When you’re fresh out of college and starting your first job, you are probably so focused on dealing with debt that you completely forget to think about retirement. It’s so far away; it just isn’t a priority and information about your company sponsored retirement account is easily glossed over during orientation. However, paying attention to retirement now make a huge difference later, in the form of tens of thousands of dollars or even more.
What is a 401(k) Account?
A 401(k) is an employer-sponsored retirement account that allows you to contribute pre-tax income towards your retirement savings. So by giving your future self money, you can lower your tax liability for the current year.
Before you get too excited, you are limited in how much you can contribute each year. In 2017 the limit for 401(k) contributions is $18,000. You might think that $18,000 sounds like a lot and there is no way you could do without $18,000 of your income this year. That depends on how much you earn. Keep reading, though, because doing without now can pay off big time.
Many companies offer employer matching contributions. That means that if you contribute some, your company will contribute some too. For example, a company might match your contributions dollar-for-dollar up to the first 3 percent of your salary. If you contribute 6 percent of your income, your actual savings is 9 percent of your income.
There are other retirement accounts, such as a 403(b) for public service employees, Individual Retirement Accounts (IRA), and Roth IRAs, but a 401(k) is the most common when you are employed by someone else.
What You Need to Know About Your 401(k)
You need to know more than just the basics of if your employer offers a 401(k) plan and that you can contribute up to $18,000 in 2017. You should also know whether your company offers any contribution match, the terms of the matching contribution, when the employer match vests, and how to roll over an account if or when your employment changes (your bank may offer a retirement account and there are lots of other options, too).
Mistakes 20-Somethings Make with Their 401(k)
Mistake #1: Not taking an employer match
To be clear, if you do not take full advantage of a company match, you are walking away from free money.
Besides forgoing saving for retirement there are several other mistakes 20-somethings make with their retirement accounts that result in big losses. Here are some common mistakes.
Employer Contribution Programs
In addition to offering a 401(k) plan, many companies also match your contributions. While the details of the employer contributions will depend on the company, a common match program is 100% on a contribution of 3-5%. Meaning if you contribute 3% of your income, your company will automatically match that contribution. So if 3% of your income is $750, your employer will also contribute $750 to your 401(k). You double your money.
Some employers raise their match after a few years. For example, my last employer matched my contribution 100% up to 5% of my salary. After three years they would not only match the first 5%, but if I bumped my contribution up to 6% they matched that extra percent 200%. If I contributed $6, they contributed $7.
Let’s look at some numbers. Say you earn $30,000 per year and you have the match opportunity I just described. A 5% contribution is just $1,500 per year, and with the match becomes $3,000. A 6% contribution is $1,800 a year, and the total investment including the match is $3,900. Now you’re saving 13% of your income, which is a healthy (but not preposterous) level. Many experts recommend saving 15% or more in order to maintain your lifestyle after you stop working.
One of the biggest mistakes you can make with your 401(k) is to miss out on free money by not contributing enough to max out your employer’s matching contribution.
Mistake #2: Leaving a job before you are fully vested, thinking you can take your entire 401(k) with you
“Vesting” means conveying unconditional entitlement. In other words, making the employee entitled to the money in the account. Some companies vest a little bit at a time. You might be 25 percent vested after two years, 50 percent vested after three years, 75 percent vested after four years, and 100 percent vested after five years. If you leave before your third work anniversary, you only get to keep 25 percent of the amount your employer contributed to your 401(k) account. If you wait until after your fifth work anniversary, you get to keep it all.
You always get to keep 100 percent of the money you contribute yourself.
While your employer’s contribution gets added to your account as you contribute, the contribution from your employer isn’t yours until it vests. If you leave the company before the employer contribution vests, you don’t get to keep the amount your employer contributed.
The vesting schedule on your 401(k) account will depend on the plan your company offers. At my last company, my employer’s contribution to my 401(k) vested 100% after three years of employment. After my third work anniversary, I was entitled to take all of the money with me when I left.
Other companies have a tiered vesting schedule, as I discussed above. For example, 25% vests after 1 year of service, 50% after two years of service, and 100% vesting occurs after three years of service. If you leave your company after two years, you’d be able to take all of your contributions and half of your employer’s contributions.
If you’re considering a job change, check your vesting schedule. You may want to stick it out a little longer for the added financial benefit.
Mistake #3: Failing to roll your 401(k) funds into a new retirement plan
When you leave a company, your 401(k) account will probably be closed and your money sent to you in the form of a check (some companies leave the account open, but most do not). You’ll need to deposit it straight into a new retirement account (a 401(k), IRA, Roth IRA or other qualifying account) or you’ll pay taxes and a 10% early withdrawal penalty.
Rolling Over Retirement Accounts
The reasons to roll over a 401(k) into another retirement account are to keep up the savings momentum and avoid penalties and taxes. If you cash out your 401(k) instead of rolling it over, you will have to pay income tax on the amount cashed out. Additionally, if you are under 59 ½ years old you will be required to pay an early withdrawal penalty.
For example, if you have $10,000 in your 401(k) and you decide to cash out, after taxes and penalties you are looking at having somewhere around $6,000 to show for all your hard work. If instead you roll over that amount into another retirement account, thanks to the power of compound interest, in 20 years without contributing any more money and assuming a 4% return, you will have a balance of $21,911.03. You will have more than doubled your $10,000 investment. You can see an example of how compound interest works in the graph below.
So how do you roll over a 401(k)? You just select a new retirement account. If you are moving to a new company sponsored retirement account, then this will be decided for you. If you don’t have a new employer who offers one, call your bank or research other financial institutions. Fidelity and Vanguard are popular, but they aren’t the only ones. First talk to a financial advisor to decide what type of account is best for you.
The institution where you open the new account will walk you through the steps to take to roll over your 401(k). You may also need to contact the institution holding your old retirement account to find out what they need to issue the money to you or straight to your new retirement account.
Mistake #4: Cashing out your 401(k)
There are two big problems with cashing out your 401(k) before you are eligible to make qualified distributions. First, you’ll lose money right away. The amount of the withdrawal will be added to your taxable income and you’ll pay the 10% penalty. If your 401(k) balance is $5,000, you give Uncle Sam $500 right off the top, plus tax!
Second, you’ll lose even more money over time. The biggest benefit to a long-term investment is the value of years of compound growth. Just look at that graph, above. Giving your money decades to grow is the best thing you can do for your savings. Take a look at another example:
Bob, age 25, puts $1,200 into his 401(k) and adds $100 per month until age 70. His cash investment is $55,200. If he gets a 7% average annual return on the account, his balance at age 70 will be $368,102.
Jane is 50. She puts $10,000 in her 401(k) account and adds $188.33 per month until age 70. Her cash investment is the same – $55,200 – and her average rate of return is the same – 7%. But she only has 20 years to grow her balance. At age 70 she has just $131,345.
Even if Jane invests the entire $55,200 in at age 50 (she can’t, because of annual contribution limits, but we’ll say so just for illustration), her balance will only grow to $213,607 by age 70. There is no way for her to catch up to Bob, who started saving 25 years earlier.
Which saver do you want to be?
How You Can Learn More About Your 401(k)
Making any of these mistakes will leave your retirement money on the table. At worst, it could mean losing out on hundreds of thousands of dollars in the future. To make sure you don’t make these mistakes, educate yourself about your 401(k).
To find out more about your 401(k), go to your company’s benefits page online. If you have any questions, reach out to your human resources representative.