My partner recently achieved a career milestone: her first job with an employer-sponsored retirement plan. After accepting my enthusiastic congratulations, she handed me a stack of paperwork and asked, “What now?”
It turns out, that’s a fantastic question. Even though most of us accept by default that employer-sponsored retirement programs are a good and normal part of a middle-class financial plan, I found very little accessible information out there about how they work or what you’re supposed to do with them. After walking my partner through her retirement plan enrollment, I’m thrilled to share everything I learned in the process.
Why are retirement plans sponsored by employers in the first place?
Today Americans treat 401(k) plans (for private employers) and 403(b) plans (for non-profit employers) as if they were handed down to Moses on Mount Sinai. But they’re actually a very recent development: Section 401(k) of the Internal Revenue Code was only enacted in 1978.
Unfortunately, even today this cornerstone of the American retirement system is only available to employees of companies who choose to offer it. Smaller employers are much less likely to offer employees a 401(k) plan.
What are the advantages of an employer-sponsored retirement plan?
When you contribute to a traditional 401(k) plan or 403(b) plan, your contribution is deducted from your payroll before federal income taxes are withheld (although you’ll still pay Social Security and Medicare taxes on the withheld amount), and you’ll owe no federal income taxes on the withheld amount in the year it’s earned. When you make withdrawals in retirement, you’ll owe federal income taxes on the amount of your withdrawal.
There are two big advantages to this scheme: first, the amount you save on taxes in the year of your contribution becomes part of your retirement savings. A worker in the 25 percent marginal income tax bracket will save $2,500 in taxes on $10,000 in deferred income. That means instead of just $7,500 having the chance to grow and compound over time, the full $10,000 is put to work.
The second advantage is that the overwhelming majority of people earn less money in retirement than they do during their working years. That means withdrawals are likely to be taxed at a lower rate: if your income in retirement puts you in the 10 percent federal income tax bracket, you’ll owe just $1,000 when you withdraw the same $10,000.
My employer offers a Roth 401(k). What’s the difference?
Roth 401(k) and IRA accounts work in the opposite way from traditional 401(k) and IRA accounts: you pay your ordinary federal income tax on contributions in the year the money is earned, but all withdrawals are tax-free in retirement. In general, these accounts work best for folks early in their career, who expect to be in a higher tax bracket in retirement.
Tip: Another way to look at the difference is as a kind of bet: if you think you will be in a lower tax bracket in retirement than you are now, you can use traditional accounts, while if you think your income tax rate will be higher in retirement, you can lock in your lower rate now with a Roth account.
Not all employers offer Roth 401(k)s — again it’s up to your employer what options you have available.
How much should I contribute to my employer-sponsored retirement plan?
When my partner asked me this question, my first answer was, “as much as you can afford to.” Then I thought about it for a moment, and corrected myself: “even more than you can afford to!”
The maximum amount that can be contributed to 401(k) and 403(b) (a similar type of plan offered by certain types of employers) plans is $18,000 per calendar year, or your total earned income — whichever is lower. That means if you start a new job mid-year, you can accelerate your contributions until the end of the year to maximize your total contributions. For example, instead of contributing $1,500 per month for 12 months, if you start a job in July, you can contribute $3,000 per month in order to reach the same $18,000 calendar year tax-advantaged contribution limit.
Many financial advisors will run all sorts of calculations to try to figure out how much you need to save during your working years to be sure of a steady and secure income in retirement. But instead of thinking of how much you need to save, I recommend thinking about how much you can afford to save.
How to do it
1. On your first paycheck at a new job, take a look at your take home pay.
2. Subtract all your regular expenses (it can help to use a budget management tool like the free online service Mint).
3. Add an additional buffer for unexpected expenses.
4. Then have the rest of your pay deferred into your employer-sponsored retirement plan (up to the applicable maximum contribution limits).
Maximizing savings has several obvious advantages. First, aggressive saving over the long-term might put you in a position to retire years earlier than your peers. Second, living on less income is a great habit establish early on that makes it easier to save even more as your income rises. Third, stepping up saving now could help you reach your savings goals even if you take an extended period of time off work later on, such as to care for young children.
Now that I’m saving for retirement, what should I invest in?
First, your employer may offer multiple custodians for your retirement plan. Examples include Fidelity, Merrill Lynch, Vanguard, and TIAA. Vanguard is owned by its mutual funds and is committed to a low-cost approach, while TIAA is operated as a non-profit, returning surplus fees to investors. Other account custodians are for-profit businesses and tend to charge higher fees, reducing the amount of your savings you ultimately get to keep.
Second, once you’ve selected a plan custodian, you’ll also need to select which individual investments to direct your deferred income into. Generally speaking, the younger you are, the more of your portfolio should be dedicated to stocks, which have historically offered higher long-term returns despite experiencing much higher price volatility than bonds.
If you’re the kind of person who would be horrified to see their investments drop 50 percent in value overnight, then add some bonds or cash to your portfolio to keep your balance steadier than an all-stock portfolio (while reducing your long-term returns).
Tip: Virtually all investment houses offer so-called “target retirement date” funds that will gradually shift your portfolio from stocks to bonds as you near retirement, the ultimate “set it and forget it” investment choice.
Vanguard also offers “LifeStrategy” funds which maintain a constant ratio of stocks to bonds. I ultimately recommended this final approach to my partner.
What do I do when the stock market goes down?
Absolutely nothing! Over the course of your saving lifetime, the market is going to do all sorts of things. We’ll see crashes, bubbles, revolutionary technological change, war, and peace. By making the same steady contributions month after month, you can ignore all of them. When investments are expensive, your contribution will buy less of them, and when they’re cheap, your contribution will buy more. Over 20, 30, or 40 years of saving, those differences matter less and less.
Ultimately, you don’t have any control over what the stock market does. Focus on what you can control: the amount of each paycheck you save.
How often should I check my account’s value?
My personal preference would be “never.” The less you check on your investments, the less likely you are to do something stupid, like change them. Still, once a year or so you may want to log in to make sure your contributions are being invested into the funds you specified, and that your mailing address and beneficiary designations are up to date.
What about IRAs?
Individual Retirement Accounts, or IRAs, offer many of the same benefits as employer-sponsored retirement accounts. Traditional IRAs allow contributions to be deducted against income in the year it’s earned, and withdrawals are taxed at ordinary income tax rates in retirement. Roth IRAs, like Roth 401(k)s, allow after-tax contributions and tax-free withdrawals. Roth IRAs are only available to those below certain income thresholds, currently $117,000 for individual filers.
Employer-sponsored retirement accounts and IRAs are two great tastes that taste great together: if you’re already making the maximum contribution to your employer-sponsored plan, additional savings can be directed to an IRA. You can even mix and match a traditional 401(k) with a Roth IRA, or vice versa.
Finally, after you separate from your employer, if you’re unsatisfied with the investment options in your 401(k) you can “roll over” the balance to an IRA at any institution and gain more control over your investment options.