You just signed the deal. After spending some time weighing offers and negotiating, the technology job you’ve been pursuing has become a reality. The salary works. The hours work. The commute works. The table has been set for present day success. Don’t forget about the future. At some point, a career will give way to retirement and you’ll need to fund that goal during your working years. Most companies in private industry have shifted the burden of retirement savings to its employees. Traditional pension plans, where monthly payments tie to years worked or a similar measure, have become less common. You may be more familiar with a 401(k) plan which requires regular contributions that are often matched by employer dollars. Whatever plan your company offers, be sure to participate and focus on the long haul. Whether it be 10, 20 or 35 years down the road, you’ll need a decent-sized nest egg to maintain your lifestyle after you quit working. Since it’s the most prevalent employer retirement plan, what follows is an overview of the 401(k) plan and investment strategies to help you build wealth for the future.
A 401(k) works simply. You elect to have a portion of salary withheld each pay period. If you earn $100,000 annually, you can choose to sock away up to $18,000 or 18% of gross income in 2017. Two of the main advantages of investing in a 401(k) involve taxes. Contributions made to this retirement vehicle reduce your taxable income as those dollars get invested before withholding taxes. Say you contribute the maximum. Your $100,000 salary now becomes $82,000 for the purposes of taxes such as federal, social security, state and local income taxes on your total gross earnings. You’ve truly earned $100,000, but you’re only being taxed on $82,000.
The second tax advantage applies to the investment earnings on your pot of 401(k) dollars. Any earnings from variable or fixed accounts (more on these later) are likewise exempt from income taxes until you access those funds. Withdrawals taken from the account become taxable as ordinary income. In most cases, an IRS penalty applies to any money you take out of a 401(k) prior to age 59-1/2. But, early withdrawals made under certain circumstances avoid the 10% IRS levy. Penalty-free dollars can be taken out prior to age 59-1/2 and used for college tuition, first-time home buyer down payments or expenses incurred due to a financial hardship. The basic concept of tax deferral posits that income in the post-retirement phase should be less than income in your working years. Thus, periodic withdrawals made to supplement retirement income should be taxed at lower rates.
The third benefit to 401(k) participation results from matching company funds. Many organizations contribute company dollars to your account, and those assets add to the pool. That money belongs to you. A typical arrangement might see the company toss in 6% of your salary if you do the same. So the $18,000 you’ve contributed amounts to $24,000 after company contributions are accounted for. Be aware of vesting options. Many firms use a sliding scale to determine how much company money you can walk away with should you change employers. A typical vesting schedule might hold that 20% of company funds become yours after the first year of employment, 40% after two years, 60% after three years, etc. Some businesses vest immediately, meaning that you own company contributions from the time they are made.
Before you get started with those contributions, you’ll need to choose how those dollars get invested. Most 401(k) plans offer a number of investment options that range from ultra-aggressive investments to conservative ones. If you’re not sure what type of investment to select, you’ll need to ask yourself a few questions. The first involves risk tolerance and that $18,000. How would you feel if that dollar amount decreased to $12,000 during the following year? You can either panic or push on. If you’re the type of person who can’t stomach any decrease in investment value, a conservative investment option would likely be your best bet.
The second question involves time horizons. How long will it be before you plan to use the money? If you’re 25 and just entering the workforce, it’s conceivable that you will work for 30-40 years. If so, you have much more time to recoup investment losses than a 60-year-old employee who plans to work for another five years. Folks closer to retirement age typically want to preserve capital, ensuring that what they’ve invested will be there when they hang it up. Many younger investors will realize time is on their side. Remember that $18,000? If it had declined to $12,000, more aggressive investors view time as an ally. There will be plenty of opportunity through the years to recover from that $6,000 in depleted value.
From these two basic questions, a risk profile develops. Regardless of age, if losing money haunts you, it signals a conservative or risk-averse approach might be the best fit. By contrast, if you understand the concept that, over the long term, the stock market has historically outpaced fixed investments, you probably fall in the moderate to aggressive investor category.
401(k) Investment Options
In the 401(k) universe, you can invest in company stock, mutual funds or exchange-traded funds (ETF). Company stock involves putting all your eggs in one basket. If you land a position with Amazon or Google, the growth of these companies has made both employees and shareholders very happy as share prices have skyrocketed since the initial public offerings of those stocks. If you had invested $1,000 in Amazon stock in 1997 at $18 per share, that initial purchase would have been worth $639,900 on May 12, 2017. Of course, not every company will perform like Amazon and past results should never be used to predict future returns. Before investing all your dollars in company stock, consider the quality and potential of your employer’s products and services, its competitive advantage and most importantly, its financial standing.
Mutual funds pool your money with the funds invested by thousands of other shareholders. That pool of money is used to buy the stocks or bonds issued by many different companies, lessening the risk to your investment if a few of those companies perform poorly, while others hold the line. The size of the fund might be enormous, often $1 billion or more. With that much capital at stake, mutual funds hire seasoned professionals and analysts who choose which stocks to buy, sell or avoid completely. Stock funds, representing fractional ownership in many organizations, tend to be more volatile than bond funds, whose underlying securities represent a company’s promise to pay back the money it has borrowed to finance operations. You, in accordance with your risk tolerance, can choose to allocate dollars to stock funds, bond funds or a combination of both asset types.
ETFs, like mutual funds, pool the aggregate dollars of many investors. These funds trade on an exchange and generally have lower operating expenses than mutual funds. Further, ETFs allow access to unique markets to which mutual funds don’t generally reach. If you desire to invest in Vietnamese companies, that option exists. Such specialized ETFs tend to be riskier than a domestic large-company mutual fund. Carefully read prospectuses for each investment before you decide where to park your money.
All these decisions merit some deliberation, and possibly some advice. Seasoned investors might pilot a retirement portfolio by themselves or lean on a machine for help. While robo advisers mostly cater to individual accounts, FutureAdvisor will manage a 401(k) for free if it’s part of a Fidelity BrokerageLink account. Full-service brokers don’t typically cater to the 401(k) market in an individual advisory capacity. But if you currently use a money manager, they may be willing to offer a bit of advice. A career change may be the point where a financial consultant will step in. Rollovers and direct transfers can be tricky. You’ll need expert guidance to explore the most prudent path, avoiding any taxable events.
You know how much you can afford to invest and where you should invest it. How does all of this knowledge translate to the bottom line? Let’s examine the plight of three 401(k) participants. Warren, a 50-year-old data scientist is highly risk averse and currently contributes $100 per paycheck into his retirement savings plan. His 401(k) offers numerous investment options but the only one that appeals to him is a fixed account. Fixed accounts invest in ultra-safe investments such as U.S. government bonds, money markets and certificates of deposit. These types of investments offer virtually no risk, but very little reward. With treasury and lending rates at all-time lows, the fixed account option currently guarantees Warren a mere 2% annual rate of return on his money. The guarantee insinuates that our conservative investor will suffer no loss to principal throughout the term of the contract. If Warren gets paid bi-weekly, he will have contributed $2,600 annually to his 401(k) plan. Assume that he wants to retire at age 65 and the fixed account rate stays the same through the 15 years in which contributions continue. In that fifteen year period, Warren’s total investment is $39,000. At 2%, not accounting for taxes or inflation, that total grows to $45,394 at the end of 15 years.
Our second investor is named Marissa. Marissa, at age 40, understands that inflation erodes purchasing power. In order to successfully reach her retirement goal, she needs to average 6% annually to outpace inflation, which historically runs around 3.5% per year on average. Accepting some risk, Marissa opts to put her money in a combination of stock and bond mutual funds, 60% in the former and 40% in the latter. She has adopted a balanced approach, mixing conservative bonds funds with more opportunistic stock funds. Getting paid twice per month, Marissa is an aggressive saver and contributes $500 per pay toward her 401(K). Her goal is to retire at age 60. Through that 20-year period, she will have invested $240,000. When retirement beckons, our balanced investor will have amassed $453,439. The power of tax-deferral can be seen in this example. Had Marissa invested the same dollars in a taxable vehicle outside her 401(k), that amount, net of 25% federal and 6% state taxes, shrinks to $373,029.
Elon is our third case. Elon works at Northrop Grumman and for the wide-eyed 25-year-old, not even the sky is the limit. He has educated himself on stock investing and knows the considerable risk that comes along with it. He has an ultra-aggressive approach to investing. Knocking down $250,000 annually, the young rocket scientist can afford to allocate $750 per bi-monthly paycheck into his retirement plan, maximizing his annual contribution. Elon expects to work until age 70 when his Social Security benefits will peak. After 45 years, he has invested in nothing but company stock. The average annual return in Northrop Grumman stock turns out to be 12%. His total investment through age 70 is $810,000. At retirement, Elon’s 401(k) account amounts to a whopping $25,765,280. Let’s examine the time value of money. Since the stock has performed so well, Elon decides to say goodbye to the space race at age 60. By foregoing the extra ten years in the market, Elon’s account value would then be about $8,188,457 or less than one-third the value that it would have been had he hung around until age 70.
Wrapping It Up
Contribute what you can afford without strapping yourself. The most important rules in retirement planning state that you should get started as early as possible and continue to make contributions throughout your career. As retirement nest eggs go, bigger is indeed better. Changing teams? No big deal. Many employers allow you to rollover 401(k) balances from a previous job. You also have the ability to transfer an old 401(k) to a self-directed individual retirement account (IRA). Neither the employer rollover option nor the individual transfer option has any tax consequences if executed properly.
Getting a late start need not be a concern either. The IRS allows catch-up contributions of $6,000 that can be added to the $18,000 maximum in 2017. Individuals who plan to close the gap must be 50 or older. As with any investment plan, be sure to consult with an investment professional and tax adviser before getting started. Companies may grant employees access to plan administrators who can offer pertinent advice about investment choices and plan design. With retirement funding, the ball is in your court. Run with it and enjoy the years where you no longer punch the clock and answer only to yourself.
Retirement plans figure as a vital part of any benefits package. Tremendous opportunities for savings and wealth creation stem from working at tech startups that plan to go public or established firms whose stock shows great potential. Always be on the lookout for new opportunities to boost investable income. That search may lead you to a promotion in a current position or a higher-paying job with another firm. If you’re considering asking for more money or moving on, Paysa has tons of data on tech jobs, salaries and company rankings. Browse Paysa.com before you make your next career move.