach to your 401(k) plan is to contribute generously and leave the money alone. Every employee enrolled in a 401(k) plan can contribute up to $22,500 in 2023. If you are aged 50 or more, you can add another $7,500. That limit is in place no matter how many employers you work for during the year. If your employer also contributes to the account (and most do), the total for combined contributions is $67,500 ($73,500 for workers over age 50.) However, total contributions can’t be more than your total annual compensation.
Starting early means you have more time to save (tax-free) for retirement. For example, suppose you contribute the maximum $22,500 (this amount gets adjusted periodically for inflation) for 30 years starting at age 40. The total you contribute over that period is $675,000. Suppose instead that you started at age 30 and still made the maximum contribution every year. The total now is $900,000. But that doesn’t include potential employer contributions or investment gains.
By starting early, you give the principal more time to appreciate. Even with a modest five percent increase in value, the account will grow much faster if you start sooner. The initial $22,500 earns $1,125 the first year, becoming $23,625. Remember, you are probably also getting some matching value from your employer. The following year you add another $22,500, and the total balance at a five percent return grows by $2,306.
Don’t miss out on free employer match money.
Probably the biggest mistake an employee can make is investing less than the amount that the employer will match. Every company decides its protocol, so make sure you know the details. If your company offers a 50 percent match of the first 10 percent of your income that you contribute, ensure that you contribute at least that much. For example, suppose you can receive a fifty percent match up to 10 percent, and your income is $100,000. If you divert $10,000 (10 percent of your annual income) into the account, the employer will add $5,000. None of that money is subject to federal income taxes (and most states follow the federal rules.)
Pay attention to how the money is invested.
Your 401(k) account is an investment fund for you to allocate optimally for your goals. Of course, the investment horizon depends on when you plan to retire, but 401(k) accounts are intended to be long-term funds. Most employer-sponsored programs allow you to choose from several investing options and will provide regular updates on fund performance. One popular choice for 401(k) investors is a target date fund, which is professionally managed to emphasize growth initially but gradually rebalance to a more conservative portfolio as you approach your intended retirement date. This strategy hopefully supports maximizing the return but not risking the principal as you get close to retirement age.
Don’t take an early withdrawal.
The intended purpose of a 401(k) account is to allow taxpayers to save money for their retirement. Since few private industry workers still have the promise of a traditional pension, the federal government is endeavoring to encourage these accounts to supplement your Social Security benefits. However, there are some circumstances in which you may need to consider a hardship withdrawal or loan.
Early withdrawal penalties are steep for a reason. If you withdraw money from a 401(k) before age 59.5, you will pay taxes on the amount (at your current tax rate) plus a penalty of ten percent of the withdrawal amount. Here’s what that looks like:
- · Withdrawal amount: $50,000
- · Taxes at 23 percent federal and three percent state: $13,000
- · Federal withdrawal penalty at ten percent: $5,000
- · Net withdrawal: $27,000
The IRS does allow some exceptions to the penalty, but you will still pay the taxes due. The exceptions apply if the account holder dies or is completely disabled or must divert part of the account to a spouse or partner as part of a divorce or similar event. You may also withdraw funds without penalty if you have unreimbursed medical expenses above ten percent of your AGI (Adjusted Gross Income.)
Perhaps even more significant than the taxes and penalty is that you reduce the amount of money you have working for you as you save for retirement. This aspect is also applicable if you take a loan against the 401(k) rather than a withdrawal. Financial experts typically prefer that you take a loan, both to avoid the penalty and to increase the potential for resuming your savings discipline.
Many plans allow participants to take loans against their 401(k) account for various reasons, some without requiring an explanation. In most cases, these are not considered withdrawals, so there is no tax or penalty to pay. Instead, the employee makes payments back to the account over a specified time and pays interest to the account as well. The disadvantage is twofold:
1. Many participants with loans stop contributing during their loan payment period (and some plans require this interruption)
2. The borrowed money isn’t invested and so isn’t able to appreciate.
Still, taking a loan is usually preferable to an early withdrawal if you have a genuine need. However, the best approach is to start early, consistently invest in the 401(k), and let the money grow until you retire. In addition to investing with your retirement accounts, it is CRITICAL that you are investing personally on a monthly basis. If you already are, then congratulations on starting a winning habit. But whether you are or are NOT the goal is for you to invest MORE on a regular basis to improve your wealth growth potential. Check out my new video on how to MAXIMIZE your investment amount monthly, so that you can increase your investing through managing your life budget more strategically day in and day out. Watch the video to learn how to budget for MAXIMUM investing each and every month so you can be financially free ASAP.
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President of Saint Investment Group
Nic is a two decade seasoned expert in investing and capital raising, specializing in Real Estate and debt markets. With Saint Investment Group, he leads large-scale distressed asset purchases and innovative syndications for investors.
